Euro: heading for the debts?

Euro receipt 8 August 2011

The European Central Bank’s decision to buy Spanish and Italian government debt has created a momentary breathing space, but the Euro debt crisis is far from averted. In the UK, the value of FTSE 100 companies has taken a severe battering as a result of the turmoil in the global markets. And across the Atlantic the US triple-A rating has been cut for the first time, reflecting concerns about the large budget deficit and the political infighting.

The quandary for the EU is how to square national sovereignty with international finance - and international debt. The European Central Bank is in charge of the monetary policy of the countries in the eurozone, but the supervision of the policy is up to each EU country. This made it possible for the Italian government to dodge unpopular austerity measures while the government debt kept climbing.

"The role of the central bank is the major issue at stake in this organisational structure, in particular, whether supervision should be a responsibility of the central bank," Luis Garicano and Rosa Lastra states in the Centre for Economic Performance (CEP) Discussion Paper Towards a New Architecture for Financial Stability: Seven Principles (PDF, 486Kb).

The researchers argue that a central bank needs to have responsibility both for monetary policy and supervision. The central bank will at any rate have to ensure financial stability, as it is the only institution which can take on the role as lender of last resort, and has the necessary clout to enforce actions.

"It is necessary that the European Financial Supervisory authority or authorities be endowed with authority to overrule and direct the National Supervisors," they add.

"If governments do not cooperate when dealing with an international crisis but instead behave strategically, this can lead to decisions that are 'sub-optimal' from a global perspective," Friederike Niepmann and Tim Schmidt-Eisenlohr points out in the CEP CentrePiece article Bank bailouts in a global economy: the challenges for international cooperation (PDF, 392Kb).

What happens when a country defaults on its debts? The ERSC research project Legal and Economic Aspects of Sovereign Debt Default: The Argentina Case examines the impact of the Argentine default in 2001 - looking at reputational incentives to repay debt, the relation between creditors and borrowers, sovereign debt restructuring and international regulation.

In another CEP Discussion Paper, Currency Unions in Prospect and Retrospect (PDF, 478Kb), J. M. C. Santos Silva and Silvana Tenreyro consider the costs and benefits of joining a currency union such as the Euro. Unlike estimates of the trade effect of other currency unions, they could not find "any statistically significant effects" on trade as a result of introducing the eurozone. They find that "in terms of financial integration, important changes in trends are observed with the introduction of the euro, particularly for cross-border holdings of bonds and equity".

As part of the World Economy and Finance research programme Dr Andrew Scott, Professor Albert Marcet and Elisa Faraglia have examined the optimal ways of managing government debt. In their research project Risk Sharing and Contingent Debt they conclude that it is very difficult to insulate fiscal policy from shocks by using the 'complete markets' approach to debt management (where the composition of government debt is chosen so fluctuations in market value offset changes in future deficits).

Another WEF project, Monetary Policy, Welfare and the Structure of International Financial Markets, looks at the issue of international assets. Today people in one country hold massive quantities of assets located in other countries, privately or through pension funds, insurance companies or government debts and assets. Professors Alan Sutherland and Michael Devereux have developed a new method of calculating optimal portfolios and analysing risk in an open economy model.

But as recent research from the Centre for Competitive Advantage in the Global Economy shows, an open economy can also provide some benefits. In the research project Openness, Protectionism and Britain's Productivity Performance over the Long-run Professors Stephen Broadberry and Nicholas Crafts found that the open economy allowed nineteenth-century Britain to focus on the lucrative industrial and service sectors - and that protectionism introduced in the 1930s did not improve British industrial performance.