Back in the exciting days of October, Peter, Simon, and I wrote an op-ed in The Guardian about the potential for cracks to appear in the Eurozone, even possibly leading to one or more countries withdrawing from the euro. With so many other things to worry about, this scenario didn’t get a lot of attention. Since then, pressures have been slowly building. For example, the spread between the 10-year bonds of Greece and Germany has grown from around 30 basis points during most of the decade to over 1.5% now. (The picture below is from last week.)
According to an FT chart (sorry, can’t find the link), Greece also has to raise 20.3% of its GDP in debt next year (the equivalent figure for the U.S. is 10.3%), so the spread should only get bigger.
The Eurozone is based on the idea that a single monetary policy can serve the interests of all of the member countries. The problem is that when macroeconomic conditions vary widely between countries, they will have different interests. In a severe crisis, some countries may be tempted to (a) engage in quantitative easing (of the sort the Fed is beginning to do) or (b) implement a large fiscal stimulus (of the sort that Pelosi, Reid, and Obama are about to do). (a) is impossible for a Eurozone member, and (b) is constrained by limits on deficit spending, although I believe those limits are honored more in the breach than in practice.
In any case, the potential problems are getting big enough that Martin Feldstein has weighed in as well. Hopefully this will draw more attention to the issue. It may still be a low probability, but the economic and political consequences of undoing the greatest step toward European integration in, oh, the last thousand years would be huge.
The Baseline Scenario 
What happened 1,000 years ago? I’d say it’s either ever or since Caesar conquered Gaul.
Well, I only studied early and late modern Europe, so I was just covering my bets. There was this guy named Charlemagne about 1,200 years ago, but I’m not sure he accomplished that much. The Roman Empire may be a better bet.
Or maybe you could say that the Christianization of Europe was the biggest form of integration ever. It wasn’t political or economic, but arguably it has been more important.
At least until the Reformation…
If Greece is not able to get a stimulus like US and both countries continue in different directions; 5 years down the line, will we be able to compare the two and know which strategy worked?
Or are there too many factors at play here?
As a general principle, I think the “too many factors” point is correct. Macroeconomics in general suffers from the problem of small sample sizes and too many possible explanations for any phenomenon. It’s like trying to solve two simultaneous equations with ten variables.
Is it possible for a country (I’m thinking of Germany here) to logistically back out of the Euro? Maybe that’s why Angela has been so quiet of late . . . they might be talking about it.
I agree that the lack of a EU federal government (we’re a confederacy, not a federation, check a Constitutional Law textbook for the difference) makes stabilization policies more difficult in the Eurozone.
However, please note that there is no mechanism to kick out a country out of the Eurozone. Even the sanction mechanisms for profligate countries are basically toothless (once again, because we are confederacy). So the only way out would be voluntary.
But who would benefit from it?
– Small countries would not. The Euro has considerably reduced their funding costs, even at current levels.
– Germany could benefit in the short-term… maybe. Bund yields remain very manageable. So why waste all the integration process of the last 60 years — which considerably increased the potential market of German companies (large exporters, by tradition) by enriching its neighbours — just for a few basis points??? Once the euro breaks, there is no coming back for at least a couple of decades. The present value of lost exports would be considerable.
So unless you manage to show in real money terms that benefits would offset the costs, I think this discussion about the potential breakdown of the eurozone are just a waste of time. Note that the actual opposite is happening: Eurozone governments have understood that a minimum level of cooperation is required, and even very reticent countries like Denmark now consider joining. In a couple of decades (lol), this might lead to an actual federal government.
To push the reasoning further, I think the real question should be: will the dollar remain the reserve currency for much longer? The desire of countries like China and the Gulf States to diversify their currency holdings makes me wonder…
Best, PF.
The Euro may have reduced the costs for small countries to sell bonds, but I doubt that if Greece is forced to choose between staying in the EU and providing enough stimulus to get out of a depression that they would go for the former. It sounds like it all depends on how bad the downturn is and how much the other EU states are going to try to enforce the limits on deficit spending…
The real question is not so much “will the dollar remain the reserve currency for much longer”, but “what will take its place if it is not?”
