Friday we wrote about the striking down-move in the euro. (You can read that short piece here. Here's a short-term chart; here's a longer-term one.
The up-move that started in mid-2010, from $1.20 to $1.45(ish) is the eurozone trying to fix its problems by making sure troubled economies are able to make debt repayments to bankers.
Those attempts included (1) austerity (lots of it); then (2) preventing defaults by offering lower-interest loans to troubled governments; then (3) an attempt to create "Eurobonds" as a source of funds to help these same governments. Only debt restructuring and debt forgiveness are off the table (because bankers would then take some of the losses; can't have that).
That long up-move in the euro, which shows optimism, may be ending. I took my cue from the market. Here's Paul Krugman on the same subject. His key point:
[T]he fact that European nations no longer have their own currencies leaves them vulnerable to self-fulfilling debt crises – in effect bank runs on governments rather than banks (although those too).Think about that for a second — a bank-run on a government instead of on a bank. In other words, instead of people racing to be the first to get their money out of a bank, they race to get their money out of a government.
Why? Because the usual way for a government in debt trouble to get out is to deflate [CORR: devalue; this commenter is correct and my brain is made of butter] their currency. This creates a run on the currency until it finds a bottom and the economy recovers (usually via an export boom; if your currency is cheap, your exports are cheap). But it leaves the government free to still borrow.
But what if you can't devalue your currency to fix your debts? In that case, there's a run on the debt itself, on your bonds. As your ability to repay appears to be less and less, people sell off your bonds to get the highest available price in a rapidly falling market, and that panic selling acts like a bank run. Eventually, those government bonds go to junk.
Then what happens? That government goes broke — (1) If the economy's in trouble, its tax revenues fall. And (2) if its bonds are junk, it can't borrow. Just like a bank run breaks the bank, a bank-run-type sell-off of government bonds breaks the government.
All because they can't devalue the currency first.
For Krugman and others, the solution to fixing the euro and the eurozone is to create a "lender of last resort," since the market won't lend. And this week's news on that front is bad (my emphasis):
To head off this risk, somebody – the EFSF, the ECB, whatever – has to be ready to act as lender of last resort; Eurobonds would have served much the same purpose."Self-fulfilling crisis" is another name for a bank run. People panic because everyone else is panicking, and the race is on.
By resigning from the ECB, Juergen Stark has conveyed, deliberately or not, the message that there will be no such lender of last resort, that there isn’t enough political cohesion in the eurozone to stand behind countries under market attack. And this translates directly into soaring spreads for Spain and Italy; the self-fulfilling crisis is on.
Krugman's not the only one who sees the death of the euro (or at least its shrinkage to the supposedly "strong core" countries, like Germany). As the Professor notes, Barry Eichengreen sees the same. (I may have more to say about Eichengreen later. He appears to want both backstopping the banks and debt relief. He also thinks "domestic public opinion" is what's constraining the core governments. I guess that's why he's considered a conservative.)
My question is: Assuming the worst, what's the outcome? I see three scenarii (plural of scenario [EDIT: or not]):
- ■ The eurozone could shrink to the "strong core" (and northern) countries, like Germany, France, and a few others. The result would be a stronger euro, after the dust cleared. (That dust would include incredibly cheap drachmas, lira and pesetas — plus the collapse of governments.)
■ The core northern countries could try to hold the whole project together against all the market forces allied against it. This could kill the euro for all of them (Eichengreen's scenario).
■ The core northern countries are secretly weaker than anyone thinks. That kills the euro, puts the EU at risk as well (since everyone's grabbing for the same shrinking pie, they become competitors instead of partners), and adds another boat-anchor to the American economy (since a continental market for American goods shrinks, instead of just a few national ones).
If a balanced and effective solution doesn't emerge soon, scenario 2 or 3 above looks more and more likely. (Sorry for the length; hope this helps you make sense of this topic.)
GP
