I’m confused about something: why would the threat of sovereign default cause the Euro to decline in value? If European bondholders suddenly find out they aren’t getting their money back, doesn’t that decrease the total amount of money in the system?
In that case, isn’t it deflation, and a subsequent rise in value of each remaining Euro? Instead, the threat of default is causing EUR/USD to decline precipitously in value.
Anyone have an explanation?
its a trust issue… if sovereign debt fails then banks won’t trust each other and lend to each other, which in turn dries up the credit markets and slows all the economies down as without credit our debt-laden society can’t thrive.
Basically what happened with the Lehman Bros fiasco…
When economies start to fail there is a flight to safety which can mean buying gold or buying the US dollar. Then all other currencies begin to devalue against the US dollar and often each other.
It’s a bit of a chain reaction effect… spiralling down.
The amount of money out of circulation would be nothing compared to the trust lost.
The EUR is a fiat currency and it’s value actually depends on trust, because lets face it, there is nothing else behind it is there.
A default would send the EURUSD through the floor, possibly be the end of the Euro, it would either be the end of the Euro or the Euro countries would have to move far closer to political union to ensure it was less likely to happen again.
Sovereign default has no inherent affect on the money supply. However, as has been noted above, the issue of trust looms large, and is directly related to risk. If you are a buyer of government bonds, you want to be paid back. Defaulting is a direct slap in the face of those who have lent and who would lend to the government.
This has two direct consequences for speculators (the fx market is largely a speculative market), first those who would lend to the government would be less likely to lend, this reduces the future demand for euros by foreign entities. Secondly, and perhaps, most importantly, those foreign entities who have lent to other governments in the euro zone would be more likely to drop those assets if they believed future defaults were likely. To do this, they need to convert their euro denominated asset into another currency, this increases the demand for other currencies and further decreases demand for the euro.
Indirectly, default is usually a sign of a weak economy, and any austerity measures are likely to weaken an economy before they strengthen it. Because of this, foreign investors will also be less likely to invest and those already invested would be more likely to dump their assets.
[B]Depending on your definition of money supply[/B], none of the actions above influence the total amount of euros. A euro held by an American bank, is still a euro.
One way to think about foreign exchange is to imagine 2 piles of money. One larger pile is utilized in domestic exchange and one smaller pile (mostly held by banks) is utilized in foreign exchange. Both piles together represent one measure of a money supply. It is likely that the smaller pile would increase due to a sovereign default, but this would be in direct proportion to the decrease in the larger pile. As an example, if I am dumping a euro denominated asset for another currency, I need to exchange euros for my desired currency. The euros I utilize in this exchange are transferred to another depository institution. Thus the supply of euros abroad would increase, in direct proportion to the amount of euros I am moving out of the domestic supply of euros.