Blog Post

The euro conundrum

In this piece, Zsolt Darvas talks about how the markets are charging high interest rates for sovereign bonds of peripheral eurozone countries, while keeping the euro exchange rate strong, at the same time. The euro-dollar exchange rate continues to stay well above its equilibrium value and its depreciation earlier this year meant just a correction toward equilibrium. Is […]

By: Date: November 10, 2010 Topic: European Macroeconomics & Governance

In this piece, Zsolt Darvas talks about how the markets are charging high interest rates for sovereign bonds of peripheral eurozone countries, while keeping the euro exchange rate strong, at the same time. The euro-dollar exchange rate continues to stay well above its equilibrium value and its depreciation earlier this year meant just a correction toward equilibrium. Is there not an anomaly? And do recent eurozone governance proposals play a role? What is the path forward?

Markets are charging high interest rates for sovereign bonds of peripheral eurozone countries, but are at the same time keeping the euro exchange rate strong. Indeed, the euro-dollar exchange rate continues to stay well above its equilibrium value as defined by purchasing power parity since mid-2003, and its depreciation earlier this year, which frequently occupied press headlines, meant just a correction toward equilibrium (see Figure). Is there not an anomaly? And do recent eurozone governance proposals play a role?
The strength of the euro suggests that markets do not expect a disorderly dissolution of the euro project, but large sovereign bonds spreads suggests that a government default (or debt restructuring) is not unthinkable. Recent worries about possible defaults have been amplified by the debate on a possible EU sovereign debt restructuring mechanism, following the Merkel/Sarkozy agreement in Deauville on 18 October 2010 and the conclusions of the European Council of 28-29 October. Such a mechanism would facilitate any orderly defaults by governments in a similar way to existing bankruptcy rules for corporations.
This proposal makes sense, but was missing from the recent eurozone governance reform proposals of the European Commission and of the Task Force headed by European Council President Herman Van Rompuy, which placed major emphasis on strengthening existing rules and imposing sanctions.
Sanctions do not offer an appropriate solution to current eurozone fiscal worries. They would not have helped much in averting the current crisis except perhaps in Greece and Hungary, because the major reason why 24 EU countries are currently under the EU’s excessive deficit procedure was private sector imbalances and weaknesses of the European banking industry. Sanctioning at a time of a crisis or when countries are struggling to get out of the fiscal mess caused by the crisis does not make much sense.
Also, sanctions will result from decisions of the European Commission and the European Council and there will be fruitless debates and unsettling disputes, which would not help much to foster the European project further. Sanctions can easily carry the political message that ‘Brussels fines us and does not understand our situation and social problems’. This may give rise to anti-EU sentiment, which would clearly be undesirable. It would be much better to design institutions that encourage discipline through market forces.
The sovereign default mechanism could be such an institution, but there is an even better solution: the introduction of a common Eurobond covering up to, say, 60 percent of member states’ GDP (‘Blue bond’) with the joint guarantee of all participating countries. Countries would issue any additional bonds with their own guarantee (‘Red bond’), which would be junior to the Blue bond, and the orderly sovereign default mechanism should be put in place for the red bonds only. Thereby, this system would provide an extremely strong incentive for countries to convince markets that their red debt is safe, thus promoting fiscal discipline.
Unfortunately, there is little hope that the common Eurobond will be introduced. Instead, the Commission/Task Force proposals will probably be adopted. These also include a number of good initiatives, such as the new ‘excessive imbalance procedure’, which may help to design remedies for private sector vulnerabilities, and the requirement to improve national fiscal frameworks. There is an increasing chance of agreement on a European sovereign debt restructuring mechanism.
Are these reform proposals causing the seeming anomaly between the pricing of the euro and the pricing of peripheral eurozone bonds? The possibility of a restructuring mechanism has likely contributed to rising interest rates, even though the mechanism should apply only to bonds issued after its introduction. But openly discussing the possibility of future sovereign defaults has given rise to the current worries. And Greece indeed has a real solvency problem: high debt, a high deficit, weak tax-collection capability, social unrest and a loss of confidence, and it is difficult to see how this country will be able to avoid default or debt restructuring should a new negative shock occur. But the cases of Ireland and Portugal are different and the best solution for them would be to turn to the EFSF (European Financial Stability Facility) and the IMF in order to buy time.
The continuing strength of the euro does not primarily originate in the recent quantitative easing of the Federal Reserve, nor in governance reforms. Markets have likely realised that earlier worries about the break-up of the eurozone were unjustified and may have also grasped the political commitment behind the euro. It is in Germany’s best economic interest as well to stay inside: a new D-Mark would appreciate excessively, thus halting the German recovery. And even if a eurozone sovereign were to default, it should not impact the existence of the euro. The most difficult challenge the eurozone will face is the joint fiscal and competitiveness adjustment of certain Mediterranean economies which will likely lead to significant growth divergences within the eurozone. But at least the fiscal adjustment is not mission impossible: several east Europeans gave examples of how to do this in the midst of much deeper recessions.

