Martin Wolf On EU Summit

Excellent analysis of the EU Summit by Martin Wolf on FT using the sectoral balances approach:

Let me make this point by turning last week’s analysis of the balance of payments into one of foreign, private and government financial balances in eurozone members (see charts). To remind readers: these have to add up to zero, by definition. But how they go about adding up is revealing.

As I noted last week, fiscal imbalances were modest before the crisis, but the current account imbalances were huge. Surplus private funds in some countries (notably Germany and the Netherlands) were intermediated by the financial system to fund private deficits in others (notably Greece, Ireland, Portugal and Spain). When crisis hit, these flows ceased. Deficits of private sectors collapsed (most turning into surpluses), while fiscal deficits exploded. Now, says Germany, the latter must be slashed.

By definition, the sum of private and current account deficits must also fall towards zero. The private sectors of erstwhile capital-importing countries have moved towards surpluses, for a good reason: they are trying to reduce their debts, not least because their assets are falling in value. Thus the external deficit needs to fall. That can occur in a good or a bad way. The good way would be via increased output of exports and import substitutes; the bad would be via a deeper recession. The good way requires far higher imports in the core of the eurozone or far greater competitiveness for the eurozone as a whole. But little chance of either of these exists, under plausible expectations for demand and activity. That leaves the bad way: deep recessions, in which the government reduces its deficit by deflating the private sector yet more.

In brief, it is extremely difficult to eliminate fiscal deficits in the structural capital-importing countries, without prolonged recessions or huge improvements in their external competitiveness. But the latter is relative, so the needed improvements in the external performance of weak eurozone countries imply a deterioration in that of eurozone capital-exporters, or radically improved external performance for the eurozone as a whole. The former means that Germany becomes far less German. The latter implies that the eurozone becomes a mega-Germany. Who can believe either outcome is plausible?

This leaves much the most plausible outcome of the orgy of fiscal austerity: long-term structural recessions in vulnerable countries. To put it bluntly, the single currency will come to stand for wage falls, debt deflation and prolonged economic slumps. Can this stand, however big the costs of a break-up?

The eurozone has no credible plan to fix the flaws of the eurozone, apart from greater fiscal austerity: there is to be no fiscal, financial or political union; and there is to be no balanced mechanism for economic adjustment on both sides of the creditor-debtor divide. The decision is, instead, to try still harder with a stability and growth pact whose failures have been both predictable and persistent.

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