Is the euro about to capsize?
In seafaring, there is a concept called the “free-surface effect”.
It happens when a surprisingly small amount of fluid can move freely inside a boat.
It is an accident waiting to happen.
As the boat tilts in the waves, the water starts to flood across the floor, pushing up against the boat’s lower side.
Instead of righting itself again, the boat begins to list more and more as the water moves inside it, until the boat capsizes.
Something similar is happening to the euro.
When it was created in 1999, there was a fatal flaw. While governments shared a single currency, they continued to have their own separate bond markets.
It was an accident waiting to happen.
Bonds are IOUs that governments issue in their hundreds of billions when they want to borrow money.
The real problem is that what is true of tiny Greece can equally be true of much bigger Spain and Italy”
Just like shares on the stock market, they can be traded by investors.
If investors don’t like a government’s bonds, they can sell them.
That sends their price down, which by implication means the interest rate the government would have to pay if it wants to borrow more money goes up.
Investors might sell bonds if they are afraid that a government cannot repay its debts.
Normally this is not a problem. Because normally, a government is the master of its own currency.
It can order its central bank - the currency’s guardian - to print as much money as is needed to repay its debts.
ECB boss Mario Draghi has ruled out the central bank printing money to buy up bonds indefinitely
This makes the debts of governments like the US, Japan or UK the safest investment in their respective currencies.
Moreover, if a foreign investor doesn’t like the British government’s debts, not only does it sell government bonds.
It also sells the pound.
That pushes the pound’s value down, which helps make the UK economy more competitive, which helps the UK grow, which helps the government raise taxes.
What’s more, when one investor sells pounds, another must buy them.
And where will that buyer invest those pounds? Back into UK government bonds.
So by having its own currency, the UK government is pretty much guaranteed its own pool of sterling cash to finance its borrowing.
Now consider the euro.
Investors believe that Greece cannot possibly repay its debts.
Unlike the UK, Greece does not have its own central bank that it can rely on to print money and buy its debts. And a 50% write-off of its private sector debts is already agreed in principle.
So many investors have sold Greek bonds. But they could not sell the drachma. There is no drachma to sell.
Instead they could freely move their cash into safer government bonds - German government bonds.
Just like the seawater inside a boat, liquidity - investor’s cash - can move freely within the euro from one government’s bond market to another’s.
And that made the value of Greece’s bonds plummet.
But despite all the noise, Greece is only a sideshow.
Greece is a small country. And if it stopped repaying its debts and/or left the euro, re-denominating its debts into devalued drachmas, the losses to its bond investors would be manageable.
The danger posed by Greece is rather the power to demonstrate.
It demonstrates how damaging it is to a eurozone economy when its workers’ wages rise to uncompetitive levels during the boom years, leaving its economy high and dry, unable to compete and unable to devalue its currency during the bust.
It demonstrates how self-defeating it can be for a eurozone government to try to reduce its borrowing, by raising taxes and cutting spending, when this merely drives its economy into recession, meaning fewer incomes to tax and more unemployment benefits to pay.
And as of this week, it demonstrates that there is a very real possibility that a eurozone member could leave the single currency altogether.
But most important of all, it demonstrates what happens when investors lose confidence in a eurozone government’s debts.
The real problem is that what is true of tiny Greece can equally be true of much bigger Spain and Italy.
And it is in Italy where the real damage is happening.