The Bear's Lair

The following post was contributed by Malthe Mikkel Munkøe.

The sovereign debt crises in Greece and Ireland and the mounting economic trouble facing Portugal, Spain and Italy, have long been a cause for alarm in European capitals. Many fear that one or several of the so-called PIIGS countries may be forced to leave the euro, which could exacerbate the pressure on the euro itself and possibly spell doom for the common currency. This simple argument overlooks one fact of international economics, which has been dubbed the original sin problem.

The Original Sin term was coined by economics professors Ricardo Hausmann and Barry Eichengreen in the late nineties to describe the economic situation relatively common to emerging economies where countries find it difficult to obtain loans in their national currency and instead opt for loans denominated in foreign currencies. This renders the country very vulnerable to a drop in the real value of the national currency, since the value of the outstanding debt increases correspondingly which makes it more difficult to service the debt.

A similar situation could occur in the eurozone. If a euro-country decided to leave the euro and recreate a national currency instead, it would still have to honor national debt which is denominated in euro. Having been forced to step out of the euro cooperation due to unbearable economic and financial pressures, a new national currency would by all likelihood be extremely weak relative to the euro. In other words, the burden of a euro-denominated debt would soar following a forced exit from the euro.

Leaving the euro is therefore no simple fix for the PIIGS. While an independent currency would enable them to carry out a large-scale devaluation to regain competiveness, it would also greatly aggravate their debt problems even further.

Correspondingly, a forced exit from the euro would probably have to be coupled with other measures to deal with the sovereign debt, ranging from an organized restructuring to the complete renegotiation of the debt. Both would be extremely embarrassing and lead to a further loss of investor confidence and possible capital flight. In short, if done in the context of mounting financial and economic problems, leaving the euro would be nowhere near as easy as entering it and could precipitate a crisis of the same magnitude as other full-blown currency crises in the past have done.

We are used to thinking of the euro in terms of the relatively simple Mundell-Fleming model and the Trilemma of international finance. That is to say, as a possible policy choice that implies certain benefits and costs, and one that policy-makers can decide relatively easily. In particular, by entering into a currency union countries cannot use monetary policy to keep their economy on a growth trajectory. Indeed, many have claimed that the woes of the PIIGS are to a large extent the result of an overly austere monetary policy that has been ill-suited for the business cycle dictated needs of Southern Europe. However, in a world of deeply integrated financial markets, things may not be that easy in practice. Due to the original sin problem, changing the modus of monetary policy-making is not just choosing another policy mix between costs and benefits, but will also have great repercussions if financial markets react adversely to the shift.

Hence, weak members will have to try to weather the storm and stay in the euro almost no matter what. Some, perhaps most prominently NYU Professor Nouriel Roubini, have suggested that this will not work and Greece will eventually have to negotiate an organized default. But leaving the euro is certainly not a good way to fix those problems either. The common currency render countries with an inability to stimulate their economies with monetary policy, but it is a well-known fact, although it was sometimes forgotten in the hectic days of the Greek sovereign debt crisis, that ultimately, long-run economic problems can only be solved by long-run measures, not temporary adjustments in the supply of money.

If the other euro members lose faith in the European project or become convinced that they could prosper from reintroducing a national currency, they might be able to leave the euro without incurring the terrible consequences of a forced exit. After all, financial markets would not react as adversely to a shift, and their public finances are sounder and can withstand a greater financial strain.

Of course, there is currently little prospect of this happening. The euro confers economic benefits to the members, and so much national prestige is staked at its survival. Also, no-one yearns for a return to the time where the Bundesbank pretty much dictated monetary policy in Europe, and the political aspirations of European decision-makers is generally speaking to have more, not less European integration. Similarly, both German chancellor Merkel and the French president Sarkozy favour stronger international financial governance as a response to the financial crisis, and at the World Economic Forum last year Mr. Sarkozy even called for the instigation of a new Bretton Woods system. If the euro proves to be unworkable, it would seriously question the durability of global economic governance – if it cannot work in Europe, why should it work globally? But of course things could change, especially if economic recovery continues to stall in Europe.

The lesson is that if you want to gauge the sustainability of the euro, you should look to the countries that are doing well and study the political will to maintain the euro in Paris, Frankfurt and Berlin, rather than being overly concerned with what the PIIGS might do. Sadly for the PIGS, there is no attractive policy alternative to holding tight and hoping they can weather the financial storm.

Author :


  1. Trying to analise the Euro and the European Union construction from a purely economic perspective, aparently, ignores that the whole process is (and always was..) political.
    So the trade offs to evaluate are political and economics is a “second derivative”.

    Right now the options available for the governments in countries facing sovereign debt crisis (or almost) are what kind of pain they want (or can…) inflict to their people: 1) Decades of high unemplyment, shrinking economies and gorwing poverty, while paying down debts and sticking to the Euro, or 2) deep financial crisis arising from default and eventually leaving the euro.

    I believe that Ireland will lead the way, as from all affected they are the best positioned to default and recover fast from the event. Along the way they will create the boiler plate for others to follow.

    Again, analising the current issues facing the Euro from a pure economic rationality perspective seems to forget what brought us here in the first place. And for sure it wasn’t economics.


  2. I don’t think that EU is on a dead end. The EU has showed it will survive even amid this debt crisis, beaten the weaker members. I’m sure all of us have learned from the crisis and I do still believe that we are on a point of no return. We are the first generation who love to introduce ourselfs first as Europeans and then as Germans, Dutch, Italians, Irish, etc. Europe will become stronger after the crisis, back to the top where it belongs! GOD SAVE EUROPE! GOD SAVE EUROPEANS!

  3. Hi Miguel,

    I agree that some key fundamentals in Ireland are better than in countries like Greece and Portugal- the demographics, relatively flexible workforce, low tax rate,english speaking etc. There are still some infrastructure issues but in relation to exports and FDI, Ireland should stand to benefit if, and when, the global economic recovery picks up pace. (In fact Ireland has already began to recover in these areas

    In the wider Irish economy however, domestic demand is shot to pieces, debt and interest levels appear unsustainable and I think a form of restructuring is inevitable.

    In the EU as a whole you could assign the blame far and wide and It’s difficult to see where the fault lines lie between economics and politics. From the political perspective, you could argue, like Bulgaria’s minister of finance has, that the EU’s need to agree among 27 states led to a delayed and inadequate reaction from the very start, compared to actors like the United States (or China who came in with a fast, big and well-designed response from the start).

    From an purely economic perspective though, there are huge economic differences between eurozone members that were exacerbated by a single monetary policy and were not properly reflected in pre-crisis bond yields, It is hard to see how this can be adequately addressed, not matter how unified the political response.

    Hi Manfred
    your enthusiasm is encouraging! Unfortunately it seems many people in Europe, and increasingly in previous pro-EU countries like Ireland, do not really feel the same. The EU itself will continue, that is beyond debate. The real question in the short-term is about the future of the Euro.


Comments are closed.