Wolfgang Reuter at Speigel Online says:
On the other hand, if Brussels left the Greeks to their own devices, the consequences would also be dire. Confidence in the euro would be shattered, and the union would face a crucial test. What good is a common currency, many would ask, if some of the member states pay their debts while others do not?
Furthermore, there is a threat of a domino effect. If one euro member falls, speculators will test the stability of other potential bankruptcy candidates. This could destroy the currency union. Because of this systemic risk, say the economists at the Swiss bank UBS, “we believe that if a country is facing a problem with debt repayment or issuance, it will be supported.
Greek Debt Poses a Danger to Common Currency
Megan McArdle feels similarly:
The euro zone, on the other hand, has tightfisted Germany spliced together with spendthrift Italy, which previously relied on serial devaluations of its currency to boost exports and ease the burden of its debt payments. This is why I was more skeptical than most observers–including most of my colleagues–that the euro zone was going to survive long term. If a few members are forced to exit, either because the central bank’s monetary policy is keeping them mired in recession, or because they need to inflate away a massive debt burden, then it’s hard to see how the zone survives. If investors think the euro zone is fragile, they’ll demand higher interest rates to compensate for the currency risk they’re assuming. Furthermore, a smaller currency zone means smaller gains from trade, and presumably less incentive to pay the price of turning your monetary policy over to the ECB.
Greece Threatens Bankruptcy, And the Eurozone
The conventional wisdom is that the sovereign default of a European state that did not get bailed out would be a disaster for the Euro. However, when I think about the United States, I can’t help but think that the bankrupcy of Michigan (which has a bigger GDP than Greece) would hurt the dollar very little. Therefore, I’m having trouble understanding why everyone thinks that this will be calamitous for the other European states. What is different about the Euro?
By reducing the risk countries using inflation to escape their debts the Euro lowers borrowing costs in much the same way as a credible independent federal reserve does in the United States. By increasing the growth by lowering trade barriers it also increases the debt load the member countries can bear. Those factors lower borrowing costs without any promise that the countries will bail each other out.
But why would these countries be un-stable? If the central bank in these countries have been doing their jobs then this debt should have a variety of maturity dates (the bonds come do on different weeks and months) and it is all denominated in Euros which is the currency that these countries run on. If Greece defaults and market participants starting thinking that a few others will follow then they will start jacking up their borrowing costs. That should be manageable because countries can raise their domestic taxes to substitute or simply pay the higher rates until it becomes clear that they won’t default. Of course, if their isn’t any interest at any price that is a big problem for those rolling over huge debts. The debts are simply too huge to pay off all at once. Some level of financing is essential. However, if a country saw its borrowing costs rapidly expanding, legislatures could use a combination of tax incentives to hold government debt (like we have here), tax raises to create budget surpluses, and cutting of government services to all reduce the dependence of the state on capital markets. Strong budget correction would send a signal of the country’s seriousness to pay their debts and therefore permit ongoing financing. I’d be surprised if that didn’t work.
However, it would kill domestic demand and therefore risk plunging the Euro area back into recession. But a recession is usually better than a sovereign default on a countries long term employment and growth prospects.
Ms. McArdle also says “You don’t actually need an optimal currency zone to have a successful currency: the United States is far too large to actually be optimal, which is arguably one of the reasons that we have so many areas stuck in what seems like permanent stagnation.”
There are many serious economists who argue that the optimal currency zone is the whole world and even more so who would argue that America’s is optimal. Under the gold standard and Brenton woods the whole world was essentially under a single currency. Without accepting that this was better, that was not an absurdly dysfunctional regime. There were fewer sovereign defaults during that period and much lower inflation.
