On 5 February 2010 the euro fell to US$1.36, the lowest level over the last nine months.
At first - roughly from August 2008 until March 2009 - the global crisis was accompanied, paradoxically, by a sharp appreciation of the dollar with respect to other major currencies including the euro. Faced with a global recession, worldwide investors run for cover and for safety and poured assets into the United States – the eye of the storm – investing mostly in US Treasury Bills. Then the dollar resumed its natural downward trend, out of concern for the rising budget deficit and the continuing worsening in the foreign investment position of the United States. By early September 2009 there were fears that the appreciating euro might soon overstep the US$1.55 mark past which Germany would cease to be even moderately competitive. But the euro recovery was short-lived, soon countered by worries about the worsening fiscal position of euro-zone member countries like Greece, Spain, Portugal, and Ireland (which replaced Italy in the derogatory PIGS acronym). Such worries included the possibility of Greece defaulting on its public debt, its subsequent exit from the euro-zone, domino effects on other heavily indebted high-deficit EU members both inside the euro-zone and outside (from the UK to Latvia), right down to the possibility of euro-zone dis-integration. At the same time there were widespread expectations of a bail-out – if need be – of troubled European economies, whether bilateral or pan-European, buttressed by IMF interventions, in order to prevent the feared catastrophic effects of country default.
All these perceptions – of likely sovereign default, of its catastrophic effects including default contagion, of forthcoming bail-out – were vastly over-inflated.
Sovereign debt differs from private debt in that sovereignty is a major obstacle to creditors impounding debtors’ gross assets to satisfy their rights, even if and when there are enough sovereign assets to match sovereign debt. Mostly, any impounding is purely symbolic, limited to aeroplanes and ships located outside the debtor country, and within the creditors’ reach.
Thus, in a sovereign crisis, debtors have the upper hand. The ultimate deterrent to sovereign default is the debtor’s fear of losing competitive access to international financial markets; this usually forces debtors and creditors to come to terms with default and agree forms of debt and/or interest reduction and re-scheduling. The ultimate incentive for outsiders to step in with a bail-out, providing on some terms (ranging from gift to expensive loans) the financial resources necessary for a debtor to meet outstanding obligations and avoid default, is the fear that sovereign default might seriously damage the financial position of creditors, in particular banks, in the outsider state considering bailing out the defaulting sovereign. A complex game develops: if it is confidently believed that a bail-out will be forthcoming, the bail-out itself may become unnecessary, but a change in such confidence may precipitate a default and brutally test bail-out credibility.
Here three qualifications are in order.
First, today the fiscal position of most countries in the world, in terms of both government deficit and debt, has significantly deteriorated due to the fiscal stimuli that have been mobilized to avoid a major depression on the scale of 1929-32, as well as due to their GDP fall and the related growth of social expenditure. A premature exit strategy by Central Banks and Government budgets may raise the probability of default rather than reducing it (see Olivier Blanchard’s warning in a recent interview with Les Echos Les Echos Olivier Blanchard).
Second, market expectations and credit rating agencies are based not on current parameters of deficit and debt, but on their current increments, which are extrapolated into an uncertain future; this intensifies – unduly and unfairly – the impact of current adverse trends even when levels of deficits or debts are still far from any reasonable danger threshold.
Third, before reaching the point of sovereign default there are financial discipline procedures (the Growth and Stability Pact for EU members, regardless of whether they belong to the euro-zone; IMF procedures for all) and conditional assistance that provide both the penalties and incentives to make much less likely the occurrence of sovereign default – although tough fiscal measures might trigger off a political crisis (see the Greek strikes in response to proposed cuts in nominal wages) and possibly a change of government and fresh opposition to austerity. Greece avoided the stringency of EU disciplinary procedures by falsifying official statistics, but is now being monitored all the more strictly after being found out.
What is not at all clear is whether EU institutions and member states, within and without the euro-zone, can be relied upon to provide financial resources to bail-out a fellow EU or euro-zone member. A small country’s default could be easily digested, but what should be the critical size, and how can moral hazard be avoided? We have noted in three previous posts, on European Bail-Outs , on A non-bail-out bail-out and on Sovereign Default , the dangerous ambiguity of the “Moscow rules” enshrined in EU Treaties. Apart from the legal obstacles to EU bail outs, voluntary assistance by individual euro-zone members to help their troubled neighbours – of a kind recently advocated by Le Monde for Greece – may also come up against legal hurdles (article 123 of the EU Treaty, http://openeuropeblog.blogspot.com/2010/01/another-twist.html). And in any case it is not clear whether the “exceptional circumstances” in which the Council can authorize assistance to a member-state would include a financial crisis: in an interview with Frankfurter Allgemeine Zeitung, German EU Law Professor Matthias Ruffert “completely rejects the idea that the financial crisis could credibly be defined as “exceptional occurrences beyond [the Greek government's] control”, saying: "state debt certainly cannot be counted among those [exceptional circumstances]."” Alternatively, reliance on the IMF is also problematic: paradoxically, the very suggestion that the IMF might step in to assist Greece ahead of European institutions has been interpreted as an indication that these last are not going to help, and made things worse instead of better.
However, suppose Greece did default. Bad news for its creditors, both domestic savers and the foreign holders of 73% of Greek public debt; bad news for the Greek government’s ability to re-finance the debt and fund the deficit; bad news for the Greek stock exchange and other stock exchanges, that all fell heavily on 4-5 February 2010 in response to the widening of Greek spreads. But would there be a domino effect on other defaults? Undoubtedly interest rate spreads and Credit Default Swaps would increase for all weaker countries, but additional defaults would not necessarily occur, and in any case not immediately, not simultaneously in different countries, and not in all countries. The euro exchange rate with other major currencies would weaken, but the very existence of the euro would not be at stake. Mr Trichet reminded us recently that the financial difficulties of Greece, representing 2.5% of the euro-zone GDP, could not possibly have a greater adverse impact than that exercised on the dollar by the financial difficulties of California, that represents 14% of US GDP.
The headline “Markets are starting to bet on Euro area disintegration” (Eurointelligence.com, 5 February) is not just wrong, it is plainly silly. Markets have been factoring in uncertainty about defaults and bail-outs, but the fall of European stock exchanges does not imply disintegration of the euro-zone by any stretch of the imagination.
Of course the euro-zone would ride the storm more smoothly and efficiently if three conditions were satisfied:
1) “a robust and transparent system of crisis management”, formally approved by national parliaments, involving conditionality to the point of some loss of sovereignty, in order to avoid moral hazard;
2) a reduction in internal imbalances, involving action both “in countries with large current account deficits, such as Greece and Spain, and in those with large surpluses such as Germany.”
3) a renewed effort “to construct a meaningful financial supervisory regime” (Wolfgang Munchau, in the FT of 1 February). But these are not conditions for eurozone survival, as Munchau claims.
The euro can survive just as it is – although official EU talk of “constructive ambiguity”, leaving vague and indeterminate what would happen in the worse case of Greece defaulting, while discouraging and talking down any involvement by the International Monetary Fund, creates the worst of all possible worlds in which a default could occur.