The Euro and the PIGS

Σάβ, 15/06/2013 - 13:00

Prior to the introduction of the euro; the southern European nations of Portugal, Italy, Greece, and Spain (PIGS) regularly devalued their currencies to remain competitive with the highly industrialized and sophisticated northern European countries.  The introduction of the euro permanently fixed exchange rates for all euro members; but gave the PIGS access to loans from northern banks at less than half their prior interest costs.

The euro currency seemed to be a huge success as Greece, Spain, and Portugal experienced huge real estate booms powered by low interest rates.  With the southern nations forbidden to devalue under euro membership regulations; the sales and profitability of German and other northern companies increased due to their higher productivity growth against southern companies.  But after the 2008 credit crisis; German banks demanded the PIGS pay higher and higher interest rates.  These higher rates crushed real estate prices and devastated the economies of the PIGS.

The ECB may have called itself the “Central Bank of Europe”; but it virtually no ability to act as “lender of last resort”, like the U.S. Federal Reserve that prints unlimited amounts of money in an American banking crisis.  As fear of potential defaults caused large depositors to pull money out of European banks and convert euros to dollars; the ECB was incapable of stopping a system-wide run on the banks.  In desperation; the ECB was forced to surrender its sovereignty back to the U.S. Federal Reserve by agreeing to engage in 90 swaps of euros for dollars.

Given that U.S. banks operate with half the leverage of the European banks; the short-term structure of these arrangements will put pressure on the European banks to deleverage or risk the Federal Reserve refusing to roll over the swap by demanding repayment of dollars.  This “dollarization” of the euro seems likely to be a prelude to defaults in the south as one or more of the PIGS seek to devalue by re-issuing their currencies back to escudos, lira, drachmas, and pesetas.  But whatever happens; it seems clear that from now on decisions regarding European monetary policy will now primarily be made in Washington D.C.