Martin Wolf has another excellent piece in today’s FT, which also appears without the need for a subscription in the Irish Times. A major theme of Martin’s recent analysis has been the asymmetries in the current account positions across the euro zone, and as a result the need for a more balanced crisis-resolution strategy that involves expansion in the core. While his analysis has been incredibly useful in many ways, I have always felt that he underemphasises the “capital account” nature of the crisis. It seems partly under the influence of the recent excellent Breugel paper on “sudden stops” in net capital flows, this latest article provides what I think is a more balanced perspective. For our own debate, the piece provides a useful opportunity to reflect on the relative roles of current and capital account aspects of the euro zone crisis.
Much of the discussion of the crisis has cast it as a crisis of the current account of the balance of payments. There is much to this; it is undoubtedly true that improvements in the relative competitiveness of the periphery and the relative demand growth of the core are critical elements of the solution. However, the crisis is even more immediately a crisis of the capital account, with – as documented in the Bruegel paper – a “sudden stop” in net private capital flows to the periphery. (Everybody interested in the crisis should read the Bruegel paper.)
It is useful to consider what would have happened if large-scale official funding — including the funding of periphery banks through the eurosystem — had not taken place. (The Breugel paper documents how massive the official funding has been.) Current account deficits in the periphery would have declined massively, and (absent default) would have swung to large current account surpluses as existing credit lines were not rolled over. This would have resulted in even deeper depressions and widespread defaults. Care must be taken in interpreting the current account balance – or turnarounds in that balance – as a sign of economic health.
Without in anyway playing down the importance of the need for more balanced adjustment across the euro zone (which requires more expansionary policies in the stronger countries of the core), the “sudden stop” in private capital flows highlights the critical need to re-establish creditworthiness. This is critical to facilitating more phased adjustment without putting an intolerable strain on the willingness of the core to fund the current account imbalances of the periphery.
The re-escalation of the crisis in late 2011 – which may be raising its ugly head yet again with the renewed pressures on Spain and Italy – shows how fragile creditworthiness is to bad expectational equilibria within a monetary union. This has led to efforts to shore up the lender of last resort function within the euro zone. But a reliable lender of last resort means that the stronger countries face potentially huge liabilities for their weaker partners. It should not be surprising that assurance is needed that adjustments will take place without default on official lenders in return for providing the financing to allow those adjustments to take place in a more phased way.
The fiscal compact must be seen in this light. Focusing on the unbalanced-current-accounts aspect of crisis, there is substance to the criticism that the compact forces excessively restrictive fiscal policies on the core. But the capital account – i.e. creditworthiness – aspect cannot be ignored. A commitment to shared discipline appears necessary to allow both the massive official funding to continue and to make it sufficiently reliable to make the market creditworthiness of the periphery less fragile.