Here we go again. A Eurozone country builds up a large deficit over time. Their bond yields rise as investors panic about their ability to repay their debt. They put in unpopular austerity measures to calm fears, but it does not work. Soon stocks start falling, the euro falls, and everyone panics. Eventually the European authorities step in to discuss a bailout package. Finally a package is agreed, the markets calm down, and all is well.
Except all is not well. A few months ago this was Greece, and today this is Ireland. Tomorrow it could be Spain, Portugal, Italy, or anyone else. Why are all these countries facing so many problems? The USA and UK have
high debt levels too, yet can borrow at extremely low interest rates and no one talks about them needing a bailout.
When countries decided to join the Euro, they gained improved access to trade with other European countries, as well as the opportunity for a strong stable currency. Most countries saw their borrowing costs fall when they joined the Euro (perhaps this was not a good thing, as now they have too much debt). So many benefits, but what did they give up? And could this be causing the problems today?
They gave up something many countries consider essential to their economic well being: An independent central bank. They lost the right to set their own interest rates, and control their own money supply. All the countries in the Eurozone now have a single interest rate and single currency, and this is problematic because all the Eurozone countries have different economic situations.
High deficit countries need the ability to devalue their currency to restore economic competitiveness (i.e. boost exports). Being part of the Euro prevents this from occurring.
Back to what I mentioned earlier, why are the USA's bond yields so low? How is it that we are much more certain the USA will repay its obligations, but Ireland or Greece will not? The answer is quantitative easing. The Federal Reserve prints dollars, which does two things. First, these dollars are used to buy bonds so yields are kept low and deficits are easily financed. Second, QE also devalues the dollar, which is necessary given the USA's large trade deficits.
QE will probably encounter its own problems in the future. But for the time being at least, it means we don't worry about the USA defaulting. As Eurozone members, Ireland and Greece do not have the luxury of their own central bank and thus have fewer policy tools to deal with their debt.
But surely the European countries thought of this problem when the euro was first created? Yes they did, but not fully it seems. There are rules to being a member of the Eurozone that limit budget deficits and total debt, which is a good thing. Unfortunately, most countries have broken these rules and there is no way to enforce them.
Only time will tell whether the Euro was a good idea for countries to join. However, its flaws have become apparent. We must keep in mind that countries choose to join the Euro for two reasons. First is the economics, which we know has its benefits and drawbacks. Second is the politics, which likely only brings benefits, and we can be pretty sure many countries were motivated by political factors over economic factors when deciding to join the Euro.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!