Below the surface of the euro area‘s public debt and banking crisis lies a balance-of-payments crisis caused by a misalignment of internal real exchange rates. At present, the Eurosystem generates real resource transfers in the form of subsidised credits from the creditor to the debtor countries, but this arrangement does not seem stable as these transfers are not politically authorised and hence it will compromise the Eurosystem if they are sustained indefinitely.

The path of least resistance seems to be an appreciation in creditor countries through the inflation of goods, services and asset prices, i.e. given that an outright budgetary transfer from the creditor to the debtor countries is unlikely ? and the latter also probably unable to achieve internal real depreciation.

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. The authorities in creditor countries could insure their population against inflation and a soft currency policy by offering them index-linked securities that would convert into a new currency should these governments eventually decide to abandon the euro.

Alternatively, authorities could aim at generating a combination of intra-EMU transfers, deflation in the debtor countries and inflation in the creditor countries such that the economic pain felt in each country group is shared between them in a way that leaves it below the level triggering a break-up of EMU.

In our article of June 8, 2011¹ we discussed the role of the Eurosystem in the funding of balance-of-payments imbalances of euro-area countries. In the present note we elaborate on our earlier analysis and discuss recent developments and the outlook. Our main point is that below the surface of the euro area’s public debt and banking crisis lies a balance-of-payments crisis caused by a misalignment of internal real exchange rates. At present, the Eurosystem generates real resource transfers, in the form of subsidised credit, from the creditor to the debtor countries. But this arrangement does not seem stable as these transfers are not politically authorised and hence it will compromise the Eurosystem, or lead to inflation, if they are sustained indefinitely. 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.

The emergence of balance-of-payments imbalances

Until the beginning of the euro crisis in 2009 EU officials tended to ignore the current account imbalances among EMU member countries. Some of them who failed to grasp the difference between a common currency area within a political union and a currency union of politically sovereign states even insisted that these imbalances were irrelevant. As long as financial markets were buoyant and credit easily available at rock-bottom cost for borrowers of differing quality, the flaw in this argument was not laid bare. This changed abruptly when risk appetite in credit markets plunged in the course of the financial crisis and EMU member countries with high government deficits or debt and a bleak economic outlook experienced a “sudden stop” of capital inflows and even net capital outflows.

On the surface, the “sudden stop” led to a government funding and banking crisis. In response, EU authorities began to extend financial support – associated with pressure for fiscal adjustment – to the affected countries while the ECB supported the banks. Below the surface, however, lies a balance-of-payments crisis which has so far received only scant attention.² Recall that the balance of payments is defined as the sum of the current and capital accounts. In a floating exchange rate system, the balance of payments is always zero as the exchange rate adjusts so as to equilibrate the current account balance with the capital account balance. In a fixed exchange rate system, however, balance-of-payments imbalances can emerge when the exchange rate is above or below its equilibrium value. In the first case, when the exchange rate is overvalued, a country imports more than it exports, and the current account moves into deficit. At the same time, domestic asset prices in foreign currency are higher than foreign asset prices, so investors sell the first and buy the latter. This leads to net capital outflows and hence a deficit in the capital account. The combined deficits of the current and capital accounts then lead to a deficit of the balance of payments. Traditionally, balance-of-payments deficits have been funded by the sale of foreign exchange reserves of the central bank. When the stock of reserves is depleted and the central bank can no longer fund the deficit the exchange rate drops so as to restore equilibrium between the current and the capital account. In the second case, when the exchange rate is undervalued, the current and capital accounts and hence the balance of payments are in surplus and the central bank accumulates forex reserves. This process only comes to an end when reserve accumulation has increased the money supply to an extent that inflation rises to intolerable levels and the authorities up-value the exchange rate in an effort to regain price stability.