ECONOMICS:The underlying reason for the trouble in Europe is the failure of the financial system to allocate capital
MANY ANALYSTS and commentators seriously underestimated the flaws in the design of the euro before the crash of September 2008. The depth and duration of the crisis can leave no one in any doubt that much more will have to change before the single currency can be put on a secure foundation, if indeed that is even possible.
One of the analytical errors made in the first decade of the euro was the downplaying of the imbalances between what a country earns from the rest of the world and what it buys from the rest of the world, known in the economics jargon as the current account on the balance of payments.
I recall writing 10 years ago that if Scotland and Bavaria had never worried about their current accounts, why should Ireland or Finland, after having joined the euro? This was wrong, because Scotland and Bavaria are also part of respective fiscal and political unions.
As has been so painfully revealed, national economies in the euro can suffer the kind of sudden halts to external funding of their current account deficits that do not occur in regions of fully fledged sovereign states (a country that buys more from the rest of the world than it earns must borrow from foreigners to pay the difference).
If too many people understated the importance of current account imbalances before the crisis, now, too much emphasis is being placed on them. The most flawed argument is that the euro itself created the imbalances that has brought the single currency to the brink of collapse.
Hans Werner Sinn, an influential German economist, wrote recently: "The cheap flow of credit for private and public purposes made possible by the euro until 2007[my emphasis] fed an inflationary bubble that pushed prices for property, government bonds, goods and labour above the market-clearing level and resulted in huge current-account deficits and foreign-debt levels."
He is right about the effects of excessive capital inflows, but wrong about the reason they happened. While the single currency makes dealing with problem countries more difficult, not least because it intensifies the spillover effects from one weak economy to others, it was not the cause of the crisis in the first place.
In April, I wrote here on the issue specifically in relation to Ireland, pointing out the credit bubble here began to inflate in late 2003 when banks suddenly and massively ramped up their issue of bonds abroad to fund even more property lending. That had nothing to do with the euro, which had come into existence half a decade earlier, and everything to do with a financial system that had become blind to risk.
The failure of the financial system to lend and borrow prudently led to a dozen European countries being bailed out by the International Monetary Fund. Most were not in the euro. The single currency cannot be the cause of excessive foreign borrowing in countries from Iceland to Romania and Latvia, where the euro has never been adopted.
The first chart shows the external balances of those three economies over an extended period. Even the most cursory glance shows how their deficits exploded in the middle of the last decade. By 2005 all three recorded their largest imbalances. By the time the global financial crisis erupted in 2007-08, both Iceland and Latvia along with five other non-euro countries were running much larger external deficits than the worst offenders in the euro zone – Greece and Portugal.
For Ireland, the current account evidence supports the conclusion of that April article, based on credit growth and bank bond issuance. In the first half of the last decade the current account was in broad balance, as the second chart shows. A deficit emerged only in 2005, from which point it deteriorated rapidly.
Italy proves in a different way the very limited relevance of the euro to current accounts. It is difficult to discern any impact on its external position from the adoption of the euro. As the second chart shows, Italy has had the smallest imbalances over three decades among the Club Med countries. No step change took place after the euro was launched in 1999 and developments since then are in line with patterns over the previous two decades.
Spain’s current account position up to 2005 was similar to that of Italy’s in that post-economic and monetary union patterns did not diverge from the previous 20 years. That changed in the middle of the last decade, and for exactly the same reason as in Ireland – Spanish banks sought and obtained from lenders abroad additional funding to plough into a property boom.
Portugal and Greece were very different. Both countries’ external deficits ballooned from the mid-1990s, well before there was certainty that the single currency would be launched and long before their participation in it was assured. There was no inflection point after either country joined to suggest the euro caused a change in the trend.
The creation of the euro was a mistake and, if it breaks apart, it will turn out to have been one of barely calculable proportions. But the underlying reason for the trouble in Europe is the failure of the financial system to allocate capital. The euro crisis is rapidly reaching tragic proportions. It would be an even greater tragedy if the dangers that finance poses to security and wellbeing are not learnt.
