In a monetary union, governments of member countries do not have their control on the currency in which they issue debt; the case is different for a non-member country, because, they are capable of issuing debt in their own currency on which the government has full control. In the article, Paul De Grauwe, has evaluated the economic position of a member (Spain) and non-member (UK) of euro-zone. The state of banking sector of UK is not much healthier than Spain, UK government has their control over their own currency on which they issue debt, whereas Spain is a member of euro-zone, and has no control over the currency on which they issue the debt. For UK, if an investor sell UK government bonds and exchange the currency in foreign exchange market, it will depreciate the currency value in the market and increase inflation in UK, but, will not result in liquidity crisis in the country, because, their currency will remain static within the UK money market, and UK government can force Bank of England to buy their debt. In case, if an investor sells the Spanish government bond and invests his earning in some other euro-zone country, the euro reserve of Spain will decline without effecting national price index but, Spain will experience a liquidity crisis. Government of Spain cannot force, Bank of Spain to buy their debt. In such a condition, money market will lead UK to a good equilibrium and lead Spain to a bad equilibrium. A bad equilibrium on a member country will infect the banking sector and financial market of other member countries of the union with good equilibrium. Under such liquidity loss, the member country of the union will experience recession, government budget deficit and the country will downgrade in status in the emerging economy. In case, if UK experiences a bad equilibrium, they will try to stabilize the situation, by allowing their currency to drop in the foreign exchange market and government of UK can force the central bank of the country to buy the debt and ensure the supply of liquidity. In a monetary union, a common central bank buys the debt of the countries of the union. In a debt crisis in euro-zone, ECB bought the debt of the distressed countries and rechanneled liquidity to the distressed countries of the union.
In order to control solvency crisis if the National government budgets of member countries are centralized, it can be effectively used for transferring fund to a member country to counter its solvency deficit.
Integration at the political level of member nations can keep a monetary union in a strong position and counter such crisis. Through political integration, the member countries will jointly issue Eurobonds, and introduced in such a way that the member countries with favourable credit rating find it attractive to participate. Common bond will protect the countries benefit from being pushed into a bad equilibrium and it will result in a decline in average debt cost and increase in the marginal cost of the debt. A country should be entitled to issue blue bond up to 60% of their GDP, the participation fee for blue bonds would differ depending upon the participating country’s financial condition. Favourable credit rated countries would be entitled to low interest rate than the other so that they can find the scheme of common Eurobond attractive.
The economic crisis on debt has compelled the union, to set up a permanent European Rescue Fund. So that it can obtain funding from members and provide loan to the countries in distress. An intelligent approach in setting up interest rate on lending and risk premium may effectively serve the financially sound as well as weak countries of the union. And, when a member country suffer a budgetary deficit on increasing debt, instead of charging the member country with high interest rate on debt, the country should be given financial assistance to overcome the crisis. Because, in existing situation, a higher interest rate on debt has been imposed on Ireland as Irish Rescue Program and which resulted in an increasing burden of fiscal deficit on the budget of Ireland.
In the collective action clauses (CAC) in government bonds of the monetary union, the investors may suspect risk and which may frequent sell their bond to avert financial loss, but, this activity will raise the interest rate on the bond and may compel a member country to seek a funding support.
Reference:
De Grauwe, Paul. (2011), “The Governance of a Fragile Eurozone”. CEPS Working Document, pp. 1- 24.
