2010 January 03 Sunday
Interest Rate Rise To Trigger Euro Crisis?

Ireland and some southern European countries that are members of the Euro currency zone have run up too much public debt and some of them continue to run up sovereign debt at an alarming rate (just like the United States and Japan). A New York Times story suggests the moment of crisis could happen when economic recovery causes a sharp rise in interest rates. Suddenly sovereign governments that are already paying 1%-2.5% more than Germany on new debt will find their spread over German debt puts their cost of new bonds beyond their reach.

The true test for the world’s largest common currency zone, analysts say, will be whether it can withstand the economic, political and social strains once the European Central Bank begins to raise interest rates in response to economic improvements in Germany, France and other Northern European countries.

At that point, the laggards on the union’s fringe — Portugal, Ireland, Italy, Greece and Spain (the so-called Piigs) — will face even tougher choices to cope with what looks like several more years of stagnant economies, high unemployment and gaping budget deficits.

The higher their rates go the more the market will doubt their ability to pay and hence the market will demand even higher rates. Greece seems the likeliest candidate for such a crisis.

At that point a few choices become possible:

  • Germany lends Greece a large sum of money. The Germans would find this a repugnant solution. It would enable the Greek government to keep running up more debt besides.
  • Greece exits the Euro zone and borrows money from its own central bank in its reintroduced drachma currency. Then inflation makes the bonds worth less. Problem with this approach: Greece still needs to pay off large Euro bonds and an exit from the Euro would require it to use declining drachma to buy expensive Euros to pay interest and principal.
  • The Greek government defaults.
  • The Greek government increases VAT and other taxes to levels that drive out many of its most productive. Short term revenue boost but stagnation and crisis later.
  • The Greek government must do massive lay-offs of government works and slashing of welfare state benefits.

Note that These options are not all mutually exclusive.

Whenever global oil exports start declining year after year sovereign defaults and/or high inflation will happen. If the Germans insist on a stable Euro then southern European countries will default on their debts. Outside of Europe some countries will pursue expansionary monetary policies in response to economic contraction caused by declining supplies of oil. Those countries will experience high inflation that will cut back on debt in inflation-adjusted terms.

What I would like to know: Which countries will experience inflation and which will experience deflation in response to declining world oil production?

Share |      By Randall Parker at 2010 January 03 04:28 PM  Economics Sovereign Crises


Comments
electricians los angeles said at January 16, 2012 3:59 PM:

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lexapro lawyers said at July 9, 2012 9:55 AM:

yeah its very amazing and its also a good points for me i like it thanks...

Alexis Gagnon said at June 13, 2013 10:41 PM:

As if this writer has traveled in time and then wrote this article. He wrote this a year ago and now, what he has written is slowly taking shape. Europe today is in the middle of a crisis. I was shocked that I've read on the news just a few months ago that some people in Spain depend on ration for food and other basic commodities? Very sad.

Sarah Jones said at June 24, 2013 11:48 PM:

Look at how Spain and Greece are doing now. In Spain, it was learned that there are a few people there who are dependent on rations from bread to toilet paper and, fortunately, for Greece, it is slowly coming around. But, in general, interest rates have really affected most European countries and back in Asia, because of these unexpected turn of events, China's currency is going strong. It seems that it's not only the North and South pole that may experience shifting but also the economy of the world as well.

John Tyrone Williams said at July 1, 2013 11:27 PM:

Well, it's happening now. But, I'm glad that there are things that have actually prevented things from getting worse. But, unfortunately, there are still countries in Europe that are swimming in the raging waves of economic turmoil. Hopefully, things can be better for them in the near future.

Brian Johnson said at July 18, 2013 7:36 PM:

Three years after this article, right now, it seems that Greece is really plunging into darkness. Is there any other way that Greece can be helped to prevent from being another Albania? If nothing can stop its demise, Greece will remain a memory in our minds.

Laura Hunter said at August 7, 2013 1:12 AM:

What will happen to Greece now? Will it be another one of those countries erased from the map or specifically the financial map?


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