The Fixed-Currency Trap

Many conservatives see Greece as a parable upon the dangers of excess government debt. It is that. Above all, however, it is a parable on the dangers of excess government debt in a fixed-currency regime.

Kenneth Rogoff (co-author of the brilliant new book on financial crises, This Time is Different) in today's em>FT<:

The cruel irony of the euro area’s predicament is that, in many ways, the whole exercise was designed to produce the very credit explosion that bedevils it today. After all, one of the driving motivations of the euro was to enable member states to compete with the U.S. for a share of the global reserve currency business. Reserve currency status, in turn, is the essence of America’s “exorbitant privilege” (a term coined by Valéry Giscard d’Estaing, the former French president). The most important perk the U.S. gets is the ability to issue debt at a lower interest rate than would otherwise be the case. Indeed, recent research suggests that simply by enhancing the size and liquidity of financial markets, the euro may have helped to lower real interest rates across Europe, and not just for government borrowers.

Lower interest rates, in turn, helped fuel greater borrowing, especially in the countries of the eurozone periphery. Thus, the spreading debt crisis is as much a product of the “success” of the euro as of its failure. The euro was designed to be a superior debt financing machine and, to a considerable extent, it has delivered.

This "success" however carried an unspoken catch.

Unfortunately, it should have come with a warning sign: Europe’s leaders were far too quick to admit members who might have been better served with a much longer probation period. The Maastricht treaty and, more importantly its implementation, was simply too forgiving, especially for countries with chequered financial histories.

Rogoff could have added: and once those dubious buyers were admitted to the Euro, the Euro then imposed a very hard constraint on their domestic policy if anything should go wrong. In order to borrow more cheaply, Greece forswore the freedom it once had to cope with debt by devaluation, as Canada did in the 1990s, as the United States is doing now, as the United Kingdom likely will in the 2010s. Greece must repay in a currency whose value is set without reference to the needs of the Greek economy.

Many conservatives, including some posters here on the FrumForum, see Greece as a parable upon the dangers of excess government debt. It is that. Above all, however, it is a parable on the dangers of excess government debt in a fixed-currency regime.