Eurosceptics remedial education class 1

If I got a pound – even the current rather devalued pound – every time an English eurosceptic (it’s almost always an English eurosceptic, hardly ever a Scottish, Welsh or Northern Irish one) utters something utterly insane and hilariously wrong about the EU, the euro area or the euro, I would by now be rich enough to count Peter Mandelson among the regular visitors to my yacht.

Unfortunately, if complete nonsense or an outright falsehood is repeated often enough, it tends to become part of the mental furniture of the public.  This would be unfortunate, because now more than ever, it is essential that the UK give up its opt out from the third stage of Economic and Monetary Union and join the euro area as soon as possible.  I have therefore decided to use this blog to expose and denounce the half-truths, outright lies and nonsense promulgated by the eurosceptic media in the UK.  This is the first of what could become a long series of remedial education classes for eurosceptics.

My target today is Neil Collins’ column in the November 6, 2008 Evening Standard, London’s only remaining evening paper (not counting the two free rags). I will quote him at length so he can do himself an injustice:


If you’re thinking of tucking away a few euro notes in case the pound melts down and you can’t afford to cross the Channel, look at the numbers on the notes first. If they start with an X, and the digits of the serial number add up to a number ending in two, hang on to them. These are good, solid German euro notes, worth their face value. If they begin with S, with digits that add up to a number ending in seven, spend these first. They’re Italian euros, and with luck they won’t stand at a discount in Europe’s shops, or at least not yet.

If you think this is fanciful, look at the chart above. It shows the yield on 10-year Italian and Greek debt, less the return on the equivalent German government bond. I wrote last year that the risk of Italy falling out of the euro was underpriced at around 32 basis points (0.32 percent a year) and now the markets are waking up to the danger.”

The chart, not reproduced here, does indeed show the widening spreads of 10-year Italian and Greek government debt over German government debt (Bunds). On Friday, November 7, these spreads were 1.40% for Greece, 0.92% for Italy and 1.04% for Ireland.  As the government securities in question are denominated in the same currency (the euro) and are very similar in all respects except for the identity of the issuer, these spreads reflect differential sovereign default risk and differences in liquidity vis-a-vis Germany.

Although the market for Bunds is indeed more liquid than that for Italian, Greek or Irish 10-year government debt, it is highly likely (and consistent with the evidence provided by credit default swaps) that most of the spread reflects differences in the market’s perception of sovereign default risk.  I don’t have ready access to sovereign CDS data where I am writing this blog, but for benchmarking purposes, on Friday October 10, 2008, the spreads on 5 year sovereign CDS were 0.456% for the UK, 0.33% for the USA ad 0.265% for Germany.

So, Neil Collins and I agree that the market believes that the Italian, Greek and Irish governments are more likely to default on their debt than the German government.  I even believe that the markets make sense, for a change, in their judgement.  But after that, oh dear, oh dear, the nonsense starts flowing freely.

Neil Collins confuses the likelihood (or the market’s assessment of the likelihood) that the Italian government will default on its debt with (1) the likelihood that Italy will leave the eurozone and (2) the likelihood that euro currency notes and coin printed or minted in Italy will be worth less than euro currency notes and coin of the same face value printed or minted in Germany.

These three events are completely logically distinct and have rather different probabilities attached to them.

A country like Italy, say, can default on its sovereign debt (which is euro-denominated) without Italy leaving the euro area (adopting its own independent currency again).  Italy could leave the euro area without defaulting on its sovereign debt.  Even if it defaulted on its sovereign debt and left the euro area, this would have no impact on the value of euro currency notes and coin printed or minted in Italy relative to the value of euro currency notes and coin printed or minted in Italy.

I believe that the likelihood that Italy will default on its sovereign debt is probably quite accurately reflected in the spreads in the CDS markets and in the spreads in the sovereign debt markets itself (CDS spreads tend to suggest a somewhat lower probability of default than the sovereign bond market spreads).  It is also pretty clear that the likelihood of Italy defaulting on its debt would be much higher if Italy were to leave the euro area.

A currency depreciation risk premium for the New Lira would be added to the liquidity premium (which would increase if Italy were to drop the euro) and the default risk premium.  Nominal Italian interest rates would shoot up immediately.  After the initial sharp depreciation of the New Lira, prices would rise rapidly and the initial competitive advantage gained as a result of the currency depreciation would be lost promptly.  Soon even real interest rates on the public debt would rise, triggering an unstable debt spiral.

If Italy were to leave the euro area without first having defaulted on its debt, the nominal and real depreciaton of the New Lira would increase the real burden of servicing that debt – which would continue to be denominated in euro.  A higher real debt burden and a higher real interest rate would make an eventual default that more likely.  Only an economic and financial  suicide artist would take Italy out of the euro zone.  That does not mean it could not happen.  It does mean it is extremely unlikely – much less likely than an Italian sovereign default.  Italy would be much better off defaulting on its sovereign debt as a member of the euro area than out of the euro area.

