The fragility of Eurozone finance
Nov 30, 2010
3 minute read

Over at the FT, Gavyn Davies writes concerning the Eurozone,

Member states cannot print the euro, which automatically increases the risk that they will default on their debt. (Admittedly, it also reduces the risk that they will inflate their debt away. The markets are not too worried about this in these deflationary times, though one day they might be.)

I think about European sovereign debt in somewhat similar terms, but I want to elaborate on Davies’s framework a little.

First, refusing to pay up and paying up in inflated currency are both forms of default. The fact that EU member states cannot print the Euro therefore changes the form of the risk of default.

Second, the form of the risk of default matters. Think about the payout of a security under variable outcomes. When the outcome is very good, the security pays out a high amount, and when the outcome is very bad, the security pays out very little. We can imagine that in the middle of the outcome spectrum, there are a number of possible payout profiles. You can have payouts vary smoothly with outcome, or you can have a tipping point, above which the payout is high and below which the payout is low. When payouts vary smoothly with outcomes, the price of the security is not going to be very volatile. When payouts vary sharply with outcomes, the price of the security may be highly volatile when outcomes may fall on either side of the tipping point. I think this is what Nassim Taleb means when he says that debt is fragile and equity is robust: debt payouts vary sharply with outcomes and equity payouts vary gradually with outcomes.

Third, when a government can inflate away part of its debt, the real, inflation-adjusted payout can vary more smoothly with outcomes. This makes the debt a little less like debt and a little more like equity. When a government cannot inflate away its debt, the price of its securities are going to be very volatile around the outcome tipping point.

Fourth, since EU governments cannot inflate away their debt, the risk premia on their bonds are going to take a highly volatile form. This is going to lead to frequent debt crises unless the governments are highly responsible and avoid landing anywhere near the outcome tipping points.

Davies concludes his post with “Something, somewhere has to give.” I think that what has to give if people want to preserve currency union is that member countries are going to have to accept balanced budget requirements as the US states have. But at the same time, I am skeptical that the southern European countries can really be counted on to abide by such requirements if they are imposed. They failed to keep their deficits within the 3% of GDP limit the EU treaties currently require, and they have been and are going to be rewarded with bailouts.

Many commentators are talking about fiscal union, which is perhaps a subject for another post, but I am not too enamored of this option as it has many public-choicy downsides. Probably the thing to do, though difficult, is to give up on the common currency and instead focus on creating the largest free-trade and free-movement zone in the world. That is the robust road to prosperity.