Or, is Germany right to worry about inflation?
A theory to chew over…
An excess of savings over investment helps to create a credit boom in a current account deficit country and legitimises pro-cyclical fiscal policy. And then a sovereign debt crisis in the deficit nation kicks off when the government is hit by weak growth and incurs the liabilities of the private sector. The solution requires painful exchange rate adjustments and sparks political acrimony between creditor and deficit nations.
This is the current-account-imbalance argument for the global crisis – i.e. deficit US vs. surplus China – yes?
Hold your horses: a consensus is emerging that the eurozone crisis is also at its root a pure balance-of-payment crisis. Hidden behind an opaque monetary wall that requires inflation in Germany and deflation elsewhere to stem the rot. In short, without the freedom to adjust nominal exchange rates, relative price changes within the EMU — i.e inflation in Germany — is needed.
Scared? Sit back, here are some excerpts from our very own Gavyn Davies on Sunday on the issue: (Emphasis ours)
It is normal to discuss the sovereign debt problem by focusing on the sustainability of public debt in the peripheral economies. But it can be more informative to view it as a balance of payments problem. Taken together, the four most troubled nations (Italy, Spain, Portugal and Greece) have a combined current account deficit of $183 billion. Most of this deficit is accounted for by the public sector deficits of these countries, since their private sectors are now roughly in financial balance. Offsetting these deficits, Germany has a current account surplus of $182 billion, or about 5 per cent of its GDP.
Viewed in this light, it is clear that there needs to be a capital account transfer each year amounting to about 5 per cent of German GDP from the core to the periphery. Without that, the euro will break up.
So what can be done?
The eurozone’s proposed solution to this problem – budget contraction plus economic reform in the debtor nations, with no change in policy in the creditor nations – is very familiar to students of balance of payments crises in fixed exchange rate systems such as the Gold Standard or the Bretton Woods system in the past. It is not impossible for these solutions to work, but they are very contractionary for economic activity, and very frequently they fail. When they fail, they lead to devaluations by the debtor economies, normally because the required degree of contraction proves politically impossible to undertake. That is where Greece probably finds itself today. Others may be in the same position before too long.
Is there any way of improving the chances of success for the eurozone’s chosen strategy? Theoretically, yes. Germany, as the main creditor nation could choose to grow faster, and accept higher domestic inflation for a while, in order to ease the process of adjustment. In practice, Germany shows no sign of accepting this, but it is the best solution available, not only for the debtor economies, but also for Germany itself.
Let’s dig deeper. In short, surplus countries have to extend balance-of-payments credit, in addition to the finance provided directly by governments and the ECB through its Securities Markets Purchase Programme. But how does the former work in practice?
Thankfully, Deutsche Bank analysts on October 25 waded in with an instructive report to explain the mechanics:
Since EMU has been built as a union of sovereign states, each state has retained its own national central bank, which has become a member of the so-called Eurosystem with the ECB at the top. National inter-bank payment systems have been merged into a euro area interbank payment system (Target2), where national central banks have assumed the role of the links between countries (see our GEP from 8 June 2011 for a description). A key consequence of this system is that each euro area country has a national balance of payments in the form of the net position of its central bank within Target2.
This net position can result in a claim (balance-of-payment surplus) or liability (balance-of-payment deficit) against the ECB, which sits in the centre of the payment system. The consequence of this system is that a country with a balance-of-payments deficit automatically receives unlimited funding.
Take the example of a country which, due to an over-valued internal real exchange rate and a large government budget deficit, has a current account and capital account deficit (with the latter due to capital flight as residents exchange over-valued domestic assets. against foreign assets). As the banks extend credit to an over-indebted government and an uncompetitive private sector they are considered unsafe and are therefore cut off from private sources of funding. To ensure solvency, the banks in this country receive credit from their national central bank, which acts on behalf of the ECB.
Thus, reserve money flows from the ECB to fund payment outflows induced by the current and capital account deficits. While banks in the country with the overvalued internal real exchange rate rely primarily on their national central banks and the ECB for funding of their balance sheets, banks in the country with the undervalued exchange rate that receive the payments have plenty of liquidity and therefore do not need ECB funds. Hence, the ECB’s funding operations become tilted towards the countries with overvalued exchange rates.
A good way to think about balance of payments positions then is to look at the net claims and liabilities of Eurosystem central banks against the ECB for the end of last year and in recent months, as this table lays bare: (Click to enlarge)
Why is this unsustainable and why Germany is so scared about inflation?
As long as the balance-of-payments imbalances persist, claims of the Germanic central banks against Latin central banks via the ECB rise. Since interest on these claims is given by the ECB’s refi rate, which can be set to zero if the majority of ECB Council members decides so, and since there is no repayment obligation, the claims can theoretically rise to infinity. However, economically the balance-of-payments imbalances and hence the rise in national central banks’s claims and liabilities vis-a-vis the ECB represent real resource transfers from the Germanic to the Latin countries. In other words, goods, services, and assets are transferred from the creditor to the debtor countries at subsidised prices, with the subsidy measured by the claims and liabilities vis-a-vis the ECB.
The transfer is automatic and outside any budgetary control. However, representatives of the Germanic countries in the ECB Governing Council and other Council members concerned about the integrity of the Eurosystem may well use their influence to limit these transfers below the comfort level of the Latin countries. Hence, it seems that a resource transfer through the Eurosystem cannot be enforced on a permanent basis. In addition, excessive reserve money creation in “Latin” countries will eventually raise the euro area reserve money stock above a level consistent with low inflation (a point, which we take up further below).
Okay, say we agree now that this is a current account crisis. What are the options?
1. Fiscal transfers from Germany to the deficit nations.
2. Internal Latvia-style deflation that would require the write-off of sizeable amounts of public and private debt.
3. “The Latin countries could exert their influence over the ECB to pursue a monetary policy that leads to higher inflation in the Germanic countries,” DB note.
If you think pigs might fly before the latter option takes root, think again. It’s the path of least resistance, the bank reckons:
With outright budgetary transfers from the creditor to the debtor countries unlikely and the latter also probably unable to achieve internal real depreciation through deflation of goods, services and asset prices, the path of least resistance seems to be an appreciation in creditor countries through the inflation of goods, services and asset prices. With representatives of debtor countries holding a majority of votes in the ECB”s Governing Council, a policy of easy money and exchange rate depreciation that leads to overheating in the creditor countries seems most likely.
In other words, the monetary battle has only just begun. The only thing we can say for certain is that Germany will fight tooth and nail to stop option one.
And even if the eurozone manages to muddle through, in the medium term, sustainable solutions to this vexing current account issue are hard to come by. Remember when Geithner last year floated the idea of current account targets between the US and China only for it to be shot down as unworkable in practice? Would it be easier to impose binding targets of such nature within the EMU? We are not quite sure. And would Germany ever argue that surpluses were a bad thing? A consensus on this is surely needed before anything can de done about it. Just ask John Maynard Keynes.
For now, mind the gap.
The eurozone decouples from the world – FT