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A Sound Euro, or Bailouts for Greece and Ireland?

John Tamny in a column over at Forbes argues, rightly, that

there’s no reason that debt problems within certain euro countries should lead to the extinction of what is merely a “unit”, or a concept meant to put a money price on goods and investments.

A default by the Greek government on its euro debts would not bring down the euro any more than a default by the government of California on its dollar debts would bring down the US dollar.

Tamny is also right in arguing that a Greek exit from the Eurozone and adoption of a floating drachma would not improve Greek’s economic prospects.  It didn’t boost Argentina’s economy or solve its governement debt problems when its central bank de-linked from the US dollar and re-floated the peso.

Tamny suggests that Europe would be better off if the ECB “strengthens and stabilizes the euro unit” and in particular its best move “would be to define the euro in terms of gold, and make euros redeemable in the yellow metal.”  I agree that the ECB, while it exists, should keep the euro a strong, low-inflation currency. 

But Tamny unfortunately errs in thinking that a sound-euro policy “will stave off looming default for the euro bloc’s weakest countries.”   On the contrary.  A policy of restraining euro inflation means the end to ECB participation in the bridge-to-nowhere EU loans that are currently postponing Greek and Irish government defaults.  It also means the end to ECB purchases of Greek and Irish government bonds to hold their yields down.  Whatever prevents the ECB from bailing out the fiscally weak countries, and from inflating away their euro debts, makes outright default or debt restructuring (which appears to be unavoidable) arrive that much sooner.

Tamny writes:

For one, if the ECB were to give the euro a gold definition, the cost of servicing euro-denominated debt for Greece and Ireland would decline. With markets suddenly aware of the euro’s extreme credibility, investors would demand lower interest rates due to greater certainty about the value of the money being paid back. This on its own would reduce the pressure presently placed on the governments in Greece and Ireland.  Right now the euro’s weakness serves as a stealth default on euro-denominated debt, so a stronger currency would reduce the cost of a potential “haircut” for holders of Greek/Irish debt.  

The real interest rate a country pays includes not only an inflation-risk premium but also default risk premium. The nominal interest rate adds an expected-inflation-rate premium.  Any move that lowers and stabilizes expected euro inflation by restraining ECB monetization of Greek and Irish debt would reduce the inflation-rate and inflation-risk premia, but such a move would significantly increase the default risk for Greece and Ireland and thereby their bonds’ yield spread over German (low-default-risk) bonds.  In real terms the cost of servicing euro-denominated debt for Greece and Ireland would rise.  

If stealth default by inflation is barred, then outright default — overt losses for holders of Greek and Irish debt –  becomes the alternative.

It would be better for the average Eurozone citizen to have outright defaults on Greek and Irish government debts than to debauch the euro–have stealth defaults–in order to stave off overt defaults, thereby loading the costs of Greek and Irish government profligacy onto euro-users in other countries.  But that's the choice.  Let’s not imagine that Europe can eat its sound-money cake and keep the Greek and Irish governments from defaulting too.