The dollar’s standing amongst the global financial community reminds me of the old army joke where the sergeant asks a line of privates standing at attention: “volunteers please take one step forward” and everybody but two poor schmucks step backwards.
Maybe we don’t really need a reserve or key currency anymore – I’ve seen figures that show proportionately less global trade today denominated in dollars than 5, 10 and 20 years ago – but if we need one, the U.S. dollar is going to be it until such time as something else reliable comes along. IF the good old DM was still around, THAT currency could suffice, but neither the Yen nor EU nor anything else is going to serve as the reserve currency anytime soon, IMO.
Fish:
I fail to see why Greece would have to choose between staying “in the EU” (one word of caution: the EU is not the eurozone! E.g. the UK is in the EU but kept the pound!) and providing a stimulus.
As I mentioned before, the “stability pact” (which limits government deficits in the eurozone) is completely toothless (at worst, there is a temporary fine — which has never been applied, even though Germany and France have breached criterias several times) — and there is no mechanism to kick a country out of the eurozone. On top of this, the stability pact allows temporary breaches in case of severe crisis (like now — note that the European Commission has acknowledged this in late November). So Greece is fairly free to do what it wants here.
Note also that ECB interest rates are currently at a fantastically low levels for a small, almost emerging country like Greece. After seeing this scary-looking chart on Greek sovereign CDS (above), I checked what were the current yields on 10-year Greek government bonds: are they at distressed levels? Is the bond market pricing a failure of the Greek government?
Not at all. 10-year Greek bonds currently yield 4.7%, compared to ~8% in early 1998 (the earliest I could find), and presumably much more before (Greece was already known to adopt the euro at that time, and 1998 was not really a period of crisis…).
As a comparison, Turkey 5-year bonds (couldn’t find a 10-year maturity) currently yield 18.5% — this gives you an idea of what Greece would have to pay if it decided to abandon the euro voluntarily in order to have a stimulus package: a bit expensive, don’t you think?
A final word on this Greek example: given that the ECB has already extended liquidity lines to non-EU members in Central Europe like Bulgaria, why should we worry about Greece leaving the euro???
Anarchus:
What if… we had no single reserve currency anymore, but a basket of them, like the dollar, the euro and the yen? What would it do to the global economy, and to FX volatility (already a nightmare for practicians, given its heteroskedasticity)?
I’m really looking for some good reading on this, in case anybody has some.
It isn’t absolute debt yields that matter, but spreads. In “early 1998” the 10-year Treasury was around 5.6%, so Greece had a risk spread of 2.4%. Today the Treasury is at 2.6%, so the Greek risk spread is 2.1%. Yes, you’re right, it’s lower than in 1998, but that’s not really conclusory one way or the other (what else has changed in Greece in the last 10 years?).
Thank you very much for your answer, James, however I continue to disagree. This is probably because I am quite new to the sovereign debt markets (honestly!) — so please feel free to correct me if I’m wrong.
1. “Greek risk spreads are slightly lower now than in 1998 but it does not prove a thing”
Actually, based on your recommendation, I had a look at what changed in Greece over the past 10 years and I found it very interesting.
According to the IMF database, Greece’s evolution in the past 10 years is a mixed picture. On the one hand, their GDP per capita has increased by by an impressive 7% per annum (in real terms), and their unemployment has slightly decreased (from 11 to 8%).
On the other hand, they still run a budget deficit (4% in 1998, 3% this year) and their current account deficit has actually deteriorated (from -4% of GDP to -14% now).
Given the current market focus on these elements (public debt, public deficit, current account, etc.), I am honestly very surprised that their risk premium compared to the U.S. has remained so low.
I am trying to see how Turkey’s risk premium has evolved over the same period, it could be interesting to compare with Greece’s.
