Friday, February 12, 2010

Should the Euro Have Slipped on Greece?

The United States and the Eurozone are both currency unions. Member states within each union are prohibited from issuing the common currency. Money creation is delegated to a central authority (the Federal Reserve in the U.S. and the ECB in the Eurozone). The US dollar and the Euro are both major world currencies.

Given these similarities, my question is this: Why is the recent Euro depreciation being explained by the fiscal problems experienced by a subset of Eurozone members?

Actually, let me put the question another way. Why are state-level fiscal problems in the American Union not associated with sharp depreciations in the USD? (California, by the way, is an economy larger than Greece, Portugal, and Spain combined).

One difference between the U.S. and the Eurozone is that the latter has no central tax authority to accommodate wealth transfers (bailouts). In fact, Article 103 of the Euro Treaty explicitly states that the EU shall not be liable for or assume the commitments of central governments.

Another difference between these two unions is that there is no counterpart to U.S. treasury debt in the Eurozone. Hence, while the Fed "monetizes" federal-level debt; the ECB "monetizes" state-level debt (in this case, sovereign debt).

So, perhaps the answer to my question is as follows. When California experiences a fiscal crisis, markets expect it to be bailed out by federal transfers; the market does not expect the Fed to monetize California state debt. This does not pose a direct inflationary concern, and hence is ignored in the FX market. The opposite holds true for the Eurozone; hence, the direct impact on the exchange rate.

There are several reasons why I am not satisfied with this answer. One has to do with my preferred theory of the exchange rate, but I'll leave this aside for now. The other has to do with the perceived credibility of the ECB. I doubt very much that the ECB will monetize Greek debt (and if it does, it will discount it heavily) and I don't think the market believes this either. The market likely believes that a bailout is coming (you don't actually believe that Article 103 is credible, do you?).

The bailout will be sold as "saving Greece;" but in fact, the bailout will in effect save the Germans and other Europeans holding Greek bonds. In short, a typical wealth transfer. Disgusting, perhaps...but inflationary, no.


  1. Thanks for addressing a few unanswered questions. As yo point out, Greece's economy is such a small part of the total European economy, why the fuss?

    Some of the pundits have commented that if Greece defaults on its public debt, the crisis would set of a chain reaction that would affect other fiscally vulnerable European countries. Is there a legitimate worry of a domino effect with real economic impacts here? Or is the implicit concern once again the welfare of other-country bond holders?

    In passing, it is fascinating to observe that Olympic Games debt played a significant role in this crisis. Does the rich history of Greece inspire Greeks to greater things or simply burden them?

    Rampant corruption is not part of the official history but may have historically permitted Greek City-States to achieve great things.

  2. Paul Krugman has an op-ed on this subject publish 14Feb10 in the NYT here: The Making of a Euromess

    He seems to imply that national prices cannot adjust without huge economic dislocation. He also leaves unanswered the question of what Europe could have done to become more "ready" for a currency union.

    But more fundamentally, I think Krugman too easily forgets the centuries of brutal tribal and colonial warfare that have periodically ripped Europe apart. Am not sure that Krugman's focus on near-term outcomes is all that helpful.

  3. Lots of food for thought. As a result of reading this post, I found this article:

    One quote that got my attention was this:

    "But German and French leaders doubtless would be happy if world markets resume ignoring Greece’s obvious problems until some undefined time in the future, as markets did for a decade. Meanwhile, Greeks would continue to suffer in an economy suffocated by a bloated public sector and too much debt."