This is an incredibly difficult topic to understand. Cullen Roche presents it succinctly here; however, for this post I am going to use a very basic example and really simplify this complicated issue down:
- Country ABC and Country XYZ have the same currency, but broadly speaking, Country XYZ is a more risky place to invest.
- Given that they share the same currency and central bank, when things are good Country XYZ can borrow at the same low interest rate as Country ABC.
- Because Country XYZ is more risky, the private sector takes on more debt (if you should be borrowing at 7% and you can borrow at 2%, you borrow more), which is often lent to them by Country ABC.
- Country ABC wakes up one day and realizes this is lunacy and stops funding to Country XYZ’s private sector. This presents a problem as Country XYZ’s growth is dependent on this funding.
- Given Country XYZ shares the same currency as Country ABC they can’t inflate/devalue their currency, increase competitiveness, and boost exports, which would reduce the debt burden and help growth.
- As a result Country XYZ must have the government spend money in order to keep growth from plummeting. However, given they don’t print their own currency they are dependent on Country ABC to fund their government.
- Country ABC won’t fund Country XYZ’s government given the massive drop off in growth and high debt burden.
- Country XYZ has to cut government spending, reducing growth further and creating a vicious cycle.
- Country XYZ may have to leave the currency, devalue, default, and suffer a lot of pain before ultimately recovering or…
- Continue to cut spending, stay in the currency, and have a drawn out stage of low/negative growth.
In my next post I will compare and contrast the Eurozone with the US. Here’s a hint: while we have our own problems, at least we don’t have these.
