The home-currency problem in the euro area
In a recent article, Satyajit Das discussed what determines the sustainability of government debt of crisis-ridden European countries. Beside the level of interest rates and maturity structure, the size and structure of the economy, and current and expected economic growth the list includes the currency in which debt is denominated. Regarding the experience of the US, Japan and the UK borrowing in a country’s own currency has considerable advantages:
Instead of being exposed to the risk of exchange rate changes, and the moods of international investors, the government can finance its expenditures relying on domestic lenders whose “flight instinct” is much less pronounced and whose saving and investment decisions can be influenced in many ways. Furthermore, in issuing their own currency these countries cannot become insolvent.
A comparison of currency denomination in bond markets in the euro area and other regions (table 1) at first view is reassuring. The share of local currency in Europe is lower than in Japan and other Asian countries, but with around 90 per cent it has been constantly high in recent years – and much higher for example than in Latin America.
However, the picture is misleading. Less than in other world regions, in the euro area “local currency” also means “local investor”. Intra-European investments are high and shares of foreign investors differ considerably among countries. Das indicates that in Greece 91 per cent of government debt is held by foreign investors, in Ireland, Portugal and Italy the numbers are 61, 53 and 51 per cent respectively, and even in France (50 per cent) and Germany (41 per cent) they are high.
Does this mean that in an acute crisis in some countries about half of the government debt is particularly prone to fear and panic, or – to put it the other way around – can at least half of it be expected to remain comparably stable and less affected? This idea disregards the special nature of the common currency in Europe. The euro differs from a “domestic” currency in the traditional sense in a very important way: It is the currency of the euro area, not of its individual parts. Initially, at its introduction, the distinction did not matter. Conceptually, since all member countries adopted the euro and none kept its former currency, the euro was thought to become an equally perfect substitute for drachme, lira, D-mark, French franc and others.
In the current crisis, however, with economic and financial differences between member countries becoming more and more apparent the question seems no longer too far-fetched whose currency the euro is. With rising tensions within the euro system it is becoming increasingly difficult to think of the euro as home currency, say, of both Greece and Germany at the same time. The consequences would become immediately apparent at a breakup of the euro zone when values of the new national currencies would drift apart. But even in the current state, dangers are looming on the horizon.
There is a growing overall awareness that the European currency is not appropriately representing member economies. The situation can be compared with Akerlof’s market for “lemons” (faulty used cars whose defects are unknown to potential buyers; see below):
Assume the strength of the euro is reflecting the average of member countries’ economic conditions and investors have no information about their true state. While the stronger ones are undervalued, the weaker members are unduly overvalued. Since this is not apparent, in analogy to the Akerlof example, money and finance should flow to the comparably “cheap” stronger economies and to the weaker overvalued economies alike –as actually happened in the EZ for many years. (However, Akerlof’s suppliers of the undervalued products withdraw from the market, as the compensation they are offered is insufficient, and only the overvalued ones – the lemons – are left.)
With increasing awareness of market inefficiency one would expect financial flows to be redirected from weaker to stronger economies until a new equilibrium is reached which would reflect true economic conditions and, after a period of possibly painful adjustment, the euro area would come out of the crisis strengthened like a phoenix from the ashes.
At this point, however, the analogy breaks down. In Europe, money does not – or only to a limited extent – flow from Greece to Germany (to stay with this example). There are several reasons. The euro zone is an open system. There are ample investment opportunities outside. Moreover, weak and strong countries in the euro area are exposed to the same risk of default and insolvency which is not rooted in individual countries’ economic weaknesses but in the failure of the common currency system. In addition, there is another option within the system which is risk-free and widely used. This is the European Central Bank. In contrast to individual member countries, the ECB with its currency-issuing capacity cannot become insolvent. Thinking about it, the fact that money is deposited there instead of elsewhere in the region appears perfectly consistent: The ECB is the monetary institution representing the whole of the euro area, the one which most closely matches the “currency of the average”.
In the current situation, no member of the euro area has a home currency. Furthermore, since none of them can issue its own currency, and the ECB is not willing to fill the gap, in principle, all face a risk of insolvency. The euro is increasingly regarded as non-sustainable, and fear and panic is a threat to each market and product denominated in this currency. A member’s default or exit from the euro zone would not only intensify pressure on the next link in the chain, but jeopardize all debt in the area, both foreign and “domestic”. Greece would immediately be perceived as country of the drachme, Germany as D-mark country, and so on. The euro has long become a foreign currency to all of them.
In the beginning I wrote that foreign debt increases countries’ vulnerability to crises. In Europe, the amounts at stake rise considerably if we take into account that the distinction between “foreign” and “domestic” has become mostly obsolete. Furthermore, the ranking of crisis candidates changes. Table 2 shows the figures for both foreign and government debt to GDP and the shares of euro zone gross government debt. Apparently, not Portugal and Spain are the next weak links behind Greece, but Germany, France and Italy. There is no safe haven left in the euro zone.
there ain’t nowhere to hide,
waiting for the hurricane Chris De Burgh
…The Market for Lemons “In his classic 1970 article, “The Market for Lemons” Akerlof gave a new explanation for a well-known phenomenon: the fact that cars barely a few months old sell for well below their new-car price. Akerlof’s model was simple but powerful …” Read more from The Library of Economics and Liberty (Econlib)