Most people think of the eurozone crisis as a fiscal crisis. They see the southern European countries collectively called the PIIGS (Portugal, Ireland, Italy, Greece and Spain) with huge debt/GDP ratios or huge fiscal deficits that look unsustainable, and require rescues by prudent northern Europeans.
This is true, but masks a much bigger picture. This is that the private sector in the PIIGS is as indebted and insolvent as the government, reflected in huge, growing current account deficits. For viability, private overspending needs to be tackled no less than public. A 10-year wage freeze (leading to a terrible depression) might do the job, but looks politically impossible.
Economists like Martin Wolf argue that the eurozone crisis is at heart not fiscal at all but a balance of payments crisis. Wolf looks at fiscal deficits in the eurozone between 1999 and 2007 and finds that the biggest deficits are not in the PIIGS. He then looks at countries with the highest debt/GDP ratios, and once again finds that PIIGS do not monopolise this list. Next he looks at the countries with the highest trade deficits. These are, overwhelmingly, the PIIGS. So, Wolf argues, this is a balance-of-payments crisis cloaked as a fiscal one.
Why has this not been highlighted much earlier by many others? Because the main deficits of the PIIGS are overwhelmingly with Germany. The eurozone as a whole has a negligible trade deficit. The big deficits are those of the PIIGS within the eurozone.
Had the PIIGS run up massive deficits with the rest of the world, everybody would have known. But deficits within the eurozone are paid for not in foreign exchange but in euros, which happen to be the domestic currency too. So, these deficits have escaped public attention. Analagously, the trade deficit between Texas and California is also in the same domestic currency, and also escapes public attention.
However, a big academic debate has now broken out on what are called the balances in TARGET2 (the inter-European banking mechanism for transfers in euros between eurozone members). A paper by Prof Hans-Werner Sinn of the IFO Institute, Munich, shows that Germany (along with Holland and Finland) had accumulated TARGET2 surpluses of over 400 billion euros by August 2011, with the PIIGS accumulating a corresponding deficit. By today, the figure must be well over 500 billion euros, bigger than even the 440 billion euros of the EFSF (the European rescue fund).
Martin Wolf interprets this to mean that the national central banks (like the Bank of Greece) are able to print euros to finance their countries’ current account deficits. This amounts to a painless monetisation. And so, Wolf argues, the eurozone is already a transfer state, transferring automatically money from the surplus to deficit countries.
Others disagree. Some say that the balances are IOUs, not transfers, and will need to be repaid in due course. However, the imbalances are so large that they cannot be repaid in the foreseeable future. Some economists argue that in a monetary union, such deficits can continue indefinitely, like deficits between Texas and Mississippi in the US. Economist Willem Buiter of Citibank points out that the TARGET 2 surpluses of Germany may represent not just trade deficits but also capital flight from the PIIGS to Germany, with bank depositors seeking safe havens.
Amazingly, this debate is occurring in an academic ivory tower, and is not a staple of everyday media discussion. Interested readers can follow this debate in Martin Wolf’s blog in the Financial Times. Like me, they will be amazed that such an important debate can escape mainstream discussion. We need more clarity on the ability of the national central banks of the PIIGS to print euros.
The big debate in Europe bypasses this altogether. European politicians have pledged to sign a fiscal stability pact, limiting future fiscal deficits in all countries to 0.5% of GDP, adjusted for the business cycle. This is not so different from the original Maastricht Treaty, which set a fiscal ceiling of 3% of GDP that was broken by everybody (including Germany). Adjusting the fiscal deficit in any year to the business cycle is a very inexact and fudgable exercise.
So, sceptics feel the eurozone is no closer to solving the problem of how to maintain a single currency for countries with very different levels of competitiveness, like Greece and Germany. Many believe the eurozone will break up. Maybe the competitive countries of northern Europe will exit to form a super-eurozone. Maybe the PIIGS will exit into a lower-level eurozone, or back to national currencies again.
Any eurozone break-up will create horrendous problems. But it will enable the PIIGS to default on their massive official debts, devalue and make a fresh start. They will go through a horrendous transition period, but there will be light at the end of the tunnel.
What will happen to TARET2 imbalances after a break-up? Probably the deficit states will refuse to pay, leaving Germany with massive, worthless TARGET2 credits. If so, this is one more incentive for the PIIGS to leave the eurozone, and for Germany to make sacrifices to keep them in. Right now, German voters oppose, with much outrage, further sacrifices to rescue the PIIGS. But if this results in the PIIGS leaving the eurozone, Germans may have to sacrifice even more through unpaid TARGET2 balances.