The similarities between debt crises and currency crises
Sep 19, 2011

The similarities between debt crises and currency crises

During the nineties, the predominant form of economic crisis that could hit a nation was the currency crisis whereby the value of a country's currency drops precipitously. Most infamously was the Asian financial crisis, whose effects rolled around the world, but also the Russian, Mexian, Argentine and many other similar currency related crises in countries around the world. Sometimes, usually in smaller countries, this resulted from shifting economic factors quite beyond their own control and resulted in a temporary balance of payments problem. But a very large portion of this resulted from government over-expenditure financed by printing money which result - in a lumpy way opposed to an even way - in the dropping value of the currencies.

For the last year in Europe we have been beset by a superficially different problem: a debt crisis not a currency crisis. At its core, however, the base problem is the same, much of the effects are the same, and many of the proposed solutions are the same. When the European countries joined into a currency union, individual countries gave up their sovereignty over one issue first and foremost: the ability to print their own money. The result of this is that when a government runs a sustained deficit, it can no longer print money to alleviate this accounting problem. The "debt crisis" experienced now under the Euro would, were there not to have been a currency union, have likely been in a currency crisis instead as Greece et al. print money to pay for their debt.

The market response is likewise similar and triggers a feedback mechanism which exacerbates the problems. With a debt crisis, the market raises the borrowing costs of the debtor which, in turn, makes it harder to pay off the debt and exacerbates the problem. With a currency crisis, the currency becomes weaker and so it is hard for governments to pay off foreign obligations in their own currency; they resort to printing money to meet these obligations which drives the currency weaker still. The risk of cross border conflation is very high.

The economy suffers either way. We are seeing across Europe the extreme belt tightening (euphemistically refered to as austerity) that is slashing all kinds of government spending or increases taxes. This shrinks the net size of the economy, leaves more people with less money, and plunges the economy into a deep recession. With a currency crisis, the devaluation of the purchasing power of individual and company money is equivalent to a form of tax hike and achieves very similar economic shrinking. The orthodox solution, such as it is, is the same in both cases: standard neoliberal economic policy of slashing government spending, privatizing government assets at all costs, and raising the tax burden on lower and middle classes.

One of the goals of the Euro was to fix this most basic problem of high government spending relative to revenue. It prescribed a very reasonable 3% of GDP maximum deficit and 60% of GDP maximum debt. Were those targets to have been maintained, we would likely not have a problem. Greece, however, was able to achieve almost 150% GDP debt and deficits over 10%. The problem was a combination of a lack of enforcement mechanisms and the political will to enforce the mechanisms that did exist. There is a crisis right now that needs to be dealt with in the short term, but in the medium term, coming up with a sustainable and enforceable program of incentives to make the countries match these targets is imperative.

One solution that is being loudly whispered is the idea of Eurobonds. Currently the European Central Bank can print money and issue loans to member countries, but what it cannot do is sell Euro denominated debt to the market. Doing this would go a long way to solving the short term program. It would allow the ECB to leverage enormous amounts of money from the markets and funnel it through bailouts to troubled indebted member countries without having to exclusively resort to printing to generate funds. The additional security that comes from the full faith and responsibility of the entire economic bloc would keep interest rates for Eurobonds far lower that the PIIGS could get form the market on their own.

The downside to this idea, is that it further removes the incentives for governments to be fiscally responsible. Currently, the biggest disincentive towards having big debts is that the markets will crank up the interest rates as they have done. If a country has a background implicit promise that it can always get low interest rate loans from the ECB it has much less incentive to do this. The cost of a country doing this will be spread around the entire region (through marginally higher inflation or interest rates on Eurobonds) and not just on themselves. Germany is thus very correct when they qualify that Eurobonds must be predicated on much stronger enforcement mechanisms to deal with countries that do not conform. There has to be a real and meaningful incentive to conform to the reasonable debt and deficit requirements otherwise we will be back here in the next decade just as we repeated the mistakes of the nineties in this decade.

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