Monday, November 21, 2011

Curse of Debt (5) - Political Union

Many commentators say that the Euro is failing because a common currency cannot work without political union. That view is not correct.

The common currency is under pressure because banks lent to the weaker countries at a rate similar to that offered to the frugal Germans. They assumed that sovereign risk had disappeared. This was a huge mistake. The low rates allowed the governments of these countries to borrow like crazy. The banks should have seen this coming . Lending to Greece was always more risky than lending to Germany, so the interest rates should have reflected the difference.

Sovereign risk has been discovered again, so riskier countries like Greece and Italy, are now facing high interest rates. Provide that continues into the future, there is no reason why a currency union cannot continue without political union.

The big difference is that individual countries can no longer inflate their own currencies to get rid of their debts. That is a good thing, because it will put a constraint on government spending. The countries in the Eurozone now understand that excessive spending and borrowing has a huge cost, with no easy escape.

2 comments:

Anonymous said...

Sometimes the right answer -- keep the Euro, but just price the various sovereign bonds properly -- is right before my nose.

Makes sense. Thank you!

Blessed Economist said...

The downside is that all inter-regional adjustments have to be made through price and wage adjustment, rather than through exchange rate adjustments.