Is The Euro Dead? No, But...

Today brought the news that the crisis in the eurozone may be spreading beyond Spain to Italy and even Belgium. The Euro has slipped below $1.30; as recently as November 5th, it was at $1.40. Meanwhile, debt spreads between Germany's debt and the weaker members are widening:

Despite the commitment of 200 billion euros, or $260 billion, in bailout funds to Europe's two most stricken nations -- Greece and Ireland -- institutional investors were unimpressed with the rescue effort this weekend of Ireland and continued to sell bond holdings in the weaker euro-zone economies.

But what is worse for the European Union and an increasingly stretched International Monetary Fund is that investors have begun to disgorge some of their positions in Belgium, Italy and even Germany.

Even as the yields on the 10-year bonds of Greece, Ireland, Portugal and Spain ended trading Tuesday off their highs for the day, attention in Brussels turned to the rise on Italian sovereign debt to 4.64 percent, of Belgian bonds to 3.97 percent and the recent increase of German bonds, the European benchmark, which at 2.67 percent were down from Monday but well above the 2.1 percent of last summer. Rising yields reflect increased risk in the eyes of investors as well as inflationary expectations. Not that anyone expects Germany, by far Europe's most powerful economy, to come close to defaulting on its debt. And neither Italy nor Belgium is considered in the same boat as Greece, Ireland and Portugal, since their deficits are lower and they borrow primarily from domestic lenders. Instead, the fear is that Europe's strategy so far -- painfully drawn out step-by-step bailouts of Greece and Ireland -- has failed to impress the markets and that the burden to finance even larger rescues for Spain and perhaps even Italy would be too much for Germany to bear, both financially and politically.

Belgian debt levels are actually pretty eye-popping, and they seem to be embroiled in a slow-motion political crisis that could reasonably raise fears about this debt being repaid; Business Insider had an entertaining little primer a while back. But Belgium also has a more reasonable budget deficit, and a hefty subsidy from the Eurocrats in Brussels, so I think it just as likely that rising spreads are less due to fears of a Belgian default, than to fears of a euro breakup. Even if the various entitities reaffirm the debt in their own currencies (which I expect Belgium would), there's a reasonable risk that the individual central banks would be less inflation hawkish than the ECB.

I'm a longtime euroskeptic (the currency, not the EU). But I think even the greatest europhile would have to admit that there is a significant risk of the currency union breaking up, even if their estimate of that risk would probably be much smaller than mine. How many more bailouts can the EU provide? If the country in question is Spain, the answer seems to be "none".

Optimal currency zones are places where the markets are tightly integrated--i.e., everyone using the same currency is on the same business cycle. The US, incidentally, is not really an optimal currency zone--but we have a number of factors which let us get away with this. With automatic fiscal stabilizers, and emergency assistance to the states, we naturally transfer money from booming regions to those which are underperforming; this considerably eases the strains of mismatched business cycles. We also have very high rates of labor mobility. While there is a narrow educated elite that moves around Europe quite a lot, compared to Americans, most Europeans don't even move around that much in their own country, much less across borders.

This has contributed greatly to the current problems: Ireland's economy was overheating even as Italy's was stagnating. Now that the crash has come, monetary policy is wildly too tight for Ireland, which has contributed to the fiscal death spiral.

The EU can save the euro by tighter integration, both to help synchronize the business cycles, and to enable fiscal transfers when they diverge. The Irish bailout is a move towards this sort of thing, but as Paul Krugman has pointed out, it's probably not going to work. And the project of ever-closer union, already struggling, seems to have been killed dead (or at least, knocked into a deep coma), by the current crisis.

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