Finally, the deficit countries could exert their influence over the ECB to pursue a monetary policy that leads to higher inflation in the surplus countries. In this case, the internal real-exchange-rate realignment would be achieved by a rise in goods, services and asset prices in the creditor countries. As prices in these countries would rise faster than in the debtor countries, their intra-EMU current, capital and hence balance-of-payments surpluses would disappear. From the deficit countries’ point of view, a policy that overheats the surplus countries is the best outcome as it spares them the costs of deflation. The adjustment costs would be shifted to the creditor countries in the form of the economic costs of inflation. Since these costs are intransparent and distributed over a long period of time it is difficult to organise resistance against them. A policy of easy money and a soft exchange rate could help achieve such an outcome.

As mentioned above, even in the absence of an explicit easing of monetary policy, continuous balance-of-payments deficits in those countries help to create the outcome described. If the Eurosystem is forced to continuously fund the banking system in the debtor countries in order to avoid a euro break-up, liquidity injected in the debtor countries will eventually find its way into the creditor countries. Capital inflows into the surplus countries, in turn, leave banks in this part of the euro area with access to relatively cheap funding. This may limit the ECB’s ability to control the interest rate and sterilise excess liquidity in the surplus countries. Capital flight within the Eurosystem – even in a moderate form – can thus help facilitate the realignment of real exchange rates by creating inflationary pressures in the surplus countries. The ability of the deficit countries in EMU to reflate the surplus countries has been likened to the corresponding role of the reserve-currency country in a fixed exchange rate system.⁷ The latter can also fund its balance-of-payments deficit through central-bank money creation and reflate its partner countries in this way. Thus, thanks to Target2, the deficit countries in EMU have the “exorbitant privilege” of obtaining central bank money from the ECB to fund their balance-of-payments deficits. The key difference between a fixed exchange rate system, such as the Bretton-Woods system where the US had the position of the reserve-currency country, and EMU is that in the former it tends to be the strongest country that assumes the role of the reserve-currency country while in the latter it is the weakest countries that are in this position.

Conclusion

In this article we have argued that below the surface of the euro area’s public debt and banking crisis lies a balance-of-payments crisis caused by the misalignment of internal real exchange rates. At present, the Eurosystem generates real resource transfers 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. 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. But will the electorates in the creditor countries accept such an outcome or push an exit from EMU? As we pointed out in a recent article of October 5⁸, 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.

Copyright © 2011 • Deutsche Bank AG, DB Research

Published by kind permission of Thomas Mayer.

Footnotes:

[1] Mayer, Thomas, Jochen Möbert and Christian Weistroffer (2011). Macroeconomic imbalances and the Eurosystem. In: Deutsche Bank Global Economic Perspectives. June 8, 2011.
[2] The problem was identified first by Hans-Werner Sinn, President of the German Ifo Economic Research Institute, who recently published a collection of articles by a number of economists on the subject (Ifo Schnelldienst 16/2011 from August 31, 2011).
[3] The nature of Target2 balances depends on the degree of cross-border diversification of euro-area banking operations. As long as banking operations remain organised along national lines, the Target2 balances are a good proxy for a country’s balance-of-payments position. This would change only if banking operations became independent of national borders. In this case, Target2 would turn into a truly integrated euro-area payment system.
[4] In this example we have linked balance-of-payments imbalances to exchange rate misalignments. In theory, a balance-of-payments deficit could also arise in the case of irrational capital flight entirely unrelated to a country’s fundamentals. While markets certainly tend to exaggerate, we regard irrational capital flight on a sustained basis entirely unrelated to the country’s fundamentals as being extremely unlikely.
[5] As the Bundesbank is eager to point out, its credit risk is determined by the Eurosystem’s refinancing operations with commercial banks and not the intra-system balances (Target2).
[6] Offering first-loss bond insurance against a default of Italy strikes us as being akin to offering glass insurance to a homeowner next to a nuclear power plant on the verge of a meltdown. Neither the homeowner nor the owner of Italian bonds would feel much relieved by such insurance.
[7] See Wilhelm Kohler, ?Zahlungsbilanzkrisen im Eurosystem: Griechenland in der Rolle des Reservewährungslandes?” Ifo Schnelldienst 16/2011, pp. 12-19.
[8] Thomas Mayer, “EMU’s Stress Test”. In Deutsche Bank Global Economic Perspectives. October 5, 2011.

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