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The flaws of the EU’s asymmetric approach to imbalances


Originally published on on July 19, 2011. It has been used as a source in Rachael Wheeler’s dissertation Not If, But When – The Inevitability Of The Eurozone Crisis (University of Dundee, April 2012); also by e-commerce digests. It was also discussed on European Tribune.

The EU is pursuing a lopsided approach to resolving the eurozone’s internal imbalances. If all the adjustment were to take place among deficit countries, one of the consequences would be a situation under which the capital investment to improve productivity can hardly take place.

Earlier this month [July 2011], Eurointelligence ran a piece by Bruegel’s Guntram Wolff entitled “high time to address macroeconomic imbalances”. Indeed, but which macro-economic imbalances?

The “excessive imbalance” tearing the Eurozone apart is the internal trade imbalance, given that the Eurozone as a whole has balanced external trade. The European economic policy elite interprets this as the exclusive responsibility of the Eurozone’s internal deficit countries, but the internal deficit is the mirror image of the internal surpluses and ones cannot exist without the others. This surplus being a national goal for so-called “core” European countries, any tendency towards moderation of internal Eurozone trade surpluses was prevented by beggar-thy-neighbour policies in the surplus countries. Indeed, Germany complains about the trade deficits of other countries but takes any available political and economic step to retain its surplus, including the depression of internal demand. This makes deficit reduction within the Eurozone a race to stay in place.

We seem to have collectively forgotten what was known at least since Keynes at Bretton Woods proposed an International Clearing Union with a surplus recycling mechanism and penalties for both deficit and surplus countries. Namely, we ignore at our peril that trade imbalances cannot be moderated by taking corrective action on the deficit side alone, especially in the presence of a fixed-exchange-rate regime such as the gold standard of Keynes’ time or the Euro as currently configured: a monetary union without fiscal union where the central bank’s price stability mandate trumps concerns over financial stability or full employment. Adjustment on the deficit side under a fixed exchange regime requires a painful recession in the deficit country, under which the capital investment necessary to improve productivity can hardly take place. Moreover, a recession on the deficit side deep enough to significantly reduce imports necessarily hurts export-dependent businesses in surplus countries. As presently designed, the Eurozone is a modern version of the gold standard, with the expectation that long and painful adjustment processes in deficit countries —which were a given rather than an unintended consequence— would unfold without a systemic crisis.

However, considering the nature of the European internal trade imbalances, systemic crisis is unavoidable in the present situation. Trade is a bilateral relation, and generally speaking structural trade imbalances have to do with the economic structures of both the surplus and the deficit countries. In addition, the trade imbalance is funded by the surplus side lending to the deficit side. When, as in the Eurozone, public sector finance is constrained, the debt necessary to maintain economic activity in the presence of structural import dependence is taken on by the private sector of the deficit country. This is what happened in the Eurozone over the first decade of its existence, where deficit countries except for Greece adhered to the Maastricht fiscal rules and so the import dependence manifested itself as private debt. If this surplus recycling had taken the form of productive investment in the physical plant of deficit countries, it would have acted as a negative-feedback loop on the trade imbalance, working to reduce the size of the imbalance. However, in practice, the lending form the surplus to the deficit countries followed the path of least resistance, namely funding asset-price bubbles.

When the debt-financed asset-price bubble burst in the deficit countries, as such bubbles eventually do, a “balance sheet recession” ensued, with the corresponding banking crisis (Footnote: banking in surplus countries which provided the net lending took an indirect hit from the asset-bubble of the deficit countries). This has also been known essentially since the Great Depression when Fisher formulated his Debt Deflation theory but, like Keynes’ contemporaneous insight on international trade imbalances, it has been studiously ignored since. As a deep recession hit Europe in 2008, European governments made good on their implicit or explicit economic guarantees to their societies: on bank deposits; as investors, employers, and capitalizers of last resort; and, in the treasury/central bank tandem, as lenders and market-makers of last resort. It was then and only then that the private sector debt amassed over a decade-long business cycle began to manifest itself as public debt. In 2009, with the private sector deleveraging at double-digit rates, the alternative to double-digit government deficits would have been double-digit GDP contraction. Since 2010, austerity packages intended to rein in these deficits have resulted in disappointing GDP growth and failure to meet deficit reduction targets.

But the future of the Eurozone looks even darker. At the inaugural G20 meeting at the end of 2008 the European Union and its leading Member States rebuffed American attempts to agree a global fiscal stimulus package on the argument that Europe’s more generous “automatic stabilizers” rendered an ad-hoc stimulus unnecessary. However, when in 2009 the said “automatic stabilizers” exceeded the wholly arbitrary limits set by the Maastricht rules (as they couldn’t fail to do given the depth of the crisis), the European economic policy elite panicked and is currently hard at work dismantling the automatic stabilizers in the deficit countries. This will in fact ensure that when the next Eurozone business cycle ends, no double-digit deficit will arrest the GDP collapse brought about by debt deleveraging. This is sold as “doing one’s homework”. Estonia’s experience with double-digit GDP contraction in this crisis, under EU fiscal guidance and praise, seems to be the blueprint for the future. The Euro Plus Pact, the public debt brakes, and the focus on “competitiveness” and “reform” continue to ignore private debt and the complementary nature of internal eurozone deficits and surpluses. For this policy to succeed, all countries must become net exporters, a requirement as manifestly absurd as requiring all children to be above average.

Fortunately, there is another way, and it has been outlined in the Financial Times with a recent proposal for “a New Deal for Europe” by Amato and Verhofstadt and co-signed by other former European office-holders. This requires, first, a different diagnosis to the one currently favored in Brussels and Frankfurt: that the European Union has twin banking and sovereign debt crises, and that there is a chronic underinvestment problem in the Eurozone deficit countries which is the ultimate cause of the internal trade imbalances and thus of the private and then public debt buildup. The “New Deal for Europe” would begin to address the trade imbalances by funding productive investment in the deficit countries through the European Investment Bank, a healthier way of recycling internal trade surpluses than fueling asset price bubbles. There would be a true “structural fund” spent on proactively improving the productive structure of the chronically underinvested areas in the Eurozone. This is a way out of the crisis which will deliver the “growth and jobs” that the European Union has been promising with great fanfare for over a decade, rather than the biting austerity currently on offer, and which may last “for decades”. Returning to the piece by Bruegel’s Wolff, the fact is that reminding people of the need for “reform” in the deficit countries is not “urgent” as that is already an undisputed part of the policy response to the present crisis. What’s urgent is an acceptance of the concept of a surplus recycling mechanism and an end to deflationary monetary, fiscal and industrial policies in the EU. In particular, it is urgent to remind certain surplus countries that wage increases cannot sustainably fall short of productivity increases, because this invariably leads to demand-side depressions like the present.

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