We now know that it was French finance minister Christine Lagarde who begged Mr Paulson to save the US insurer AIG last week. AIG had written $300 billion in credit protection for European banks, admitting that it was for "regulatory capital relief rather than risk mitigation". In other words, it was underpinning a disguised extension of credit leverage. Its collapse would have set off a lending crunch across Europe as banking capital sank below water level.
It turns out that European regulators have allowed even greater use of "off-books" chicanery than the Americans. Mr Paulson may have saved Europe.
The mind boggles at what would have happened to the European banking system had Treasury let AIG file for bankruptcy. But perhaps more interesting for the Euro-sceptic crowd is this:
The interest spreads on Italian 10-year bonds have jumped to 92 points above German Bunds, a post-EMU high. These spreads are the most closely watched stress barometer for Europe’s monetary union. Traders are starting to “price in” an appreciable risk that EMU will break apart.*
It seems fairly likely now that sooner or later one of the big European banks will fall off the cliff as well and it will be interesting to see whether European leaders will be able to coordinate and put together a rescue plan should this come to pass. An impressive list of European economists has already told policy-makers that they better prepare themselves for this eventuality.
But even if EU leaders manage to respond to the banking crisis adequately, there’s still the macroeconomic fallout of the crisis to deal with, one that seems to fall rather unevenly on the countries of the Euro zone. This is a situation in which individual members like Spain, which is already in the middle of a recession, might then have an incentive to leave the Euro and deflate its currency. Is this a likely scenario? Probably not. As Barry Eichengreen wrote in an excellent VoxEU column back in December, “the decision to join the Euro is essentially irreversible”:
The insurmountable obstacle to exit is neither economic nor political, then, but procedural. Reintroducing the national currency would require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else – to be redenominated in the domestic currency. The legislature could pass a law requiring banks, firms, households and governments to redenominate their contracts in this manner. But in a democracy this decision would have to be preceded by very extensive discussion.
And for it to be executed smoothly, it would have to be accompanied by detailed planning. Computers will have to be reprogrammed. Vending machines will have to be modified. Payment machines will have to be serviced to prevent motorists from being trapped in subterranean parking garages. Notes and coins will have to be positioned around the country. One need only recall the extensive planning that preceded the introduction of the physical euro.
Back then, however, there was little reason to expect changes in exchange rates during the run-up and hence little incentive for currency speculation. In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. This effectively ruled out depressing national currencies in order to steal a competitive advantage in the interval prior to the move to full monetary union in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible. The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.
Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises.
* Technically this spread is mostly a market estimate for the likelihood that the other Euro members would bail out Italy were it to default on its debt. An increase in the spread, i.e. a higher default risk, is not incompatible with Italy remaining part of the Euro. In fact, the Treaty of Maastricht contains a no-bail-out provision that explicitly forbids the other Euro countries from bailing out a defaulting member state. This is to reduce the incentive to free-ride on such a commitment and keep national debt in check through rising risk premia for default risk. Still, such a marked uptick in the premium is worrying.