Tuesday, May 10, 2011

Managing a fragile Eurozone

by Paul De Grauwe

Vox

May 10, 2011

Why does the Spanish government pay significantly more to borrow than the UK government – despite having a smaller deficit and lower overall debt? This column argues that the reason lies in the Eurozone’s fragility. Its members lose their ability to issue debt in a currency over which they have full control. The column discusses ways to deal with this weakness.

A monetary union is more than just a single currency and a single central bank. Countries that join a monetary union lose more than one instrument of economic policy. They lose their capacity to issue debt in a currency over which they have full control.

This separation of decisions – debt issuance on the one hand and monetary control on the other – creates a critical vulnerability; a loss of market confidence can unleash a self-fulfilling spiral that drives the country into default (see Kopf 2011). The economic logic of this is straightforward.

Suppose that investors begin to fear a default by, say, Spain. They sell Spanish government bonds and this raises the interest rate. If this goes far enough, the Spanish government will experience a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates.1 The Spanish government cannot force the Bank of Spain to buy government debt and although the ECB could provide all the liquidity in the world, the Spanish government does not control that institution. This can be self-fulfilling since if investors think that the Spanish government might reach this end point, they’ll sell Spanish bonds in a way that turns their fears into a reality.

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