Tuesday, March 29, 2011

Some Politics of Debt, Default, and the EMU

. Tuesday, March 29, 2011

Tyler Cowen notes that Irish (and Portuguese and I'd add Spanish) are not yet out of the clear, and writes:

The first country which can, with no shame, credibly threaten to leave the eurozone or outright default can blackmail Brussels and Berlin into further aid, due to fear of contagion effects. Some are arguing that Portugal is already assuming that strategic stance.

Let's try to tease this out a little bit. One of the first rules of bargaining theory is that the side with the best outside options has quite a lot of negotiating leverage. Eric Voeten has looked at this dynamic in the context of international institutions, where there is an asymmetric power distribution among the members. Specifically, he looked at the UNSC and found that the presence of strong outside options makes multilateral agreements more likely, so long as there is some incentive not to exercise them. But, and this is key, Voeten argues that "the first condition for multilateral action is the [most powerful state] be willing to act alone or with close allies" (p. 856). In other words, thinking only about how the PIGS have leverage over Berlin is probably not the best way to go about it.

Which most needs a Euro that includes Ireland, Greece, and Portugal: those countries, or Germany? Well, departure from the Euro (and ensuing debt restructuring/default) will massively impair those countries' abilities to engage international credit markets for a long while to come. Michael Tomz has written about the reputational effects of debt defaults, and it's not pretty. Defaults not only adversely affect countries access to foreign credit in the short-run, thus making austerity inevitable, but these effects persist. In other words, possible EMU defaulters have two choices: austerity with devaluation (which reduces real wealth but boosts competitiveness) but no external finance, or austerity without devaluation but with external finance (in the form of ECB/EFSF plus continued access to bond markets in at least some form). The question is which benefit is greater: access to foreign finance that can help smooth out the pain from austerity, or the shock treatment of devaluation. So far the answer appears to be the former.

What about Germany? Now that it's in a currency union it's better to keep it. The EMU is very good for German exporters. If the union splits, and peripheral European economies devalue, Germany's exports become much more expensive for those economies. Additionally, if some of the weaker members left the Euro the currency's value would likely increase against other international currencies. That, too, would bad for German exports. So Germany has incentives for keeping the EMU intact, and thus fulfills one of Voeten's criteria. On the other hand, Germany would do fine under a narrower Eurozone. The value of EMU membership that accrues to Germany is significant, but limited. There is a price tag that is simply too high for it to pay. That should give Germany quite a lot of leverage in Voeten's framework.

This is where Cowen's mention of contagion could come in. I'm not sure what he means by that; it could be Asia1997-style currency contagion across the PIGS, or it could be the fact that German (and French) banks are heavily exposed to PIGS' debt, so a sovereign default could have large knock-on effects for the financial systems at the core of the Eurozone. From Germany's perspective, the latter is much more salient. It increases the costs associated with a break-up in the EMU, and thus provides incentives to keep the union intact. But these costs, too, are not infinite. At some point it might be easier to bail out the financial sector than to bail out Europe's periphery, especially if domestic polities in the PIGs revolt against austerity or demand better terms from the EFSF.

So Cowen's right: the PIGS have some blackmail room, but only until the German and French banking sectors recapitalize. Meanwhile, Berlin has the nuclear option. If it comes to blows, Germany will end up in far better shape than the PIGS. So given what we know about the ways that powerful states use international institutions to help them achieve their goals, the most likely outcome seems to be either that the PIGS pay up, or that there is an intermediate period where the ECB/EFSF provides some funding to the periphery basically as a stalling tactic, buying time for the banks, and then pulls out the rug. The former seems to describe Ireland, the latter may end up being the story of Greece and Portugal.


Some Politics of Debt, Default, and the EMU
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