Euro crisis: it didn’t end, and it won’t12 April, 2012, 6:07. Posted by Zarathustra
For whatever reason, the market seemed to be relieved by the LTRO of the European Central Bank, which kicked the can down the road for a bit longer than they used to. Some were even happy to say that the worse for the Euro crisis is over.
The crisis in Europe is a complicated one. People are losing faith on governments’ finances, contributing to the sovereign debt part of the crisis. At the same time, with private sector banks in the peripheral countries running a big exposure to the sovereigns, inevitably, the crisis also has the banking crisis-ish dimension to it.
Of course, at heart, the crisis in about the euro. Specifically, how flawed the monetary union is.
The problem with the European monetary union (EMU) has now been well popularised: that the EMU is merely a monetary union, without fiscal union. What exactly does that mean?
In a simplified stock-flow consistent framework (think Wynne Godley), if we conceive the Eurozone as a closed economy, some of the countries are bound to run trade surplus, while the others are bound to run trade deficit. This should be self-evident: within a closed system, it is impossible for all countries to run trade surplus all at the same time.
The national income accounting gives us the following identity:
(S-I) + (T-G) = (X-M)
Where S is private sector saving, I is private sector investment, T is tax revenue, G is government expenditure, X is export, and M is import. If a country runs a trade deficit, that means the right-hand side of the equation is negative. The left-hand side of the equation will be negative, by definition. The government will also run a deficit, and/or private sector net saving is negative. In Godley and Lavoie (2007)’s simplified model, of course, they found that if one part of the monetary union decided to import more, not only would that part of the union run a trade deficit, government budget would automatically turn into deficit, even though the starting point was a balanced budget condition.
If it wasn’t that these countries are using the same currency, the problem would be simple. Drachma, or Lira, would simply fall against the Deutschmark. If the EMU is also a fiscal union, the problem would also be simple. Countries running trade deficits would most likely be running government budget deficits as well. With proper fiscal transfer, these countries can be “subsidised” by those running surpluses.
Unfortunately, EMU is not like that. The treaty and the new fiscal compact thing want all countries to limit government deficits or run surpluses all at the same time, but that is actually not possible, almost by definition. Unless there is an external third party that runs a massive trade deficit with the Eurozone countries (or in other words, the Eurozone countries run trade surplus with the rest of the world), otherwise, it is hard to see how all things could resolve.
As said in in Godley and Lavoie (2007):
But while everyone knows that, in a two-country monetary union, one of the partners will be running a trade deficit, it is not always understood that in that same two-country monetary union, the laws of accounting are such that the country running a trade deficit must be running a government budget deficit as well once the steady-state position is reached. Despite this mathematical necessity, all countries of the EMU are strongly encouraged, with financial penalties being imposed otherwise, to run balanced budgets or budgets with surpluses. Such a rule must presuppose that countries that are part of the eurozone are running balance-of-payments surpluses relative to the rest of the world. But why should this be the case? (page 183).
In other words, the European Monetary Union was flawed from the start.
Wynne Godley and Marc Lavoie, 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave MacMillan.