This paper from Paul De Grauwe is I think one of the best paper to understand Eurozone (EZ) crisis. (shorter version here though fonts are real tiny). It has been highly recommended with Krugman wishing he had written the paper (Though Paul Wenzel says he wrote the same De Grauwe thought in one line and is waiting to get praise) .
Grauwe points why countries in a monetary union are disadvantaged compared to a non-monetary union country. When times are good, the MU model works well otherwise it just falls flat on its face.
He compares UK to Spain and says though UK debt has been higher than Spain, interest rates in Spain are much higher than UK. Why is this so? It is because Spain is part of EMU and UK is out if it:
The reason why this happens can be described as follows. Suppose that investors fear a default by, say, the Spanish government. They sell Spanish government bonds, raising the interest rate. The investors who have acquired euros are likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. Thus the total amount of liquidity (money supply) in Spain shrinks. The Spanish government experiences a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates. In addition, the Spanish government cannot force the Bank of Spain to buy government debt. The ECB can provide all the liquidity of the world, but the Spanish government does not control that institution. This is not the case for countries that are capable of issuing debt in their own currency.
Let us trace what would happen if investors were to fear that the UK government might be defaulting on its debt. In that case, they would sell their UK government bonds, driving up the interest rate. After selling these bonds,these investors would have pounds that most probably they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets.
UK has Bank of England and depreciating pound, Spain (and other EMUs) don’t have wither of these two.
He points to an interesting relation:
Budget Surplus> (real rate of interest – growth) * debt to GDP ratio
If this is not true, the country is heading for a default. Based on this, he calculates the budget surplus needed for UK and Spain. He finds UK does not need a surplus where as Spain needs 2% of surplus. In other words, if Spain is unable to raise budget surplus, it becomes bankrupt despite having lower debt levels.
He then shifts attention to multiple equilibrium. Because of interconnections, MU economies could be together in trouble if one goes bad. This he calls as bad multiple equilibrium.
What is the way out?
- European Monetary Fund : EFSF is a start towards this but charges too high interest rates. Instead there should be a carrot and stick approach. Stick is conditionality of fiscal consolidation over a long period of time. Carrot is those who do it, get concessional rates.
- Eurobonds: He prefers Blue bond/ red bond combo instead of plain eurobonds. Plain eurobonds have problems of moral hazard and core countries like Germany would not want to give their AAA status for these bonds issuances.
- Economic Policy coordination: too much chaos at the moment with everyone talking is different