When the seventeen countries that make up the Eurozone joined the monetary union, they each gave up a very important privilege: the ability to borrow in their own currency. For most members, this seemed at first less a concession than a windfall. Rather than paying a premium over the German benchmark, Eurozone members saw their borrowing costs fall to near parity with their German neighbors. Investments poured across European borders, as the removal of exchange rate risk and capital controls promoted financial integration within the Eurozone.
Capital flows to the periphery grew strongly, as increased investment opened up new avenues for economic growth in countries like Spain and Ireland, which became celebrated as the ‘Celtic tiger.’ But even as capital flowed like rum punch at a good cocktail party, the high times masked a crucial design flaw that has now become an existential threat to the survival of the Euro.
Countries that maintain monetary sovereignty and the ability to borrow in their own currency – like the US, UK, Japan and Switzerland, can never be forced to default. In the event of a collapse in investor confidence, their central banks can always step in and monetize the debt. This might cause inflation, but there will be nominal repayment. Liquidity crises can never lead to sovereign insolvencies in these countries, because central banks will act as lenders of last resort. Even if private creditors no longer want to buy sovereign debt, central banks in these countries can always buy the debt and prevent a default.
By contrast, all members of the Eurozone are vulnerable to a ‘sudden stop’ of capital inflows that can force default on otherwise solvent borrowers. This is the ‘original sin’ of the single currency. It is essentially the same original sin identified by
Barry Eichengreen and Ricardo Hausmann in their seminal study of emerging market debt crises. Eurozone capital markets are ‘incomplete,’ because they lack a lender of last resort that can guarantee sovereign borrowers’ access to liquidity. Eurozone members issue debt in what amounts to a foreign currency. By subsuming their central banks into the ECB, Eurozone members did not simply subject themselves to a one-size-fits-all monetary policy (the ECB failed to take away the punch bowl once the party got going in Spain and Ireland because other Eurozone members were experiencing slower growth), they lost a crucial insurance policy that protected them from sovereign liquidity crises.
The European Central Bank could conceivably fill this role. However, it was created with but a single mandate – price stability – and important restrictions on its ability to intervene in the Eurozone’s sovereign debt markets. German citizens, with their historic fear of hyperinflation, were promised that under no circumstances would the ECB monetize the debts of other European countries. But this principle has left the members of the Eurozone at the mercy of financial markets and self-fulfilling prophecies of ruin.
A sovereign liquidity crisis is analogous to a bank run. When depositors withdraw their money from a bank en masse, the bank can be forced to close because the maturity mismatch on its balance sheet – it has borrowed short and lent long – has left it vulnerable to a sudden withdrawal of funding. Likewise, in the Eurozone, sovereign borrowers have short term funding needs, and are long domestic tax revenues. That is, their ability to pay off their debts is dependent upon their long run growth prospects. But even if their long run prospects are good, in the short run they may be subject to a liquidity crisis just like a run on a solvent bank.
If investors lose faith in the ability of a country to service its debts – whether that belief is justified or not – they will withdraw funding and trigger a liquidity crisis that the sovereign cannot unilaterally halt. No single Eurozone member can force the ECB to act as a lender of last resort and buy its sovereign debt. The countries facing sovereign liquidity crises can now only borrow at interest rates that are higher than their economic growth prospects. They face a debt deflation trap – as borrowing costs rise, prices and output fall, creating a vicious cycle that feeds on itself and leads inexorably to default.
As
Paul de Grauwe has presciently pointed out, the free movement of capital within the Eurozone amplifies the liquidity crises and spreads contagion throughout the financial sector. If an investor owns Italian bonds and wishes to sell, he will likely not put the proceeds of the sale into an Italian bank account, but rather will choose a German bank, Dutch bonds, or other safe place to park the money. In this way the money supply in Italy shrinks, further constraining credit in the domestic economy and lowering long run growth prospects.
Thus a run on sovereign debt will also cripple the domestic financial sector. As liquidity leaves the country, banks find it more and more difficult to raise funding. And since banks routinely hold large amounts of sovereign debt as core capital, any sovereign default would trigger insolvency in the domestic banking system. This run on banks in the defaulting country would quickly spread contagion throughout the Eurozone’s financial system.
What is worse, countries facing liquidity crises cannot employ counter-cyclical macroeconomic policies to restore economic growth. They must instead take severe austerity measures – cutting spending and raising taxes – because their ability to run deficits and borrow more money has been compromised. Nor can competitiveness be restored through currency depreciation. Instead they can only adjust through internal devaluation – cutting wages and prices. These pro-cyclical fiscal policies will only make recessions deeper and debt deflation dynamics more toxic.
The upshot is that if an initial shock leads to a sudden stop of capital inflows in a Eurozone country, the fear of insolvency will become a self-fulfilling prophecy. Greece is insolvent and will likely default soon. Financial markets will then wonder who is next. If financial markets continue to demand sharply higher interest rates to lend to governments in Spain, Italy, even France, all these countries could face insolvency as well. Their status in international capital markets is now akin to that of emerging market borrowers. Because they do not have their own currency and a central bank to lend to them when private creditors will not, they are all at risk of the equivalent of a bank run and ultimate default.
The solution is for the ECB to act as lender of last resort. It is the only institution that can halt the liquidity crisis. Only the ECB has the firepower to overwhelm speculators who bet against sovereign borrowers. Plans for a bailout fund financed by Eurozone governments are too small to do the job, and too subject to political opportunism, as yesterday’s vote by Slovakia shows. Any fund that requires approval by 17 different parliaments is unlikely to be big enough or to be put in place soon enough to prevent sovereign liquidity crises in Spain, Italy, and France once Greece defaults.
This solution is far from ideal. It will not solve all the Eurozone’s problems and needs to be coordinated with the introduction of some sort of Eurobond as described previously. There is also a real risk of moral of hazard associated with ECB purchases of sovereign debt. The ECB has, of course, already dipped its toe into these waters. But the backlash these purchases caused, including the resignations of Jurgen Stark and Axel Webber, has prevented the ECB from taking more decisive action. The Eurozone no longer has the time to allow the perfect to be the enemy of the good. Sovereign borrowers need an insurance policy against liquidity crises, and only the ECB can provide it.
Ben Carliner is a Fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. Mr. Carliner has also worked for Barron’s Business and Financial Weekly and WBAI Radio in New York. He holds a B.A. from the University of Wisconsin-Madison and an M.A. in International Political Economy and Public Policy from the University of Texas-Austin. The original article can be found on Ben Carliner’s blog.