A Balanced Balance-of-Payments Diagnosis of the Euro Crisis

It is developed by Galina Hale, a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco in a FRBSF Economic Letter January 14, 2013 article, “Balance of Payments in the European Periphery.”

Excerpts:

“Greece, Italy, Ireland, Portugal, and Spain (GIIPS) are going through balance of payments crises stemming from persistent current account deficits and net private capital outflows. These crises are like the sudden stops in capital flows that have previously taken place in some emerging market economies. Traditionally, such crises triggered currency collapses, which restored external accounts to sustainable paths. For GIIPS, that can’t happen as long as they stay in the euro area.

(….)

The 2007–08 global financial crisis hit cross-border capital flows hard, but GIIPS were not initially affected more than other countries. However, in 2009–10, a sudden stop in private capital flows took place as it became apparent that the sovereign debt of some periphery countries might not be sustainable. The credit ratings of Greece, Portugal, and Ireland were marked down, and spreads on their government debt relative to German debt began to rise. If these countries had not been euro-area members, their current accounts would have adjusted, most likely through a currency crisis and rapid depreciation. Instead, these countries remained in the euro area and continued to run current account deficits, despite rapidly falling private capital inflows, and, in some cases, capital flight.

How was that possible? In essence, public capital replaced private capital. As private capital flows to GIIPS fell, they were replaced by growing liabilities of the central banks of GIIPS to the European Central Bank and the central banks of individual euro-area countries, a network known as the Eurosystem.

(…)

The ability to continue running current account deficits without private capital inflows has allowed GIIPS to avoid balance of payments crises, giving them opportunities to gradually adjust their external accounts.

Of course, gradual current account adjustment is generally preferable to abrupt rebalancing. This is especially true for GIIPS because exchange rate adjustment is not an option as long as these countries remain in the euro area. Nevertheless, to greater or lesser extents, the European peripheral countries have to go through painful adjustments similar to those experienced by other countries in the throes of balance of payments crises. For current accounts to return to surplus, the competitiveness of GIIPS within the euro area must be restored, which means wages have to fall relative to those in Germany.

Some of these adjustments have already taken place over the past two years. As Figure 2 shows, current account deficits of GIIPS have shrunk. Except in Italy, real wages have fallen about 5% since 2010, and a lot more in Greece. However, for GIIPS to return to sustainable growth paths, further adjustments may be necessary. In previous emerging-market balance-of-payments crises, current account reversals were as much as three times larger than the adjustment registered so far by GIIPS. In some cases, real wages plunged 20–25%. In addition, the sovereign debt and banking problems of GIIPS must still be resolved.”

Read more here.

My comment:  Can it be done while the current deflationary policies contribute to shrinking the economies of the GIIPS, and thus deteriorate the Debt/GDP ratios as well as destroy social and political cohesion?

It must also be understood that the initial disequilibrium inflow of capital in the south was largely a result of a same nominal ECB interest rate applied to countries with quite different inflation rates. Negative real interest rates in GIIPS made heavy borrowing attractive for investment and speculation purposes in these countries and determined the excessive capital inflows that pushed balance sheets (public and private) into highly risky zones.

Even if these balance sheets are returned to equilibrium through the current painful  (and relatively slow) deflationary adjustment, what will happen in the future when inflation rates diverge again, as they did in the past after the austerity adjustment period required for the entry into the Eurozone? Very open economies cannot easily accommodate shocks and divergences without a flexible exchange rate.