My Random Ramblings

The Eurozone Crisis

Prof. Jonathan Haskell taught a course in the winter called Europe in the Global Economy (EGE). It was a very interesting course that explored the various elements that together make up the European Union, the Eurozone and numerous other Euro-entities. He was back at Tuck today and gave a nice little summary of the EGE course.

The Euro Crisis in 1 Slide:

  • The summary of the Euro crisis is this: If you lived in New Hampshire, and opened an account with a local NH bank, then the value of a dollar deposited there is the same when you withdraw it in California. That’s not the case in Europe today: A euro in a Greek bank is not the same as a euro in a German bank.
  • Why did this happen? The simple graph below explains the reasons for the debt crisis.
  • As the graph illustrates, interest rates were widely dispersed before the introduction of the Euro. Greece, Portugal, Spain etc. paid more, Germany, France paid less.
  • After the introduction of the Euro, every country suddenly had the same borrowing rate even though nothing really had changed (of course, this wasn’t conventional wisdom during the 10 years).
  • After the Lehman bankruptcy, individual countries borrowing profiles reverted to pre-Euro states. However, the huge debts piles had been built up until that point, and servicing that debt is what’s causing much of the pain today.

What are first order causes of the Euro crisis?

  • A triggering event - like a Hurricane, oil crisis etc. In this case it was the Lehman Bankruptcy.
  • Amplification: Something which causes the triggering event’s consequences to be much worse. For instance, poor housing construction will amplify the damage that a hurricane causes. In the Eurozone, the amplification event was the leverage of the banks - which was many times higher than that of  US banks.
  • Lack of equalizing/market mechanism: Assume the above happen. Market forces then come into play to cause adjustments. Rents will rise, that will give impetus to more housing construction and so on. In the Eurozone, the fundamental equalizing mechanism - exchange rates - has been taken away. Hence the freeze and extremely painful adjustment.

So what’s next for Europe?

  • No one really knows, but any exit from the Euro by Greece or Germany will be painful
  • The really gloomy scenario is that Europe stays in a state of uncertainty for a long period of time, and the situation really becomes like that of the interwar years.

Prof. Haskell made a great comment when asked about a return to the gold standard. He said that any commodity that is used to back a currency is subject to price-corrections when new reserves of said commodity are discovered. In that sense, geologists are setting monetary policy as opposed to economists.

  1. wanderingyogi posted this