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Managing a Fragile Eurozone

Countries that join a monetary union lose more than an instrument of economic policy (interest rate or exchange rate). When entering the monetary union, they lose their capacity to issue debt in a currency over which they have full control. As a result, a loss of confidence of investors can in a self-fulfilling way drive the country into default (see Kopf 2011). The reason why this happens can be described as follows. Suppose that investors fear a default by, say, the Spanish government. They sell Spanish government bonds, raising the interest rate. The investors who have acquired euros are likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. Thus the total amount of liquidity (money supply) in Spain shrinks. The Spanish government experiences a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates. In addition, the Spanish government cannot force the Bank of Spain to buy government debt. The ECB can provide all the liquidity of the world, but the Spanish government does not control that institution.