Zsolt Darvas is Research Fellow at Bruegel, Research Fellow at the Institute of Economics of the Hungarian Academy of Sciences and Associate Professor at the Corvinus University of Budapest.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

Will European Union recovery spending be enough to fill digital investment gaps?

The recovery facility will boost digital transformation, but questions remain whether it will be sufficient to achieve Europe’s digital ambitions.

By: Zsolt Darvas, J. Scott Marcus and Alkiviadis Tzaras Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 20, 2021
Read article Download PDF
 

Policy Contribution

A new direction for the European Union’s half-hearted semiconductor strategy

The EU needs a more targeted strategy to increase its presence in this strategic and thriving sector, building on its existing strengths, while accommodating its relatively low domestic needs.

By: Niclas Poitiers and Pauline Weil Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 15, 2021
Read article More by this author
 

Blog Post

Fit for 55 marks Europe’s climate moment of truth

With Fit for 55, Europe is the global first mover in turning a long-term net-zero goal into real-world policies, marking the entry of climate policy into the daily life of all citizens and businesses.

By: Simone Tagliapietra Topic: Energy & Climate, European Macroeconomics & Governance Date: July 14, 2021
Read article More on this topic
 

Blog Post

Fair vaccine access is a goal Europe cannot afford to miss – July update

European countries must do more to tackle the vaccine uptake gap. Vaccination data should be published at the maximum granularity level so researchers and local decision-makers can monitor progress.

By: Lionel Guetta-Jeanrenaud and Mario Mariniello Topic: European Macroeconomics & Governance Date: July 14, 2021
Read article More by this author
 

Blog Post

SPACs in the gap

Special-purpose acquisition vehicles could fill a gap in European equity markets and lure risk-averse investors off the sidelines.

By: Rebecca Christie Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: July 13, 2021
Read about event More on this topic
 

Upcoming Event

Sep
1
12:30

The EU recovery fund - state of play and outlook

Bruegel Annual Meetings, Day 1- In this session we will discuss the EU recovery fund, its state of play and outlook.

Speakers: Nadia Calviño, Karolina Ekholm and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic
 

Upcoming Event

Sep
2
10:00

Conversation on the recovery programmes

Bruegel Annual Meetings, Day 2- In this session, we discuss the recovery programmes.

Speakers: Maria Demertzis, Mehreen Khan and Tadeusz Kościński Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event
 

Upcoming Event

Sep
2
13:00

European banks: under global competitive pressure?

Bruegel Annual Meetings, Day 2 - European banks have lost stature and remain generally low-profitability, low-valuation in comparison to their global peers. Is that a problem? If so, what can EU policymakers do to address it?

Speakers: José Antonio Álvarez Álvarez, Mairead McGuinness and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
2
15:45

Blending physical and virtual: shaping the new workplace

Bruegel Annual Meetings, Day 2 - This panel will cover the changes the COVID-19 pandemic made to our workplaces, and what to expect in the near future.

Speakers: Nicholas Bloom, Michael Froman, Mario Mariniello, Sara Matthieu and Luca Visentini Topic: European Macroeconomics & Governance Location: Academy Palace
Read about event More on this topic
 

Upcoming Event

Sep
3
09:00

The role of the EU's trade strategy for an inclusive and sustainable recovery

Bruegel Annual Meetings, Day 3 - We are delighted to welcome Valdis Dombrovskis, Executive Vice President of the European Commission for An Economy that Works for People to talk about Europe's trade strategy.

Speakers: Valdis Dombrovskis and Alicia García-Herrero Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
3
10:15

Conference on the Future of Europe: envisioning EU citizens engagement

Bruegel Annual Meetings, Day 3 - Panellists will discuss different options and what they may entail while revisiting the debates on the future of Europe at national and EU-level that have been conducted thus far.

Speakers: Caroline de Gruyter, Kalypso Nicolaïdis, Niclas Poitiers and György Szapáry Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read article More on this topic
 

Blog Post

A breakdown of EU countries’ post-pandemic green spending plans

An analysis of European Union countries’ recovery plans shows widely differing green spending priorities.

By: Klaas Lenaerts and Simone Tagliapietra Topic: European Macroeconomics & Governance Date: July 8, 2021
Load more posts