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Euroconfusion — Crooked Timber

November 18th, 2010

Most of the discussion I’ve seen of the financial crisis as it affects the eurozone seems to me both confused and confusing. A country outside the eurozone and without the “exorbitant privilege” of being able to sell lots of debt denominated in home currency has three options when it runs into debt trouble: default, depreciation and dependency.

Default is the straightforward solution, but it involves a big loss of face, and unpredictable long-term costs. Depreciation doesn’t directly improve the debt position, since debts are in foreign currency, but by making exports cheaper and imports dearer it helps a country to trade its way out of difficulty, without the need for a reduction in domestic prices and wages. Finally, there’s the option of dependency on an outside rescuer, normally the IMF. This has been the most common solution, but the IMF always demands a price (in terms of policy “reforms”) that makes a rescue only marginally more attractive than default.

A eurozone country doesn’t have the option of depreciation. In return, however, it has two dependency options, calling on either the IMF, or the European Financial Stability Fund. Since the EU would like to keep the IMF out, a distressed debtor can expect slightly better terms from the EFSF.

The default option isn’t affected, except in the same way as any kind of behavior viewed as discreditable affects membership of any club. A government that defaults on its debts might be thrown out of the eurozone, but then again it might be thrown out of the OECD, and the eurozone might expel a member that facilitated tax evasion.

The big question is whether the EFSF will work. That’s certainly challenging, but it still seems like a better bet for debtor countries than going it alone. And of course, there’s more commonality of interest than is often supposed because any bailout benefits the creditors, usually French and German banks

Posted via email from John’s posterous

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  1. Purp Traitor
    November 18th, 2010 at 23:09 | #1

    John, it appears when using the term ‘exorbitant privilege’ that you’re referring to the US, where QE2 is even now releasing a green tide on the globe. However, there is no restraint on a country issuing debt in its own currency if that’s what its citizens want, as in the case of Japan. The yen may come under external pressure from Japan’s trade surplus, or QE2, or pure speculative runs, but it does not come under pressure from its domestic denominated debt (and the domestic interest on that debt goes directly into Japanese savings).

    Ultimately there is no reason why a country can’t use its own currency to drive aggregate demand, except that no politician has yet been known to actually do this without totally stuffing up their economy. Perhaps it is just too hard a tap to turn off once turned on.

    However, the technical discussion on how the Irish bail-out will run is a little akin to two kids discussing the efficacy of particular methods to commit patricide. I see this as the classic failure of a democratic type government collapsing under sectional interest. The banks stuff up, the government stuff up by guaranteeing the banks, and the Irish population are left with no choice but to pay up or leave. No wonder so many are choosing the latter.

    To say that the Irish have lost face is to conflate the Irish elite with the Irish nation. The nation cannot lose face (in the sense that it will all still be there tomorrow, just as green as ever) but the elite may very well lose everything (and if justice prevails, perhaps even end up in jail).

    So why should the Irish have their wages cut, their services curtailed, their children forced to again follow the great 18th century diaspora seeking refuge in foreign lands so that (mainly foreign) bond holders, the wealthiest 1% in the world, can again gorge themselves on Irish blood?

  2. Hayek’s horror
    November 19th, 2010 at 10:22 | #2

    On a related note I see Steve Kates has described QE2 as Keynesian policy.

    He frequently criticises Keynesian policy however he doesn’t know what he is talking about. ( A prerequisite for writing at Catallaxy.)

    Keynes advocated using monetary policy at all times EXCEPT where there was a liquidity trap.
    (In the US interest rates would be -5 to -6% under a forward looking Taylor rule.)
    In those cases monetary policy didn’t work so you had to use fiscal policy.

    Steve Kates and Sarah Palin are equals in this respect!

    Glen Rudebusch at the San Francisco Fed showed the FED really could not use QE effectively as the Balance sheet would grow far too much. Interestingly his estimates had the original QE only making a difference of around 250 basis points to interest rates.

  3. Hayek’s horror
    November 19th, 2010 at 10:51 | #3

    On second thoughts I may have been too harsh after all it is easy to confuse policies advocated by Friedman and Keynes.

    Economists do it all the time.

  4. November 19th, 2010 at 17:44 | #4

    @Purp Traitor

    So why should the Irish have their wages cut, their services curtailed, their children forced to again follow the great 18th century diaspora seeking refuge in foreign lands so that (mainly foreign) bond holders, the wealthiest 1% in the world, can again gorge themselves on Irish blood?

    That should be “19th century diaspora”; although it didn’t happen only in that century, that was its heyday.

  5. Purp Traitor
    November 19th, 2010 at 23:31 | #5

    Thanks P.M., looked up Irish Famine on Wikipedia, and second entry said ‘Irish Famine (1740–1741)’, so I went no further. Its not that Wikipedia’s information is particularly suspect, but some of it’s users certainly are.

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