Wow, what a report.

That link leads to a fantastic summary of the Euro area’s trouble. There is no pleasant scenario on the horizon.

Here is my big-to-small picture summary:

Currency unions are really tough to make work. See this (short) and this (long) from Krugman. There are economic benefits to joining up (lower transaction costs and higher trade/specialization) but, as we’re finding out, a gigantic loss in flexibility in a crisis.

Countries not in a currency union, like Iceland, can just let their currency devalue when they hit the buffers. This drives up the cost of imports (ie inflation), which crushes the real wage and lowers the standard of living. Newly competitive export industries and domestic suppliers pick up the slack and get everything started again. It takes a bit of time and pain, but it’s pretty straightforward.

Members of a currency union can’t do this, so they to relay on other stabilization mechanisms. The two biggies are labor-market integration and fiscal integration. As an example, remember that the USA is a currency union, too, while I borrow Krugman’s analogy.

Let’s say Nevada had a similar crisis to Ireland.

Nevadans that lose their jobs can move to California (um, bad example) or North Dakota. Nevadans speak the same language and share a pretty similar culture, so that’s pretty easy. Bingo, labor market integration. We’ve reduced the unemployment burden in Nevada because the whole state shrinks to fit its economy. Moreover, Nevadans that stay put benefit from a social safety net provided by the feds (medicare, medicaid, unemployment insurance, etc). That’s fiscal integration.

You need fiscal and labor market integration for currency unions to work.


The Germans are NEVER going to pay for Greek medicare. Not with Michael Lewis painting evocative pictures of Greeks as free-riding crooks. And change the laws all you like, but different languages make immigration really difficult.

So the Euro was risky all along? Yep. But they also made it worse when they designed the financial system. The article above has a great example: the ECB accepts sovereign debt as collateral for loans and started out not distinguishing among sovereign names. They later changed this to adjust for risk, but “these adjustments were minor”.

What does this mean? Well this means that a bank can buy a bunch of Greek debt (at, say 10%) and park it with the ECB as collateral for a 2%  loan. Big spread.

Greek bonds are therefore much more attractive to institutions that can use this trick. This lowers interest on Greek bonds but concentrates Greek credit risk in the Eurozone. I can only imagine the happy-clappy atmosphere these kind of ridiculous rules were forged in.

So you have a shaky system supercharged with systemic risk that you’re politically welded to. Eurocrats don’t want to admit the whole thing was a mistake and, besides, there are some quirky problems with breaking up the Eurozone:

Let’s say German banks get a bit freaked out about Irish bonds. They sell those bonds to an Irish bank (probably the only market makers left) and take their Euros home. Weirdly, though, the Irish bank doesn’t pay the German bank.

What happens is that German central bank pays the German bank the money and the Irish bank pays the Irish central bank. This means that now the Irish central bank owes the German central bank the money.

That, apparently, is a loan that is not meant to be paid back. What might be seen as a de-linking of the system actually concentrates the credit risk of Ireland with the German government. Now pretend it isn’t Germany but Italy that is suddenly more exposed to Ireland. Systemic risk piling onto systemic risk.

Get the picture?

The Euro was conceived as a way of bringing the stability of the Northern financial systems to the wayward southerners. The Euro, therefore, was really meant to behave just like the USD. And it has. The problem is that the longer everyone sits in the purgatory of politically squeezed half-assed bailouts, the longer the list of problem countries gets.

Eventually, the inmates take over the asylum and the Euro becomes more like the Italian Lira or the Greek Drachma than the German Dmark (more here). The idea I hadn’t heard until today was that maybe Greece and Ireland should stay in the Euro.

It’s Germany that’s the outlier now.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s