Twenty-first century competitive currency devaluations

Marshall Auerback was on BNN’s SqueezePlay yesterday talking about the crisis in Greece (this time without his banker’s pinstriped suit – but we all know he’s a fund manager anyway!). He made some interesting comments about currencies I wanted to run by you.

Greece is the Bear Stearns of sovereign debtors

I know you have already seen comments from me, Marc, Claus, and the other Edward on Greece today. But this is a very big deal. Marshall calls it the Bear Stearns event in the sovereign debt crisis, a line he got from me. Here’s the thinking:

Talk about Minsky moments. We are facing one right now.

It reminds me a little of the subprime crisis.  When it engulfed Bear Stearns, policy makers stepped in with bailout money.  The immediate problem of Bear Stearns’ collapse was solved, but the systemic issues remained. Yet, recklessly, policy makers did almost nothing in the few months afterwards to deal with those issues. This was a crucial error given that people like me were warning of impending calamity. I was mystified (see comments at the end of my Swedish crisis post). The Minsky moment came and policy makers missed it entirely.

In fact, many were incensed because they thought Bear should have failed. So when Lehman came around, it did fail.  And we all know how that turned out.

So, here we are again. The sovereign debt crisis has been building for three months now – ever since Dubai World announced it wanted to default on its loans. In my view, we have now reached a critical juncture. If Greece is allowed to default, all hell will break lose.  On the other hand, Greece has run a deficit for years. It’s ‘cheated’ to meet the standards set forth in its previously agreed-to treaties and it is unwilling to take austerity measures that Ireland, faced with similar circumstances, has taken. What should the EU do?

The dilemma is this: how do you eliminate moral hazard for perceived free riders while still credibly safeguarding against the destruction and contagion that a Eurozone sovereign default would create?

Greek death spiral hits bank credit ratings. What should the EU do?, Feb 2010

Whether deficit hawk or dove, pro- or anti-bailout, these are the real issues we all see: moral hazard, safeguards, contagion, default.

The fact is Greece faces an enormous funding gap (at least 60-80 billion euros over the next few years). No rescue plan is credible unless it backstops Greece for the entirety of that gap (see The Economist’s "Still in a spin").

But, Greece has run budget deficits in good times and bad due to its bloated public sector. Meanwhile uncompetitive wage rates mean recovery via exports is a tough road to hoe. So, the ‘bailout’ on offer is not credible in the least.

And since Portugal, Ireland, Italy and Spain have the same problems, Greece is to Bear Stearns as the next of these countries to hit crisis is to Lehman Brothers.

What to do?

Competitive Currency Devaluations

Marshall says there are two scenarios.  Watch Marshall’s BNN clip linked at the bottom. It runs just over eight minutes. He explains the scenarios well. I want to add some colour to the discussion.

In scenario one, you eject Greece from the Eurozone, they devalue their currency and, after a turbulent period, they are on the road to recovery.  The problem, of course, is that it’s on to the next Euro debtor, Portugal.  Do they then get ejected too?  Next stop, Spain. And then Italy. Marshall says that France, in particular, would face a serious problem with competitiveness in such a scenario. As I recall, France is a founding member of the so-called Club Med southern European Eurozone countries. This is not a good outcome for France. And it is certainly not a good one for the European banks which hold the sovereign debt of countries like Greece, which has the largest external sovereign debt-to-GDP ratio in the world.

Outcome number two is to depreciate the Euro, of course. The Euro is dropping as we speak.  But, I am talking about a more serious decline. As I recall, the Euro dipped to as low as 83 cents during Robert Rubin’s strong dollar policy days.  If the EU structures the bailout in the right way (fully backstops the period of increasing debt to to GDP) and floods each country with liquidity (aka prints money), you are sure to get this kind of outcome. Everyone gets a massive boost to competitiveness. Problem solved.

However, the Germans would never go along with this ‘weak currency’ strategy.  Moreover, the Americans would cry bloody murder because this is a competitive currency devaluation of the entire Eurozone.

To date, I have talked about the EU as a external-deficit neutral block.

you can’t have Germany and Spain both running current account surpluses, unless the EU as a whole runs a current account surplus. So, if Germany (or the Netherlands) wants to be the export juggernaut and run a massive current account surplus, this has intra-EU ramifications. The most important is that Germany’s (or the Netherlands’) current account surplus (capital account deficit) is matched by current account deficits (capital account surpluses) in Spain (Portugal, Greece, Ireland and Italy).

Spain’s debt woes and Germany’s intransigence lead to double dip

But, if the Euro fell to parity with the US Dollar for example, the Eurozone would become a net exporter, pushing the US external balance even more into the red.

Neither of these scenarios is particularly palatable as they are likely to increase already mounting trade friction.  The other Edward mentions the only other viable alternative: a restructuring or default.


SqueezePlay : April 22, 2010 : Euro to Fail? [04-22-10 5:20 PM]

  1. John Haskell says

    “As I recall, France is a founding member of the so-called Club Med southern European Eurozone countries.”

