Tomorrow is Euro Day and it reminds me of aspirin.
On May 9, 62 years ago, the French foreign minister proposed a limited economic partnership with West Germany. By the time the treaty was signed in 1951, the Netherlands, Luxembourg, Belgium and Italy had joined also to form a 6-nation coal and steel free trade zone. With people, services, goods and capital moving ever more effortlessly across European borders, that free trade zone grew and became a monetary union. Here, I would usually say that 19th century free trade advocate David Ricardo would be smiling.
Instead, aspirin comes to mind.
Imagine for a moment, a country with a sick economy. Lenders know it is ill so they ask for relatively high interest payments when that country borrows. Then though, the country joins the euro zone. Rather like taking aspirin for a fever, being a euro zone member makes it look healthier than it really is. As a result, lenders let the country borrow more easily. But really, it was still sick. It needed an economic antibiotic to attack the disease rather than just an aspirin for the symptoms.
That country is Greece. And now, with its illness having resurfaced, Greece has been prescribed fiscal medicine that includes 11 billion euros of spending cuts. Based on current political turmoil, they believe it was the wrong prescription.
Our Bottom Line: Can euro zone monetary union work without nations being required to take fiscal–spending, taxing, borrowing– medicine?
The Economist has a superb series of maps that display, country by country, different euro zone debt, growth, unemployment in which Greece, Portugal and Italy stand out for their massive debt. This Chicago Tribune story from Reuters tells more about Greek political turmoil. And here, in a NY Times Magazine article, Paul Krugman clearly and logically talks about euro zone history and challenges.
Some of the euro zone’s problems actually started with the Exxon Valdez oil spill.
After the 1989 Exxon Valdez calamity, when an Alaska jury said that Exxon owed $5 billion in damages, they asked J.P. Morgan for a $4.8 billion line of credit. Concerned about so large a loan, J.P. Morgan wanted to protect itself.
So, they invented the credit default swap in 1994 at a J.P. Morgan “team-building” weekend in Boca Raton, Florida. A new kind of insurance, the credit default swap (CDS), was sort of like fire insurance that you could buy for a house you do or do not own. Instead though, the J.P. Morgan product insured different kinds loans that included money borrowed by businesses and by countries.
Let’s fast forward to today. The CDS market has grown to more than $15 trillion. In the euro zone, the CDS has become a complement to bond buying. Does a bank want to purchase an Italian bond? To minimize its risk, it needs a corresponding CDS. How did we get from Alaska to Italy? That is another story.
Here is a more technical description of a CDS.
The Economic Lesson
Selling bonds called sovereign debt, Country A is the borrower and a bank could be the lender. However, like J.P. Morgan and the Exxon line of credit, the bank then enters Country A’s CDS market to reduce its risk. If Country A defaults, the CDS seller pays the bank that bought the insurance.
When investors buy Greek, Portuguese and Italian bonds can they buy the corresponding credit default swaps and “eliminate” their risk? It all depends on what “default” means.
An Economic Question: Explain how credit default swaps might be good and bad for a nation with a history of loan defaults.
Almost everyone seems to be debating the same issues. Spend less, tax more, or both?
Now perhaps Portugal has made some progress. Hoping to bring its budget deficit down to 4.6% of GDP in 2011, their VAT will ascend to 23%. But will they cut public sector pay 5%? They vote in several days. Last spring, Italy announced a civil servant wage freeze. Meanwhile Ireland, with the highest budget deficit in the EU (Luxembourg was the least indebted in the EU) announced that its spending cuts and refusal to pay into a pension reserve fund were achieving some success. Interestingly, Spain said it has made progress but, the areas it will not cut include pensions and unemployment benefits. Finally, Greece. Maybe some progress with spending cuts but tax revenue is a challenge.
What does all of this mean? Markets are not optimistic. The price of insurance, a credit default swap, on PIIG’s debt has risen.
The Economic Lesson
A credit default swap is like an insurance policy. Instead of diminishing the impact of a house fire or a jewelry loss, this kind of insurance lowers the risk of a financial investment. Yes, credit default swaps were central to AIG’s financial debacle because AIG sold much more “insurance” than they could possibly cover. Managed appropriately, as described in this econtalk discussion, credit default swaps perform a valid financial role.