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« Building Hedges around Greece? | Main | Greece Raises the White Flag »
Monday
May032010

The Catch 22 of Eurozone Imbalances - Fighting the Debt Snowball

Edward does a nice job to sum up the flurry of the past week which saw the ongoing problems in Greece elevated to a full fledged systemic crisis in the Eurozone economy which, if it ultimately blows, will have ramnifications far beyond the borders of the European continent. Being a firm believer in the notion of markets as conversation it is funny to see that although Lehmann Brothers is dead and buried, people are talking an awful lot about it.

Consequently, the official figure for a Greek bailout has now risen to EUR120-130bn and with S&P downgrading Spain on Wednesday it suggests that the ultimate cost of this mess may exceed the already dizzying number note above many times over. As the Economist neatly puts it this week;

THERE comes a moment in many debt crises when events spiral out of control. As panic sets in, bond yields lurch sickeningly upwards and fear spreads to shares and currencies. In September 2008 the failure of once-stellar Lehman Brothers almost brought down the world’s banking system. A decade earlier, Russia’s chaotic default on its sovereign debt rocked the credit markets, felling Long Term Capital Management, a hugely profitable American hedge fund. When the unthinkable suddenly becomes the inevitable, without pausing in the realm of the improbable, then you have contagion.

As the Economist goes on to argue events are indeed spiralling out of control, a statement with which I concur in full. One question then which, at the moment, may not seem particularly important is how we managed to get ourselves into this mess.

In my most recent working paper entitled Quantifying and Correcting Eurozone Imbalances - Fighting the Debt Snowball I try to provide an intial answer to this question. Well actually, I don't set out to address this question specifically. But, I do think that if you want to understand why the Eurozone has ended up where it is today and why it is essentially threatened as an economic entity you need to take a long hard look at the issue of intra-Eurozone imbalances and why correcting them from within the Eurozone is almost impossible without some form of disruptive sovereign default in key member economies.

As an introduction, here is the abstract:

This paper quantifies and discusses the concept of Eurozone current account imbalances. Using panel data estimations, the analysis shows how the external positions of the Eurozone economies can be modelled as a function of divergences in unit labour costs. Specifically, the results indicate that the formation of EMU has exacerbated the extent to which even relatively small divergences in unit labour costs may materialize in large current account imbalances. These results are framed in the context of the idea of a debt snowball effect and why the idea of an internal devaluation as a tool to correct external imbalances is inconsistent with the current setup of the Eurozone.

So, do I bring anything new to the table in terms of the overall discourse on the Eurozone's economic problems? Not really. The story I tell is pretty well known but I still see the main contribution of the paper as the attempt to give a concrete quantitative perspective on the effect of divergent inflation rates (in my case unit labour costs) in an economic setting where countries are grouped together with seperate control over fiscal policy and no sovereign monetary policy and exchange rate.

Crucially, I argue that the forces which have lead to the build-up of imbalances are joined at the hip with the same forces which make it almost impossible to correct from within the Eurozone. Specifically the idea of a debt snowball effect is a good way to show why it will be almost impossible for some economies to correct their external imbalances without an explosive evolution in government debt and since they need to correct external competitiveness issues in order to achieve economic growth, the whole thing turns into a vice and essentially a catch 22.

Please note that this is a first draft only and still subject to several re-reads and editing (especially the tables) before I send it off for hopeful approval somewhere. However, for now your comments are welcome both on the paper itself as well as the topic.

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Reader Comments (1)

Well I hope you don't take a too deterministic view point. Remember that the independent variable is a figment of imagination or, if you prefer, a way of hiding from the complexities of the real world. I continue to believe that current account deficits are driven by capital inflows and that if you deregulate capital flows then you lose control of current account deficits. I say this as an Australian and this is the experience of a small country with financial market deregulation: large current account deficits. No Balance of Payments crisis over the past couple of decades but the jury is not out on that one. Until Germans find ways of investing at home this will continue to be a problem for the whole Euro experiment.
May 4, 2010 | Unregistered CommenterIvana Bottini

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