There's a lot of talk about the declining dollar, but we might better be worrying about the euro. Greece may finally be reaching the end of its ability to borrow at any price, and what the euro zone does about this crisis--the EU is statutorily forbidden to intervene--may determine whether the euro ultimately survives.
Greece has already accumulated a mountain of debt that will be difficult if not impossible to pay off. The government has borrowed more than 110 percent of the country's economic output over the years, and if investors lose confidence in the bonds, a meltdown could happen as early as next year.
That's when the government borrowers in Athens will be required to refinance €25 billion worth of debt -- that is, repay what they owe using funds borrowed from the financial markets. But if no buyers can be found for its securities, Greece will have no choice but to declare insolvency -- just as Mexico, Ecuador, Russia and Argentina have done in past decades.
This puts Brussels in a predicament. European Union rules preclude the 27-member bloc from lending money to member states to plug holes in their budgets or bridge deficits.
And even if there were a way to circumvent this prohibition, the consequences could be disastrous. The lack of concern over budget discipline in countries like Spain, Italy and Ireland would spread like wildfire across the entire continent. The message would be clear: Why save, if others will eventually foot the bill?
On the other hand, if Brussels left the Greeks to their own devices, the consequences would also be dire. Confidence in the euro would be shattered, and the union would face a crucial test. What good is a common currency, many would ask, if some of the member states pay their debts while others do not?
Furthermore, there is a threat of a domino effect. If one euro member falls, speculators will test the stability of other potential bankruptcy candidates. This could destroy the currency union. Because of this systemic risk, say the economists at the Swiss bank UBS, "we believe that if a country is facing a problem with debt repayment or issuance, it will be supported.
When the euro finally sprang into the existence, I was at the Economist, and as you can imagine, I ended up writing a lot about its future. Much of what I wrote revolved around the theory of optimal currency zones. If your currency zone is too small, you lose out on gains from trade, because of transaction costs and currency risk. If your currency zone is too big, you have a different problem: your one size fits all monetary policy chokes off growth in some areas, and allows other areas to overheat.
You can see how this operates a little bit with the world's many failed dollar pegs. Argentina, for example, ended up in a multi-year recession because it forced a tight monetary policy on a country that needed stimulus. That (and the Argentinian government's inability to control its spending), is what ultimately led to the 2002 default.
That was the concern at the time, and indeed, that's what we saw over the last decade: Ireland and Spain racing ahead, while places like Italy got stuck in the doldrums. You don't actually need an optimal currency zone to have a successful currency: the United States is far too large to actually be optimal, which is arguably one of the reasons that we have so many areas stuck in what seems like permanent stagnation. But the United States has a lot of advantages Europe is lacking, which help to smooth over the rougher edges.
For one thing, the US has a very high level of labor mobility compared to the euro zone. This is even true within European countries, but it's really visible when you look at the zone as a whole. There are language and cultural barriers, differences in business practices, and frictions with various social security systems, that make European workers less willing to pick up and move to where the jobs are.
The US government also has automatic fiscal stabilizers which transfer money from successful regions to struggling ones. If your state is doing unusually poorly, unemployment benefits, welfare payments, and other transfer programs automatically start to rise, which mitigates the worst of the economic decline.
Until now, it also hasn't been the case that state governments varied wildly in their level of fiscal responsibility. Most states balanced their budgets by law, and kept their borrowing roughly in line with the revenues they had to cover it. (Unfunded obligations like pensions are another matter, but everyone has that problem.) They were able to do so in part because the Federal government picks up the slack during recessions or regional slowdowns.
The euro zone, on the other hand, has tightfisted Germany spliced together with spendthrift Italy, which previously relied on serial devaluations of its currency to boost exports and ease the burden of its debt payments. This is why I was more skeptical than most observers--including most of my colleagues--that the euro zone was going to survive long term. If a few members are forced to exit, either because the central bank's monetary policy is keeping them mired in recession, or because they need to inflate away a massive debt burden, then it's hard to see how the zone survives. If investors think the euro zone is fragile, they'll demand higher interest rates to compensate for the currency risk they're assuming. Furthermore, a smaller currency zone means smaller gains from trade, and presumably less incentive to pay the price of turning your monetary policy over to the ECB.
So far I've been proven wrong. But Greece's situation may provide an unhappy test of my hypothesis. There seems to be some serious moral hazard in the market for the debt of troubled euro zone members: as the quote above implies, investors are betting that other members will bail Greece out rather than risk damaging the euro. As we saw right here in America, markets that believe in implicit government debt guarantees are extraordinarily fragile. And as we saw in America, there may be no good solution: bailing out Bear and letting Lehman fail were both extraordinarily costly.
A Greek bankruptcy thus has serious implications for Europe, and indirectly, for the rest of us. European banks are heavily invested in Greek bonds, and if the country defaults, it's probable that speculators will start eying other euro zone members. Consider Ireland, which has a relatively low debt-to-GDP ratio--but which saw that ratio spike from 25% in 2007 to 43% in 2008. Europe's finance ministers face some tough decisions in the days ahead.
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