Two Versions of the European Debt Crisis

An increasing number of observers have hastened to declare that the European debt crisis has been practically resolved or at least stemmed for a few years. This view was reinforced by the falling yields at the last Italian government bond auctions of 2011, which suggested a significant reduction in the perceived sovereign default risk. Since Italian bonds are regarded as the bellwether of the European sovereign crisis, many see this development as an indication of the stabilization of the euro sovereign debt market.

The “solution” to the crisis was facilitated by the European Central Bank’s decision to lend to commercial banks for three-year terms in unlimited amounts at a very low rate. However, the ECB’s decision to do this is only part of what a central bank can normally do to fulfill its natural role as lender of last resort. Why then is there all this renewed optimism?

The immediate answer is that with the ECB’s new decision, commercial banks can now borrow cheaply from the ECB and invest in short-term sovereign bonds, pocketing a sizeable sovereign spread—a profitable “sovereign carry trade”. If banks do indeed play along, and despite the inefficiencies and distortions arising from such roundabout way of monetary financing, the European Central Bank might very much provide some lasting room to breathe for sovereign finances.

But the real reason why this otherwise standard policy decision appears to be such an important step forward is that for the first time the European Central Bank is recognizing the need to address a core drawback in the euro architecture, itself.

This crucial shortcoming relates to the currency dimension of the debate on the euro’s fate, which simply does not square with the tired comparisons to the economic crises in the emerging markets in the 1990s.

If we learned one thing from a decade of emerging market crises was that they were first and foremost currency crises— sharp corrections of overvalued currencies that bankrupted dollarized public and private sector debtors.

By contrast, the currency aspect of the European crisis is less straightforward. Is the Italian euro debt denominated in local or foreign currency? Whose currency is the euro? And whose central bank is the European Central Bank? These questions are essential to understanding the European predicament. However, depending on the answer, one could have two versions of the eurozone with very distinct issues and implications.

The first version sees the eurozone as a unity, with a fully functioning monetary union. Taken as whole, the eurozone is externally and fiscally balanced. It is also heavily indebted, but in domestic currency. The second version assumes the eurozone as a group of individual countries within a common currency area. Most of the countries are unbalanced and are indebted in a currency (the euro) that they cannot print on demand. This is equivalent to foreign currency debt.

In the first version (the euro crisis minus the currency problem), the scenario looks closer to the U.S. than to Latin America in the 1990s (with Italy being more like California than Argentina). The second version of the eurozone saga is comparable to the emerging market crises of the 1990s. That is, the eurozone sort of acts as a dysfunctional family, where the “advanced” countries of northern Europe ponder whether or not to bail out the “emerging” economies of southern Europe; the reluctance of northern European countries to use the ECB as a euro lender of last resort is just one expression of this hesitation.

The prognosis for each version is starkly different. In the first one, interest rates converge and default risk is minimal. If the ECB backstops its members’ liabilities (as the Federal Reserve did during the recent U.S. financial crisis), the euro becomes a “local currency” and the probability of a default collapses. After all, how many sovereign restructurings of local currency debt do you remember?

In the second version, there is differential credit risk and ultimately bank runs, de-euroization and default because the common currency is at odds with the needs of its members.

Which of these two alternative characterizations should prevail is an open question for euro-area members to decide. But two things are clear. First, the decision is largely about the standing of the ECB. And second, there is little in between; the halfway position that European policymakers have been treading so far will not eliminate the “currency problem” and the resulting default risk.

This perspective also helps to understand the oddity of a massive International Monetary Fund program to the region. Why would the IMF lend to Europe in a foreign currency (the SDR), thereby creating a currency imbalance— the root of all emerging market crises– unless Europe is already giving up on the euro?
The euro now faces a fork in the road. One path (a currency area without sovereign backstopping) leads to debt defaults, currency crises and the undoing of the eurozone. The other path (a monetary union with a proper central bank, internal transfers and active regionally-oriented monetary policy) leads to a slow but steady recovery and no default. Clearly, the fate of the euro and the main source of credit risk in the eurozone lie not in Athens or Rome but in Frankfurt with the ECB.