    Just a few quick questions about Club Med. (the group of substandard Eurozone countries, not the tour operator)

    1. When was it founded?
    2. Who determined which Eurozone members were in “Club Med”? Is it anyone with a Mediterranean coast? Or just anyone with poor budget discipline? Is that why they came up with “PIIGS,” because “Club Med” can’t include Portugal if Portugal is on the Atlantic?
    3. Malta and Cyprus can’t have been founding members of Club Med because they only joined the Euro in 2008. Were they told that if they joined the Euro they would also have to join “Club Med”? Because you can’t get more “Med” than being an island in the Mediterranean.
    4. Categorization of Slovenia. It has a coastline on the Adriatic and is a Eurozone member. Is it also “Club Med”? When did it join?


  2. Olivier Travers says

    Cheaper euro should be more palatable to the Germans than high inflation and huge bailouts. Sounds like the best way to give back their cheap currencies to Club Med without blowing the whole EMU up. Italy and France devalued their currencies every other year as recently as the 80’s. Then during the 90’s it seemed 1USD/6FF was a sweet spot for France’s trade, which is close to parity (1EUR=6.56FF).

    In other words, at $1.25 the EUR is still relatively expensive, and higher than at launch. EUR at $1.5+ is bottom-cheap dollar by historical standards (4FF).

    Did Europeans scream bloody murder and launch a trade war when the dollar has been below 0.7 to the EUR for years? America should suck up that their currency might go back to a more normal valuation.

  3. eym says


    After reading the article in the Independent on Obama’s role in the EU bailout and the 2nd option above, I’m beginning to think Obama was rolled by the Germans and French.

    1. Edward Harrison says

      Obama’s role in the Euro crisis, especially in Spain is peculiar. I know most Americans like to think of the US President as the leader of the free world but his intervention in Spain’s domestic policy agenda suggests he knows something that you and I don’t know. I keep pointing the finger at AIG as an insurer or seller of CDS but there could be other explanations.

      In any event, the concept that the US President would call up another government leader and ask him to make budget cuts for the good of the world is something that will require an explanation down the line. And the Spanish media are positioning it that way too. The interesting bit is that Zapatero delivered – immediately. Very odd… and very worrisome, if you asked me.

      1. Olivier Travers says

        I might be wrong, but here’s the dialog I picture in my head:

        O: Holà Zap, what’s up?

        Z: ¿Hi O, yo wassap? (wondering why the honor all of a sudden, basking in the light for a sec)

        O: listen Z, you gotta do something about that Euro shit before it goes out of control.

        Z: … ¿I thought we just did, what with the EU/IMF shit and all?

        O: well, that’s not going to fly with my Senate if you guys don’t seriously go through the motions, what with the massive US contribution to IMF… Also I have mid-terms coming up, I have to show who’s the man here. Hold people accountable, blah blah blah

        Z: I see. ¡But my hands are tied, what with I’m a socialist, trade unions and shit you know!

        O: I’m not asking, I’m telling.

        Z: … ¿Can I at least leak that you called me so it looks like my hands are tied and it’s serious and shit?

        O: Sure, you do that.

        O: Well, it’s been nice to catch up, we should do this more often. Say hello to the wife and goth kids, hmmkay?

        Z: OK, later. I think I’ll leak some shit about Sarko too. Maybe tomorrow.

  4. David Pearson says


    I strongly recommend Gary Gorton’s book, “Slapped By The Invisible Hand” as perhaps the best guide to the 2007-2008 crisis. He argues its basically a run on repo financing of the shadow banking system caused by the sudden emergence of risk in AAA-rated collateral. His idea is that panics occur when deposits (repos) go from being information insensitive (you only need to know the AAA rating) to information sensitive (you want to know much more but can’t). I would argue this is the essence of the European problem: their banks hold AAA-rated SOVEREIGN collateral, and therefore their financing is at risk of runs. The reason the EU bail-out didn’t solve the problem is that it did not absolutely remove the risk of AAA-rated collateral suffering losses (this is mostly due to the subordination of non-bilateral/IMF creditors). The fall in the Euro may reflect erosion of funding of European banks — the precursor to a “Gorton” bank panic in repo financing. The fact is “Euro’s” are created by the ECB but held mostly in the form of short term bank deposits and repo’s.

    Can the ECB keep the Euro decline orderly — a defacto loosening of monetary policy and competitive devaluation? They are playing with fire, as a disorderly devaluation would greatly harm the European banks, just as a disorderly peso or real deval hurts those country’s banks. There is a difference between a deval that occurs in an environment of sovereign risk fears and one that doesn’t. In the latter, currency holders can be relatively unaware/unconcerned about the loss of value of their holdings, as the losses are difficult to anticipate. In the former, holders are acutely aware that both the currency and the collateral backing deposits/repo’s are at risk; that speculators will attack and cause a decline; and further, that the Central Bank and government can do little to prevent that drop. In that instance, if you are a Euro holder, why not hedge and/or sell? Disorderly devals happen when (crowded) shorts spark selling by natural holders of a currency…

    So we may be past the point of an orderly, competitive deval being a realistic option. The options are: 1) bail out the European banks by backing sovereign debt 100% (something only the ECB can do — fiscal policy is constrained by politics); or 2) risk a run on European bank Euro repo’s/deposits.

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