Why the Bundesbank is wrong

by Martin Wolf

Financial Times
April 10, 2012

How far has the eurozone come towards resolving its crisis? The optimistic answer would be that it has rescued itself from a heart attack, but must still manage a difficult convalescence, with a good chance of further attacks. It must also adopt a regime able to protect itself against future crises. This task, too, is incomplete. But the eurozone has secured time. The big question is how well it now uses it.

Arguably, the crucial step is to agree on the nature of the illness. On this, progress is now being achieved, at least among economists. It is widely accepted that the balance of payments is fundamental to any understanding of the present crisis. Indeed, the balance of payments may matter more in the eurozone than among economies not bound together in a currency union. Hans-Werner Sinn of CESifo, in Munich, has done much to explain, in his words, that “the European Monetary Union is experiencing a serious internal balance of payments crisis that is similar, in important ways, to the crisis of the Bretton Woods System, in the years prior to its demise.” A special issue of the CESifo Forum, published in January 2012, is dedicated to this theme. In March, Bruegel, a Brussels-based think-tank, published a seminal paper on “Sudden Stops in the Euro Area”. Then, in late March, Jens Weidmann, president of the Bundesbank, explored the issue in a speech in London on “rebalancing Europe”.

In the years of euphoria prior to the financial crisis, private capital flowed freely, not least into countries in southern Europe. Greece, Portugal and Spain ran current account deficits of 10 per cent of gross domestic product, or more. These financed huge excesses of spending over income in private sectors, public sectors, or both. These economic booms also generated large losses in external competitiveness.

Then came the “sudden stops” in private inflows. As the Bruegel paper notes, such stops occurred during the global crisis of 2008 (affecting Greece and Ireland), in the spring of 2010 (affecting Greece, Ireland and Portugal) and, finally, in the second half of 2011 (affecting Italy, Portugal and Spain). In some cases, what happened went beyond a mere stop in inflows. Ireland, for example experienced large capital flight. Of course, when capital ceased to flow to the private sector, activity collapsed and the fiscal position worsened dramatically.

The eurozone was unprepared for such an interruption in cross-border finance: it was believed impossible. Once the stops had happened, the eurozone had two options: force external adjustment on countries shut out of the markets or finance them via official sources. The second was the chosen option, with the European Central Bank the dominant source of finance, in its role as lender of last resort to banks. The ECB has become the “European Monetary Fund” (see charts).

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