Will addressing large internal imbalances lead us out of the Eurozone crisis? This column argues that it might. Periphery countries should devalue in order to regain competitiveness and reduce imbalances. As to whether they should pursue internal or external devaluation, the answer remains unclear. Overall, given that policymakers have excluded the option of exit, economic policymaking must focus on the possibilities for internal devaluations, despite some of the difficulties it may bring.

Europe is in the grip of three interrelated crises: a balance-of-payments crisis, a sovereign-debt crisis and a banking crisis. Policymakers have primarily focused on the sovereign-debt and banking crises. However, a credible strategy for getting the Eurozone back on track needs to address the problem of its large internal imbalances. Rebalancing will require countries with current-account deficits to devalue. The crucial question is how: internally without exiting the euro or externally after exiting the euro.

There is a large body of literature on global imbalances. To date, however, little attention has been paid to the imbalances within the EU or the Eurozone (see Lane and Milesi-Ferretti 2007 for the implications of global imbalances for Europe). One reason for this might have been that the current account of the EU and that of the Eurozone were roughly balanced over the period from 1995 to 2011. The external balance of the Eurozone, however, disguised considerable internal imbalances within. In particular, the Greece, Ireland, Italy, Portugal, and Spain countries have been running a combined current-account deficit that has been rising since the late 1990s. This deficit was largely offset by the German current-account surplus during the whole period. The rest of the Eurozone was roughly in balance. Current-account deficits and surpluses resulted in corresponding changes in the net international assets position. Germany steadily improved its asset position while Greece, Ireland, Italy, Portugal, and Spain accumulated a large net foreign liability position, which amounts to about 20% of the Eurozone’s GDP.

It is important to point out that the Greece, Ireland, Italy, Portugal, and Spain relied increasingly on public support to finance themselves internationally. As of 2007 the main source of this public support was ECB Target credit. The public capital flows as reflected in the increase in the Target balances basically compensated for the private capital flows. They have financed or co-financed the current-account deficits of Greece, Portugal and Spain since the winter of 2007/2008, and compensated for capital flight from Ireland after the Lehman crisis, as well as from Spain and Italy as of the summer of 2011 (see Sinn and Wollmershäuser 2012).

What caused current account imbalances?

Arguably, there were two primary and interrelated causes of current-account imbalances:

• First, the introduction of the euro eliminated the exchange-rate risk and induced investors to disregard country-specific bankruptcy risks (see EEAG 2012);
• Second, the Eurozone system created optimistic expectations regarding the rapid convergence of the periphery countries (Greece, Ireland, Portugal and Spain) with the core of the Eurozone (see Blanchard and Giavazzi 2002);

Both causes generated an investment and credit boom in the periphery and implied a catching-up process with international capital movements from the core to the periphery that materialised as current-account deficits. In fact, the poorer a country was in 1995 relative to the average, the larger its current account deficit was on average between 2002 and 2007. This catching-up process was accompanied by rapidly rising prices in the periphery, undermining the countries' competitiveness. Prices increased relatively little in capital-exporting countries such as Germany, Austria or Finland, but much more in capital-importing countries such as Estonia, Greece, Spain, and Portugal. All Eurozone countries appreciated in real terms relative to Germany to a lesser or larger extent, but capital importers tended to appreciate more.

Rebalancing in the Eurozone

Countries of the European periphery need to devalue, that is, become cheaper relative to the countries of the core in order to regain competitiveness and reduce their imbalances. The crucial policy question is whether internal or external devaluation after an exit from the Eurozone is preferable.

If external devaluation after exit can be performed quickly, there should be no loss of output and employment in principle. However, such devaluation calls into question the stability and persistence of the monetary union. Internal devaluation through falling prices in the periphery can only be achieved through austerity programs that lead to a period of stagnation and mass unemployment in the periphery due to the downward rigidity of prices and wages. In Greece and Spain, two countries with significant austerity programs, unemployment rates are already approaching 30%. Internal devaluation through rising prices in the core does not lead to recession in the periphery. The core, however, is required to bear the cost of higher inflation, which may also undermine the stability of the monetary union.

