Monday, November 28, 2011

Who killed the euro zone?

November 28, 2011

There are many facets to the crisis in the euro zone, but at heart the problem is fairly straightforward. The euro zone developed a balance-of-payments problem; some of the countries in the single currency accumulated large external debts. To service those debts, the deficit countries need to become surplus countries, which is difficult to do without the flexibility of a floating currency. The difficulty of adjustment has led markets to doubt the solvency of some institutions, and these doubts have, in the absence of a lender-of-last-resort, metastasised into a contagion that threatens to leave banks and sovereigns bankrupt.

When you frame the crisis like that, it begins to look inevitable, and perhaps it was. It is worth pointing out, however, that perceptions of solvency are very much state-contingent. It was never a given that a country like Italy would flip from one equilibrium to another. Prior to the crisis, Italy's government was running a primary surplus and bringing down its debt-to-GDP ratio. So long as markets were prepared to finance Italy's old debt at low rates, it was in good shape. Now, of course, markets aren't prepared to do that. One interesting question is why.

One possible reason is simple contagion. The euro zone failed to contain market worries as they spread from Greece to Portugal and Ireland. Cautious investors began to shed exposure to banks and sovereigns that might potentially be affected, contributing to rising yields in places like Italy. That, in turn, worsened the outlook for Italian solvency and contributed to a feedback loop of doom. Others argue, however, that the market's souring take on Italy was attributable to doubts about the country's growth outlook. That's certainly possible, though it's difficult to prove. After all, Italy's economy has been dreadful for years. In the first 5 years of the 2000s, real Italian growth was scarcely positive and the economy ran a persistent current account deficit. It nonetheless managed to reduce its debt load, and markets were happy to fund it cheaply. Maybe markets were overoptimistic then and are now readjusting their outlook. The timing of that reevaluation nonetheless looks suspiciously like what one would expect given a contagion-driven increase in yields.


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