The Corner

Re: Moody’s Blues

Mark, as you say there was a lot in Evans-Pritchards’s column to digest, including the idea that nation-states that are members of a multinational currency union should (as a rule) have a lower credit rating than those with their own currencies. Here’s what he said on this.

Currency unions switch exchange risk into default risk. The rating on countries in currency unions ought to be lower therefore (ceteris paribus). States with their own sovereign currency and debt in their own currency can let the exchange rate take the strain when they get into trouble, as the US and the UK have done. Foreign investors lose money on the exchange rate. There may be all kinds of risks and dangers in the US and the UK, but default is not high on the list (discounting the US soap opera over the debt ceiling). This not the case at all for EMU laggards. They cannot devalue or inflate away debt. The stress shows up in the bond markets instead. The more relevant comparison in this respect is between the Euroland’s Club Med states and California.

Obviously there’s a limit how far this principle can be pushed (thus that ceteris paribus: investors will, for example, rightly continue to be a little skittish about Belarusian government debt), but the general point remains. This whole issue was examined in an interesting paper by a Belgian economist (it happens. . . ) to which I linked a few weeks back. These two passages are key.

First, look at the UK (which prints its own money):

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…

Then contrast Spain: (which doesn’t)

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…

And on that topic, look what’s happening today to Italian two-year governent debt . . .

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