Wednesday, May 11, 2011

Problems of Monetary Union in Recession


Since the credit crisis,UK government bond yields have stayed low, despite having similar levels of government borrowing to Spain, Portugal and Ireland.

Why have members of the Euro faced more difficulties in financing debt than the UK?
(It is a similar story for US and Japan where interest rates have stayed low despite high levels of borrowing.)

Essentially members of the Euro need to finance their budget deficit, but they don't control their own monetary policy.

1) Devaluation

Since the credit crisis, the value of sterling has fallen considerably. This helps boost exports and growth. This boost to economic growth helps reassure investors the government will have more ability to pay back debt. The devaluation in sterling also makes sterling assets appear more attractive and so may encourage foreign investors to buy.

2) Bank of England could buy government bonds as last resort.

If the UK has difficulty in financing the deficit, the Bank of England can act as lender of last resort and buy up government bonds. This mechanism gives investors more faith that the UK can remain solvent. There is no danger of a liquidity crisis.

If Spain or Ireland has difficult selling bonds to the private sector, investors will sell Spanish bonds, however, this won't cause a depreciation in the value of the Spanish currency (because there is only the Euro). Therefore unlike the UK, Spanish assets don't become more attractive. Also, Spain will face a stronger currency than is ideal for the state of their economy.

Spain also can't ask the Spanish Central Bank to buy Spanish bonds. In theory the ECB could, but they are reluctant to for various reasons.

The markets know that Spain is more vulnerable - they can't benefit from devaluation and they can't ask their Central Bank to buy bonds. This increases the risk that Spain faces a liquidity crisis (can't raise enough money) Therefore, investors will be quick to move out of Spanish bonds into something more secure. The fear of a liquidity crisis in Eurozone countries means they are much more vulnerable to worries over increase in debt.

Vicious Cycle

As Spain struggle to finance its deficit, it may rely on a bailout from the EU. This provides liquidity but also the ECB impose conditions (punishment). The EU make Spain and Ireland pursue austerity (spending cuts) and accept higher interest rates on bonds. The higher interest rates and spending cuts will lead to lower growth, deflation and higher unemployment. But, this fall in economic growth also leads to lower tax revenues which increases debt and makes Spanish debt more unattractive.

The result is that in a recession, Euro members have become much more vulnerable to problems in the bond market. It also means that their response to a recession needs to focus on deflationary measures (strong exchange rate, higher interest rates and spending cuts). However, this is exactly the wrong response that you need in a recession.

Also, these countries still face an interest rate set by the ECB for the whole Eurozone. The ECB have already indicated that recovery in Germany and France will lead to higher interest rates. But, higher interest rates is not what Ireland needs given they currently have deflation.

UK bonds are relatively more attractive because:
  • The economy has more flexibility to devalue and restore competitiveness
  • They can pursue quantitative easing to boost economic growth
  • The Bank of England has the independence to help buy government securities.
  • There is less risk of deflation and a recession.
  • Longer date on maturity of UK bonds.
Members of the Euro have been much more vulnerable



Anonymous said...

Nice article. Very clear and simple to understand. Great job.

Alex said...

By devaluate do you not mean depreciate?

PloughShare said...

The argument appears to be that whereas the Euro is comparable to gold,
its in limited supply and National-Banks and Governments can't make more of it,
the UK's Pound, a fiat currency?, can suffer inflation and devaluation which is said to be a 'good thing' for the UK's subjects and users of the Pound.

I disagree.
Inflation and Devaluation is just like Clipping and Debasement of gold and silver coins in the 'good old days' . A crime.

Perhaps we need some way to balance a UK economy which exploits Inflation and Devaluation?

How about an Inflation Tax?
Suppose the UK RPI inflation is 5 % p.a., then the Chancellor should impose an annual tax on all 'fixed-wealth' by which to repay the losses made by 'savers of Pounds' in that year.
At present the size of the UK savings vault is about; £800 Milliard in Sight deposits and £1200 Milliard in Term deposits. This vault loses value at 5 % p.a due to Inflation. A value lost forever, never to be recovered, each year of £100 Milliard.

Mrs Teresa May, Home Secretary, say that the UK's organised crime costs only* £40 Milliard p.a, and one might presume that this money is not so much 'lost forever' as moved to different parts of the UK economy.
Whereas there is an industry dedicated to preventing or reducing organised crime which loses say £5 Milliard a year, there is no effective treatment of the £100 Milliard loss to savers caused by inflation.

* My word, see Post 14 at

A secondary theme is that “members of the Euro need to finance their budget deficit”.
I disagree.
This is 'Cart before the Horse” thinking. Members of the Euro need to finance their Budget. This implies greater or more efficient tax collection. What is wrong with a tax on 'fixed wealth'? How is it being avoided ?

PS 13-May-2012