EMU’s Stress Test
Should confidence in the euro evaporate, this third aspect in particular would provide investors with protection, as they cannot assume with existing euro-area bonds that their claims will be automatically converted into the new currency if there were a currency reform. If the claims remained in euros, it could be that they would have to shoulder depreciation losses relative to the new currency. The proceeds from these instruments could be used for redemption of maturing traditional bonds. If the distrust in the euro were to increase, the demand for these instruments would undoubtedly be strong. The coupon might be squeezed so much during the auctions that the real interest rate would be negative. The spread that would materialise between the real interest rate of euro-area government securities and the real interest rate of the new inflation-protected securities would then be interpreted as a type of insurance premium against the softening of the euro. This would particularly be the case if the German government were to let it be known that it would not participate in a potentially necessary recapitalisation of the ECB using taxpayers’ money which might be necessitated by the purchasing of ailing countries’ bonds or granting loans to ailing banks against low-quality collateral. Since there is no unequivocal contractual obligation concerning this, any losses made by the ECB that exceed the available resources in the ECB’s general reserve fund and the monetary receipts in the respective financial year would be offset by printing new money. The liabilities side of the ECB balance sheet (and thus the central bank money supply) would then only be partially covered by valuable claims on the asset side. According to some economists, this would send inflation rising over the long term, but since other leading international economists do not believe this reasoning holds water, ECB representatives would not need to be alarmed by the insurance.
It is conceivable that private-sector companies also copy the government and issue bonds that are protected against currency devaluation. If the corresponding demand materialises, it is conceivable that it will be used by companies that are confident of also being able to sell their products in a future hard currency. If very strong demand during the auctions enables them to issue bonds at negative real interest rates, they could even collect the insurance premium against the soft euro paid by investors.
Let us assume that the ECB would attempt to limit the yield on Italian government bonds to 5% by intervening in the market. Furthermore, it would allow an inflation rate in Italy of 4%, so that with real growth of 1% nominal GDP growth would be 5% and therefore the solvency of the Italian state would also be guaranteed without a primary surplus. In view of the more vigorous economic growth in Germany it is certainly conceivable that then inflation in Germany would climb to 5% or more. Investors in German inflation-linked products would be protected against currency depreciation. The public sector and corporates that have taken out inflation-linked loans would find that inflation sends their taxes and revenues rising and could therefore easily service the loans despite the inflation protection. The more widespread investments and loans would become, the further Germany’s public and private sectors and its corporates would become removed from the euro and the ECB.
If the German public were so dissatisfied with the course being pursued by the ECB that it were to insist on a harder currency, perhaps because inflation in Germany rises to well over 5% in the end, the inflation-linked investments and loans denominated in a soft euro could be converted into (now no longer necessarily inflation-linked) investments in a new currency without a decline in purchasing power parity. This new currency – let us call it the “hard euro” – would exist alongside the “soft euro”. On the conversion date a “hard euro” would still be equivalent to a “soft euro”. Subsequently, however, the supply of hard euros would be kept scarce to ensure price stability. The future issuance of hard euros to banks for lending could then be handled by a department of the Bundesbank. Since over time both assets and liabilities in hard euros would have been created on banks‘ balance sheets, currency conversion would be possible without affecting the capital of the banking sector. The Bundesbank department responsible for the hard euro would also be in a position to prevent excessive appreciation of the new currency against the old soft euro by intervening in the forex market. Other countries with a strong preference for stable money could follow Germany’s example and correspondingly accumulate inflation-linked assets and liabilities which could also be denominated in hard euros at the required time.
…may keep the euro hard
But perhaps things would not turn out this way at all. Perhaps the prospect of currency competition would result in more cautious monetary policy by the ECB. If real interest rates on inflation-linked “convertible” bonds became negative, and the market were thus prepared to pay a premium for hedging against a soft euro, ECB Council members would have to ask themselves whether a policy of easy money and monetary financing of government debt can be reconciled with a hard currency over the long term. Perhaps the old euro would then stay hard and investors in inflation-linked instruments would have to make do with low returns. They would then, however, have the satisfaction of knowing that their insurance premiums were well invested against a soft euro.
Copyright © 2011 • Deutsche Bank AG, DB Research
Published by kind permission of the author.
 There are precedents for this behavior of the Bundesbank. In the run-up to German unification in 1990, the Bundesbank warned that a generous exchange rate between the worthless east German Mark and the D-Mark would lead to inflation. When the government went ahead anyway the Bundesbank was proven right. Towards the end of the 1990s, the Bundesbank warned that the launching of a larger EMU encompassing numerous southern European countries would turn out to threaten the stability of monetary union. Recent events have proven the Bundesbank right also on this issue.
 This part draws on an article by T. Mayer and H.-W. Sinn in FAZ from September 26.
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