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The · Psychohistorian


The Eurozone crisis

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In the U.S., when one state has a fiscal crisis - even when it's our largest state, California - we don't worry about the U.S. as a whole. What's different about Europe that the entire Eurozone is so concerned about the fiscal issues of a few of its states - Greece in particular?

After following this issue for months, I think the difference is that the Euro is a relatively young currency, and the states in the Eurozone have not yet fully adapted to the realities of a common currency. In contrast, the common currency among U.S. states has been around for centuries, long predating modern central banks.

First, I would note that the problem is not fundamentally a problem of trade imbalances. Trade imbalances can be solved in the E.U. the same way they are solved in the U.S. - by gradual adjustment of relative wages, which is why wages are lower in Mississippi than in Massachusetts. Free migration also exists within the E.U., as it does within the U.S., though I don't think it's clear whether that acts to moderate or exacerbate balance of trade issues: California's current loss of productive workers to Texas helps Texas, not California.

The problem in the Euro zone, however, is a problem with government fiscal discipline, not a problem of trade imbalance. With the low initial borrowing costs for Euro zone governments, the Greek government borrowed its way deep into debt to dispense largesse to unions and government workers. It has now racked up debt that amounts to about 160% of its GDP, and doesn't have the tax receipts to support that debt.

Normally when a government borrows beyond its ability to repay, the interest rates it must pay go up to incorporate an increasing risk premium for the higher probability of default. There's increasing pressure to reduce borrowing to avoid high interest costs, and the government budget normally comes back towards balance. Sometimes the fiscal issues aren't corrected in time, the government defaults, and the cost is borne by the bond holders. This is all part of normal functioning of the bond market, and market forces act to keep that market working reasonably well.

In the case of Greek government debt, though, market forces didn't really start affecting that debt until a Eurozone wide crisis developed, and even now, European governments are taking extreme measures to avoid a simple Greek government default. Why?

In my opinion, it is because the Eurozone financial superstructure has not yet adjusted to a unified currency. In particular, individual state central banks have been behaving as they did during the old multicurrency system, rather than adapting to a single currency.

Before we continue, let's think about what the purpose of a central bank is. Unlike, say, an investment bank, a central bank isn't there to make money. Rather, the primary purpose of a modern central bank is to manage a nation's currency. For example a central bank makes the tradeoff between interest rates and inflation that determine the long run value of the currency. In addition, central banks are often tasked with helping to control short term currency fluctuations. For this purpose, they hold reserves of other currencies, and sometimes coordinate buying and selling of currencies to buffer unsustainable exchange rate fluctuations.

Once we realize that the purpose of central banks is to control the value of a currency, it becomes clear that a sovereign that doesn't have its own currency doesn't need a central bank. In the U.S., that's how it works: states haven't had their own currencies since long before central banks existed, so they never established their own central banks. Only our federal government needs a central bank.

In Europe, however, each state had its own currency, and its own central bank, before currency unification at the turn of the century. Before unification, those central banks held substantial reserves of other states' currencies in the form of bonds from those other states' governments. After currency unification, they still held bonds issued by those other states' governments, albeit now all denominated in Euros.

These state central banks, while obsolescent, in my opinion explain why Europe has a Euro zone crisis rather than merely one or a few individual state crises. Central banks tend to hold a portfolio balanced by state, rather than optimized for financial return, so they continued to buy Greek government debt even after that debt no longer represented a separate currency. This explains why Greece was able to continue borrowing at low interest rates for longer than market forces would normally have permitted: Greece was borrowing heavily from central banks, not just from true market players.

This also means that a Greek default would have a disproportionate impact on those other states' central banks that hold Greek government debt. This could lead to the 'contagion' that the Eurozone fears - especially if the default would tempt or force other high debt nations like Spain and Italy to default on their debt as well. These central bank holdings explain why Europe as a whole seems so anxious to avoid a Greek default, even to the point of offering huge bailout packages. It also explains why the bailout package calls for renegotiation only of Greek debt held by private parties - the other governments don't want to lose money on their central bank holdings, but are fine with distributing part of the pain to Greeks who are holding their own government's debt.

Ultimately, I suspect the state central banks in the Euro zone will cease holding foreign reserves, and will simply become de facto local administrative arms of the European Central Bank, similar to the regional Federal Reserve banks in the U.S. Indeed, the foreign reserves of the Greek central bank appear to have already evaporated, going from $22 billion ($22,000 million) when it joined the Euro to a mere $69 million in 2010. European state bonds will then become subject to market forces, just as in the U.S. The present Eurozone crisis is simply part of that transition process.

Additional reading:
http://www.europeaninstitute.org/EA-April-2011/debt-default-by-eu-government-messy-but-probably-not-the-end-of-the-eurozone.html
http://www.frbsf.org/publications/economics/letter/2008/el2008-37.html
Source for Greek central bank reserve amounts:
http://webcache.googleusercontent.com/search?q=cache:8Ha50IqD5vEJ:www.finova.com.sg/news/Detail_news/282.html+&cd=2&hl=en&ct=clnk&gl=us
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On February 12th, 2012 10:13 am (UTC), izmirian commented:
I'm no expert on these matters but it looks like the US states just don't run up very much debt as a percentage of gdp. California state debt is around 7% and even if you include local debt it's around 19%. Massachusetts is the highest at 25% but that's still quite small compared to the Greek 160%.
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On February 12th, 2012 03:43 pm (UTC), treptoplax replied:
Do any of those measures include pension obligations?
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On February 13th, 2012 03:04 am (UTC), psychohist replied:
In the U.S., state spending is only a fraction of governmental spending. If you look at state debt compared to state budget, the numbers won't be so far off.

That said, most states do balance their budgets; perhaps Eurozone states will too, eventually, once they get used to the idea of not being able to inflate their way out of problems.
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On February 12th, 2012 03:53 pm (UTC), treptoplax commented:
bonds
I think that part of the issue is that wage adjustments aren't happening because of government wage controls.

Also, if I recall correctly, EU regulators allowed banks to treat any eurozone government bonds as essentially risk-free for purposes of calculating capital reserves... obviously this would make high-yield Greek debt attractive.
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On February 13th, 2012 03:07 am (UTC), psychohist replied:
Re: bonds
I think the wage adjustments are a symptom rather than a cause. Indeed, much of the "austerity" package Greece is trying to pass consists of wage adjustments, such as elimination of the extra months of salary for government workers.

I agree that the regulatory treatment of government bonds contributed to the problem. Of course, a well functioning bond market would be investing to actual market conditions, rather than investing to regulations.
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