by John Quiggin on November 17, 2010

Most of the discussion I’ve seen of the financial crisis as it affects the eurozone seems to me both confused and confusing. A country outside the eurozone and without the “exorbitant privilege” of being able to sell lots of debt denominated in home currency has three options when it runs into debt trouble: default, depreciation and dependency.

Default is the straightforward solution, but it involves a big loss of face, and unpredictable long-term costs. Depreciation doesn’t directly improve the debt position, since debts are in foreign currency, but by making exports cheaper and imports dearer it helps a country to trade its way out of difficulty, without the need for a reduction in domestic prices and wages. Finally, there’s the option of dependency on an outside rescuer, normally the IMF. This has been the most common solution, but the IMF always demands a price (in terms of policy “reforms”) that makes a rescue only marginally more attractive than default.

A eurozone country doesn’t have the option of depreciation. In return, however, it has two dependency options, calling on either the IMF, or the European Financial Stability Fund. Since the EU would like to keep the IMF out, a distressed debtor can expect slightly better terms from the EFSF.

The default option isn’t affected, except in the same way as any kind of behavior viewed as discreditable affects membership of any club. A government that defaults on its debts might be thrown out of the eurozone, but then again it might be thrown out of the OECD, and the eurozone might expel a member that facilitated tax evasion.

The big question is whether the EFSF will work. That’s certainly challenging, but it still seems like a better bet for debtor countries than going it alone. And of course, there’s more commonality of interest than is often supposed because any bailout benefits the creditors, usually French and German banks