The Drain from Spain?

by Andrew Stuttaford

I’ve been meaning to link to this paper by the University of Leuven’s Paul de Grauwe since it was mentioned in the Financial Times a few weeks back, but the growing deterioration of the situation in Greece as well as evidence of mounting discontent in Spain both provide a timely excuse:


De Grauwe writes:

In a nutshell the difference in the nature of sovereign debt between members and non-­members of a monetary union boils down to the following. Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are not part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.

 De Grauwe compares Spain (which is trapped in the Eurozone) with the UK (which is not):  

Let’s first trace what would happen if investors were to fear that the UK government might be defaulting on its debt. In that case, they would sell their UK government [Sterling-denominated] bonds, driving up the interest rate. After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets. Put differently, the UK money stock would remain unchanged. Part of that stock of money would probably be re-­invested in UK government securities. But even if that were not the case so that the UK government cannot find the funds to roll over its debt at reasonable interest rates, it would certainly force the Bank of England to buy up the government securities. Thus the UK government is ensured that the liquidity is around to fund its debt. This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default… 

This is by no means a get out of jail free card, but it would buy a competent government some time during which it could try to put things right (something that would helped by the assistance that the depreciated currency would likely give the export sector).


Now contrast Spain:  

Suppose that investors fear a default by the Spanish government. As a result, they sell Spanish government bonds, raising the interest rate. So far, we have the same effects as in the case of  the UK. The rest is very different. The investors who have acquired euros are [in the absence of a truly dramatic increase in Spanish interest rates]  likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. There is no foreign exchange market, nor a flexible exchange rate to stop this. Thus the total amount of liquidity (money supply) in Spain shrinks. The Spanish government experiences a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates. In addition, the Spanish government cannot force the Bank of Spain to buy government debt. The ECB can provide all the liquidity of the world, but the Spanish government does not control that institution. The liquidity crisis, if strong enough can force the Spanish government into default. Financial markets know this and will test the Spanish government when budget deficits deteriorate. Thus, in a monetary union, financial markets acquire tremendous power and can force any member country on its knees…  

That Brussels’s ill-judged and irresponsible ‘one-size fits all’ currency union did so much (directly or indirectly) to create or facilitate the mess in the PIIGS only adds irony to the picture. 

I certainly don’t agree with all that De Grauwe has to say in his paper, but if you want to understand why the Eurozone mess could quickly get very much worse, what he has written is well worth reading.