The likelihood that euro currency notes or coin printed or minted in Italy would be worth less than euro currency notes or coin with the same face value printed or minted in German is zero. It’s impossible.  It could not, cannot and will not happen!

Maybe I can make this clear to Neil Collins by referring to the example of a currency he may understand better – the US dollar.  Even among the small pile of US dollar bills I keep at home for travel purposes, I have bills issued by most of the Federal Reserve Districts of the US.  I have a one dollar bill from the Federal Reserve Bank of Chicago, Illinois (with a capital G in the center of the rosette to the left of George Washington’s portrait), one from the Federal Reserve Bank of Richmond, Virginia (with an E), one from the Federal Reserve Bank of Philadelphia, Pennsylvania (with a C), one from the Federal Reserve Bank of Atlanta, Georgia (with an F),one from the Federal Reserve Bank of New York, New York (with a B), one from the Federal Reserve Bank of Cleveland, Ohio (with a D) and one from the Federal Reserve Bank of Boston (with an A).  I even have one from the Federal Reserve Bank of San Francisco, California (with an L).

Following Neil Collins’ logic, I should fear that my Fed of San Francisco, California dollar might well trade (or will soon trade) at a discount to the Fed of Chicago, Illinois dollar.  After all, California is in fiscal dire straits. The governor of California has even tried to squeeze loan guarantees and other forms of Federal financial support out of Washington to forestall a default on California’s state debt, which trades at a discount relative to Illinois state debt.  With the next president of the US coming from Chicago, Illinois, that part of the country, and the dollar notes issued there, surely must be more creditworthy than dollar notes issued in California?

Stuff and nonsense, you will respond.  And you would be right. All Federal Reserve notes are a liability of the Federal Reserve system, regardless of which Regional Reserve Bank issues them.  Higher denomination US dollar currency notes have ‘United States Federal Reserve System’ in the same spot where the one dollar notes give one of the 12 Regional Reserve Banks.   Coins are a liability of the US  Treasury (the mint is a Treasury agency).

The same is true for the euro currency notes and coin.  Regardless of where in the euro area they are printed or minted, they are completely equivalent and interchangeable liabilities of the Eurosystem – the ECB and the (currently) 15 National Central Banks of the euro area.  Euro currency notes issued by the Banca d’Italia are not liabilities of the Italian state, the Italian government or the Italian central bank.  They are liabilities of the Eurosystem.  If Italy were to default on its sovereign debt, this would have no effect on the relative value of euro currency notes issued by the Banca D’Italia compared to those issued by the Bundesbank.  If Italy were to leave the euro area (cease to be part of the Eurosystem), there would be no further issuance of euro currency notes by the Banca d’Italia, but the outstanding stock of euro currency notes issued by the Banca d’Italia would remain a liability of the Eurosystem, without any discount or premium.

As in the US, with its 12 Federal Reserve Districts, the issuance of currency in the euro area is operationally decentralised through the 15 national central banks that are part of the Eurosystem.  This operational decentralisation is a historical accident and in no way affects the legal and practical reality that there is a single currency in the euro area just as there is a single currency in the US.

Article 16 of the Protocol on the Statute of the European System of Central Banks and of the European Central Bank  (unofficial consolidated version) states:


In accordance with Article 106(1) of this Treaty, the Governing Council shall have the exclusive right to authorize the issue of banknotes within the Community. The ECB and the national central banks may issue such notes. The banknotes issued by the ECB and the national central banks shall be the only such notes to have the status of legal tender within the Community.

The ECB shall respect as far as possible existing practices regarding the issue and design of banknotes.”

Article 106(1) of the  Consolidated versions of the Treaty on European Union and of the Treaty Establishing the European Community states:

“The ECB shall have the exclusive right to authorise the issue of banknotes within the Community. The ECB and the national central banks may issue such notes. The banknotes issued by the ECB and the national central banks shall be the only such notes to have the status of legal tender within the Community.”

We have been through this nonsense before.  During the two years after the euro area was created on January 1, 1999 (with the creation of a single monetary authority and the irrevocable fixing of the conversion rates between the 11 national currencies of the original euro area members) and the introduction of the euro currency notes and coins in 2001, there were any number of British ignoramuses (including some economists with high standing in the profession (up to that point at any rate)), who argued that the euro could collapse because of a speculaltive shift out of , say, the legacy Italian Lira currency notes and into legacy German Mark notes. They apparently did not know that there no longer were multiple currencies within the euro area.  All we had was the euro, and some legacy notes that represented inconvenient but completely valid non-integer denominations of the euro. So a speculative attack out of lira notes into DM notes was as likely to bring down the euro as a speculative shift out of £5 notes into £10 notes would be to bring down sterling.

So regardless of how wide the divergence becomes between the market’s assessment of the crediworthiness of the German state, the Greek, Irish or Italian state, a 20 euro note is worth a 20 euro note, regardless of which of the national central banks happens to have issued these notes.

There are no German euro notes and Italian euro notes.  There are just euro notes/ There are no Greek euros, Irish euros, Italian euros and German euros.  There are just euros.  Easy, isn’t it?

Ignorance of the facts is no excuse.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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