Swapping currency crises for credit crises

Martin Wolf for the FT focuses on the most important issue of the current Ireland crisis, the switching of currency crises for credit crises.

First, a single interest rate across countries with different relative cost structures will lead to boom and busts across the EU. There is no mechanism to control the localized credit excesses when there is a single monetary union. This problem becomes exacerbated when there is no way for prices to change in exchange rates.Without an adjustment of the exchange rate, there is no international price mechanism to adjust an economy when there is overheating through appreciation or depreciation during a recession. Without the price adjustment from exchange rates, there will be a downward spiral from debt deflation.

Economic adjustment in the EU can only be through credit markets which means that there will not be any exchange crises but more localized credit crises which will drive market extremes. That being said, we are having a currency crisis for the EU through a decline in the Euro. The size of the Euro adjustment will be associated with the relative size of the country crisis. The size of the Greece and Ireland debt problem relative to the overall size of the EU debt markets will provide some approximate value of the currency adjustment. Nevertheless, the majority of the credit crisis will be localized while the benefit of the euro decline will be generalized across the entire EU.

Hence, we have the issue of countries needing a credit bail-out that would to some degree be contained if there was a currency price adjustment. However, many currency crises also have credit crises at the same time. The two often cannot be separated. Now , the credit portion of a financial crisis will be more pronounced.