2. “It isn’t absolute debt yields that matter, but spreads”
I agree — of sorts.
Spreads are the result of a comparison between two rates. They give you an idea of how different two situations are. For example here, when you compare Greek and U.S. sovereign bonds, the spread is the difference in market expectations for default and inflation in these two areas. (On top of this, there might be a “flight to quality” component which currently lowers U.S. yields).
But in the real world, what matters is what the Greek government will be able to do — and in fine, this means: how expensive their debt will be.
To put it in a profane way, if I want to buy a home, I don’t really care that I will pay 20bps more or less than my neighbour: I just want to know what (absolute) rate my bank will offer me.
At 4.7%, Greece bond yields are honestly very low — especially compared to Turkey’s. They should provide the Greek government with a lot of leeway to fund its stimulus package, in any case much more than if a similar crisis had happened ten years ago. And remember also that Greek banks can go to the ECB, at 2.5%… There are a tremendous lot of levers to pull, here.
So, as I said initially, I agree with you that the lack of an explicit stabilization mechanism in the European treaties is unfortunate. Because of this, every few years (1999, 2002, 2008…) everybody starts wondering: “what would happen if the country X decided to default?”.
My feeling is that there is no way the Eurozone can break down. As explained above, there is no mechanism to kick a non-complying state from the zone, and even if there was, the ejection of a single country from the Eurozone would create so much badwill that the currency would probably collapse (and presumably, the European Union as well — this is also why fines have never been applied).
Also, as mentioned above, Germany would not benefit from leaving the Eurozone either, because it benefits so much from its neighbours’ growth (and reciprocally).
So in case a default happened (and to be honest, this is a Science-Fiction scenario, even at this stage of the crisis), you would very likely see a rescue package be organised by other member countries, together with specific measures from the ECB. Would it be good for the Euro exchange rate? I guess not. But the cost of a Eurozone explosion would be far worse (I think the relevant English expression is “cutting off the nose to spite the face”?).
In a certain way (and I must tread very carefully here, because I don’t know much about this but I would love to learn more), we could maybe see it like individual U.S. states (California?) or municipalities (New York City?): they can go bankrupt and have their own credit rating, but that does not mean they would have to abandon the dollar. In fine, it’s a political decision.
One final word on CDS: I wonder if we should really pay that much attention to them. They are not necessarily very liquid, and in recent months they have been hoarded by banks (in order to hedge their risk exposures): as a consequence, their prices are probably higher than their “fair value”.
Did you know for instance that there is a CDS on the US sovereign debt? As of today, it is worth 65bps. But if the US defaulted (horresco referens), would they really be worth anything, given the massive systemic risk this would imply?
Coming back to Greek sovereign CDS, I suspect (but unfortunately, I have no hard evidence of this) that they could be used by some financial institutions to hedge their Turkish and Central European exposures (because Greek CDS are relatively more liquid). So the market price of these things could be more than the actual market expectation of a default of Greece.
I hope this all makes sense, and if not I would love to hear from you.
Best regards, PF.
Yes, it does all make sense, and thanks for your comments. Starting from the end, I think you are right to wonder about these CDS prices. In some cases CDS prices and bond yields are not correlated in the way you would think they should be, so there could be some kind of market imperfection going on. And I also don’t know what’s up with the U.S. sovereign CDS. My guess is that some people are just buying them across the board because they are generally nervous.
I agree that low yields are an absolute good for Greece, but even if you don’t net out the yield on “risk-free” (U.S.) debt, you still need to net out inflation expectations. I don’t know how that factor plays out in this context.
I would also caution against the Turkey comparison. Ideally what you want is a non-Eurozone country that is similar in other relevant respects. Turkey, I believe, is in the middle of negotiations for an IMF bailout. You could read this as a sign that Greece is doing better than Turkey; you could also read it as a sign that Greece and Turkey are not comparable as economies. I don’t know enough about this part of the world to give you an answer on that specific question.