The euro really makes things different. The combined EU deficit / debt situation is better than that of the U.S. Spain's public deficit and debt situation is better than the UK's. Why is the euro unraveling before our eyes?
There is one absolutely crucial difference between countries in a currency union compared to countries that have their own currency.
Capital flight is the crucial difference between the UK versus Spain
Say investors in a country which has its own currency (Britain, for example) have-- for whatever reason-- no trust in the future of that country and want to get out. They get out of their investment (government bonds, shares, bank deposits, whatever) and get the country's currency instead.
If they don't like Britain at all, or want to invest in another country with another currency, they sell the British currency the pound sterling, buy another currency to buy another investment in some other country.
But what happens to the sold pounds? Somebody has bought them, and the new holders have bought them for a reason, or just want a return on it, or park it in a bank. In a way, these pounds can never leave Britain, for every investor that sells, there will be a buyer.
What can happen is that if there are more sellers than buyers, the pound will decline in value vis-à-vis other currencies (but unless Britain is experiencing high inflation), this actually helps it as its goods, services and assets will become more attractively priced.
Now compare this with what happens in a country under a currency union, for example Spain.
If investors are not happy with the prospects of their Spanish investments, they sell. They get euros, but are under no obligation to re-invest that in Spain, and in fact they're not likely to do that as they sold their Spanish investments in the first place.
They can reinvest their euros somewhere else, in Germany, Finland, the Netherlands, plenty of choice. The euros have left Spain.
It is capital flight that constitutes the crucial difference. Countries in a currency union can (and will) suffer from it while the country issuing its own currency can't. For every seller of their currency, there will be a buyer who has no alternative than to invest it in the country.
The pounds can never leave Britain, no matter how many times they're sold, while the 'Spanish' euros have ample opportunities elsewhere in the euro area.
Self-reinforcing feedback loops
This is happening today. Investors are selling Spanish, Greek, Portuguese, Spanish, Italian bonds and reinvesting the proceeds elsewhere. Deposit holders are withdrawing their deposits from Greek banks and are re-depositing the euros in banks elsewhere.
Whatever the investors are selling (government bonds, deposits, shares), money is leaving those countries and this is making the problem much worse. It creates a self-reinforcing feedback loop in which the confidence of the remaining investors and deposit holders is shaking.
If you have a euro deposit in a Greek bank, wouldn't you start to feel rather nervous if you see the capital ratio of that bank (and Greek banks in general) decline? This is exactly why there is a slow-motion bank run going on in Greece right now. It's tempting to leave, better safe than sorry, and it's accelerating:
Half as many euros fell out of deposits from January to April as during the whole of last year (€13bn and €28bn). Frankly, it looks like an intensification is already here [FT Alphaville]
Something similar is working with bonds. Sellers of Spanish bonds can make those euros leave the country. This cannot happen in Britain, and when things really get tough, the Bank of England can always issue more pounds (for instance, to buy up its public debt). These pounds cannot leave the country.
Therefore Britain cannot go bankrupt, as it cannot run out of pounds. These realities are reflected in the markets, where Spain pays a higher interest rate on its debt than Britain (2.83% on 10 year bonds versus 5.02% for Spain!), despite having a lower debt/GDP ratio (63.4% versus 76.5%, 2010 figures) and according to The Economist, Spain's public deficit (-6.5%) is considerably smaller than Britain's (-9.1%).
It's difficult to explain that whopping difference on 10 year bonds by any other means. The crucial difference is that despite Britain's public finances being in considerably worse shape, it is the master of its own currency, which cannot leave the country and can be created at will, unlike Spain's.
Consequences
These insights, first developed by Belgian economist Paul de Grauwe, with a sterling capability of explaining complex issues in simple terms (he's also the author of one of the best textbooks on European monetary union), provide a pretty good rationale for ECB intervention (even if the Germans think differently).
Providing liquidity keeps Greek banks from falling over just because depositors are taking their money elsewhere. One could retort that perhaps it's not such a bad idea to have Greek banks falling over and the whole propping up of Greece should stop, and you would have something of a point. Greece is probably already way past the point where a partial default and / or leaving the euro (at least temporary) start to make more sense.
However, as we argued elsewhere, the same cannot really be said for a much bigger threat to the euro, Italy. With its relatively modest budget deficit (3.8%, its primary budget is actually in surplus already) and large outstanding public debt (120% of GDP, a whopping 1.8 trillion euros) it is very sensitive to interest rates.
Italian debt financed at 1.5-2 points spread with German debt would still be manageable if the Berlusconi government would be able to significantly narrow the budget deficit and reform the economy so that it could start to grow again.
But as we've noticed above by explaining the large difference between Spanish and British yields, Italy like Spain is severely disadvantaged by its euro membership, resulting in a much higher interest rate cost.
With 300 billion euro of Italian debt having to be refinanced before the end of 2011, the increasing yield could very easily create a negative feedback loop, in which the spiraling financing cost bloats the budget deficit against which, like in Greece, no austerity will no longer work. See the figure below from Barclays Capital:
So there indeed is a reason for the ECB to intervene here to stabilize the interest rates on Italian (and Spanish) debt. So far, they've managed to do that, even using their support (and the possibility of withholding) to prod Italy into taking more measures to bring down its deficit.
This is the only game in town, although we admit, there is still plenty that can go wrong.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