Exiting a currency union is associated with the additional costs relative to abandoning a peg. Exit from the Eurozone requires the redenomination of assets, liabilities, and contracts into the new currency. Such a redenomination must be unanticipated in a country, leaving a strong currency to adopt a weak one; otherwise there will be a run on financial assets. If the exit plan becomes known, both financial and non-financial firms’ balance sheets will be put under strain, leading inevitably to a loss of employment, output and export in the short run.

Unfortunately, it is difficult to implement an unanticipated redenomination in a democracy (Eichengreen (2010) was one of the first to emphasise this). The process requires legislation by a parliament, preceded by discussions with stakeholders, including representatives of banks, firms, unions, and consumer associations etc. Implementation measures, such as distributing the new currency across the country, require extensive planning and organisation that involve a large number of people, In short, redenomination tends to be anticipated, and usually to be preceded by a run on assets. Second, it is also hard to make redenomination complete. If the government redenominates external liabilities, this would amount to default by a country on all of its external debt (public and private). However, if external liabilities are not redenominated, and an exit is anticipated, domestic lenders will transfer as many domestic liabilities abroad as possible in order to make their internal liabilities external and protect their values from devaluation. Given the large degree of integration of the financial markets within the Eurozone, this process is not very difficult. Hence a currency mismatch of some size is bound to emerge after any country’s exit from the currency union, with its well-known negative balance-sheet effects.

A major difficulty of an internal devaluation is, if it is carried out through deflation, that it raises the burden of both the domestic and the external debt. Indebted firms and households may be unable to bear the debt service and be driven to bankruptcy. In contrast, external devaluation does not increase the burden of domestic debt provided the interest rates do not increase after devaluation. It only increases the burden of external debt, but in the same way as internal devaluation does.

Internal devaluation in the periphery since 2008

Since the beginning of the crisis, there has been adjustment in the periphery of the Eurozone; but the timing and the scale of adjustment has been heterogeneous. Spain and Ireland have improved their current-account balance by about six percentage points of GDP in the last four years, while Greece and Portugal recorded somewhat smaller improvements. The current-account balance only deteriorated in Italy, which had a relatively small current-account deficit before the crisis. Overall, the pattern we observe is that the current account typically improved in countries that started out with a deficit, and worsened in countries that started out with a surplus. Unfortunately, most of the improvements in current accounts seem to be due to income effects. Given that the crisis drove down incomes, imports declined with incomes, while exports remained relatively more stable. What is needed, however, is an improvement due to substitution effects resulting from a change in relative prices through a process of internal devaluation.

Conclusions

The periphery countries need to devalue in order to regain competitiveness and reduce imbalances within the Eurozone. The key policy question is whether they should pursue internal or external devaluation. The answer is not clear. Internal devaluation through inflation in the core may not be available because of resistance in the core and because of the ECB's goal of maintaining price stability through deflation in the periphery. External devaluation, on the other hand, may entail high contagion costs, and also requires the redenomination of assets, liabilities and contracts prior to exit, which is likely to cause severe disruption in the short run. Given that, for the time being, policymakers have excluded the exit option, the emphasis of economic policy must be on seeking possibilities for internal devaluations despite its difficulties.

Authors’ note: This column is based on EEAG (2013), The EEAG Report on the European Economy, “European Imbalances”, CESifo, Munich 2013, pp. 55-72 (http://www.cesifo.org/eeag). The EEAG members are Jan-Egbert Sturm (KOF Swiss Economic Institute, ETH Zurich; Chairman), Giuseppe Bertola (EDHEC Business School), John Driffill (BirkbeckCollege), Harold James (Princeton University), Hans-Werner Sinn (IfoInstitute and LMU University of Munich) and Akos Valentinyi (Cardiff Business School). They are collectively responsible for each chapter in the report. They participate on a personal basis and do not necessarily represent the views of the organisations they are affiliated with.

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