The article “The Governance of a Fragile Eurozone” by De Grauwe analyzes the main challenges the governments of euro-zone countries face. The author connects these challenges with the fundamental changes in the nature of the sovereign debts that imply governments cease control over the currency in which they issue debts. According to De Grauwe, the transfer of control over the debt currency made the euro-zone fragile and vulnerable to the influence of market sentiments. The inability to control the debt currency creates a disequilibrating mechanism in the national markets. As a result, tremendous power that financial markets acquired with changing the nature of governments debts can force these countries into default.
The Fundamental Problem of the Euro-Zone
De Grauwe considers the inability of the governments to borrow in their own currency the major issue of member countries that became the commonly encountered problem in the whole euro-zone. The lack of control over the debt currency creates the conditions for the situation when investors in particular national markets of the union fear default in governments debts, and their decision to invest euros in other bonds leads to the currency leaving the banking system. It shrinks the money supply or the total amount of liquidity that means the reduction of resources that the governments can use to refinance their debts at reasonable interest rates. The reduction in the money supply initiates the liquidity crisis, and changes in market expectations can easily force these countries into default. Thus, tremendous power that financial markets acquired with changing the nature of the debts made member countries extremely sensitive to liquidity fluctuations.
Moreover, a destructive interaction of solvency and liquidity crises forms the basis for the risky dynamics in a monetary union. Liquidity crisis increases interest rates that give a signal to investors to withdraw their money from a national market, and the liquidity crisis starts transforming to a solvency crisis.
In addition, the high integration of national financial markets exacerbates the mentioned problem by providing strong spillover effects in the euro-zone. Therefore, when the self-fulfilling mechanism of market expectations pushes some member countries to the bad equilibrium, it also affects financial markets and banking systems in other countries.
As a corollary, the inability of governments to issue the debts in their own currency makes members and the whole monetary union “vulnerable to self-fulfilling movements of distrust” and through relationship between solvency and liquidity crises creates a potentially disequilibrating mechanism (De Grauwe, 2011, p.5).
The Consequences of the Problem
Externalities related to huge power of financial markets are a strong force of instability in the euro-zone. Only governments’ actions can solve the problems, but the member countries are restricted with taking such actions. Therefore, they face the following consequences.
The most important consequence of the mentioned problem refers to triggering a potentially disequilibrating mechanism. It includes the increased likelihood of pushing countries, which have no control of the debt currency, to the bad equilibrium characterized by deflation, high interest rates and budget deficits.
Second, in the bad equilibrium, the governments cannot “use budgetary policies to stabilize the business cycle” (De Grauwe, 2011, p.7). The lack of these automatic stabilizers undermines the political and social basis of a monetary union.
In addition, the withdrawal of the proceeds of the bond sales from a particular national market does not provide dropping the currency in the money market that means the impossibility of the currency depreciation. It affects GDP growth and inflation, which is a shield of the sovereign from default in the national markets. Thus, the other important consequence is the unfeasibility of boosting output and inflation due to the inability to use the adjustment process involving the currency depreciation.
Further, in order to stabilize the debt to GDP ratio as a necessary solvency condition, the countries have to generate a primary surplus that should be high enough to achieve this result. It forces the governments to apply much more austerity than the non-members to satisfy the solvency condition even if they have significantly lower debt level.
The other consequence refers to having fewer opportunities to restore the lost competitiveness by engineering internal devaluation rather than using devaluation of the currency. Internal devaluation can lead to a recession and increase budget deficit and risks of liquidity and solvency crises. Therefore, the period of improving the competitiveness for member countries is more painful and turbulent.
Ceasing control over the debt currency is a fundamental problem of the euro-zone that makes the monetary union fragile and vulnerable to any changes in market expectations. The inability to control the currency triggers a disequilibrating mechanism in the national markets and the whole euro-zone. As a result, tremendous power that financial markets acquired with changing the nature of the debts leads the governments into the bad equilibrium, which involves deflation, high interest rates, budget deficits, and crisis of the banking systems. Eventually, this can lead to sovereign default supported by undermining the political and social basis of a monetary union, making it impossible to boost output and inflation, and establishing more austerity and more painful and turbulent period of improving the competitiveness.