In my previous post I tried to explain in a simple way how the euro failed to create sustainable growth in the eurozone and how the surplus countries got bailed out thanks to the common currency’s flaws. In this one, I add some notes to elaborate on a number of details that complete the story and put things in good order.
Full eurozone balance of payments
The example with the two communicating vessels is a simple depiction of the balance of payments between Greece and Germany. The two countries are not however the only ones to participate in the currency block. Also, the current (capital) account of one country is not necessarily the exact opposite of another country’s current (capital) account since the two countries do not trade exclusively with each other. To capture the entire eurozone balance of payments we need to include all euro countries in the same diagram. As a simplification, we can put all the countries that run a current account deficit in one vessel and all the countries that run a current account surplus in another. Then the balance of payments looks like this:
Notice that the pipes of the two accounts are connected. This is because the eurozone countries also trade with the rest of the world and the current account deficit of one country in e.g. US dollars can be externally financed with a capital inflow in US dollars to another country of the eurozone (so euros move from the deficit to the surplus country). It is also possible that all eurozone countries are running a current account surplus, but then they will have to run a capital account deficit against the rest of the world. Currently the eurozone is running a small current account deficit of around 0-1% of its GDP.
Here I can also stress out that there is a great deal of indirectness in the net flows of capital and goods. Germany for example has not invested as much in Greece as France has. Therefore the imports of Greece from Germany have for a long period been financed by French investment inflows. But if we looked at the aggregate net flows of money in the eurozone, we would see that the surplus countries have over the last decade collectively financed the imports of the deficit countries.
A few analysts have described this as a vendor financing scheme to which I would agree only by 66%. It correctly captures the financing and the trading aspect of the business. It does not capture the third aspect however: that the lender in this case has been at the same time competing against the borrower!
Inflation through the balance of payments
Inflation is the inevitable consequence of the money supply of a country increasing faster than its potential GDP. Money supply is increased in two ways:
- Purchases of assets by the central bank with newly issued money (money “printing”)
- Credit expansion through the fractional reserve banking system
The eurozone countries have also a third way which is the sale of goods or assets to other countries. So far I have based my analysis on the movements of the money supply through the third way. Let’s have another view in how and whether this way spurred inflation in the deficit countries.
As I argue in this blog, the foundations of the current crisis were laid during the first years of the euro when the capital flows from the surplus/lending countries to the deficit/borrowing countries caused an increase in the money supply of the latter. The borrowing countries were not effective in tackling inflation, either because they found themselves in a new environment which called for new policies, or because it was politically inconvenient. As a result, product prices and salaries increased leading to a loss of competitiveness. But even if these countries managed to keep CPI below the target ECB rate of 2%, these countries would still fail to contain inflation. The reasons for that are twofold:
First, it is common knowledge (even to central bankers) that inflation does not manifest only in product price increases but also in asset price increases. This is called asset inflation and is not reflected at all in the CPI. Businesses that could not be profitable in Greece before the euro adoption slowly became profitable, especially importing activities; existing businesses saw their sales increase, making it easier for them to take on more credit and expand their operations; share prices rose due to the increase in business confidence and the additional liquidity that foreign capital provided. In Ireland and Spain, asset inflation manifested in a real estate bubble. So, even if the borrowing countries were effective in containing price inflation they would still fail to detect and constrain asset inflation.
The second reason has to do with the unique features of the eurozone. Increase in the money supply of one country does not have to cause inflation at all if the additional money and the consequent increase in domestic demand can be satisfied with an increase in imports. In other countries around the world this would not be possible because imports do not decrease the money supply of the country. So, in the case of a deficit euro country, it is more likely that imports raised inflation in another country. For example, if France invests an amount of euros in Greece, which Greece immediately and entirely spends on purchasing German goods, then money supply will increase in Germany alone. This will result in inflation in Germany unless of course Germany takes measures to contain it (as it did).
To the extent that the increase in imports is simultaneous to capital inflows, inflation would not pick up at all in Greece. However, we can reasonably assume that there was a time lag between the money inflows and outflows that increased the stock of money in Greece leading to inflation. Had the Greek government used this surplus to reduce its external debt or had the Bank of Greece built up its reserves, inflation could have been averted. But this didn’t happen because it was not their obligation. The same holds for the other borrowing countries.
Inflation through credit expansion
The first two ways I have left so far untouched and this is because they call for a separate post. For now I can advice those who do not know of how money is created through the fractional reserve banking system to read an explanation in wikipedia here.
Those who know how money works may point out that credit expansion (the second way) was the main driver of inflation and of the widening of the current account deficit of the deficit/borrowing countries. This would be true but it would not have any implication in the stability of the euro, if the euro was not a flawed currency. Here are a few points to chew over till the promised post:
- If a country issues its own currency, money creation through credit expansion or money printing cannot increase the current account deficit without increasing the capital account surplus at the same time.
- Domestic credit expansion is a “healthy” way of increasing the money supply of a country, in the sense that the debt that is created can always be repaid in full by the money created, simply because they are both created in the same accounting entry on a bank’s balance sheet. In practice, the only reason that debt is not repaid is because economic activity alters the channels through which money among agents and through time flows, making repayment of some obligations through the expected channels impossible.
- Inflation is not necessarily an outcome of credit expansion. If potential GDP rises faster than money supply then deflation is the logical outcome.
- Within the eurozone, a permanent decrease of the money supply in a country through the balance of payments, makes full repayment of the total debt of the country immediately impossible. However, permanent decreases are not really possible, only long-term decreases are.
- Credit expansion needs some stimulus to begin. This could have been mispricing of interest rates in the borrowing countries. Maybe it was the inflow of foreign capital. Or most probably it was both. We can imagine that each movement of the money supply caused the other in this circle: foreign capital inflow > raise of business and consumer confidence > credit expansion commences > new investment opportunities > more foreign capital inflow.
The irrelevance of debt, tax evasion and corruption
Maybe in my analysis you have noticed that I did not make any distinction among debt, equity or other instruments when talking about capital flows. Neither did I make any reference to the inefficiencies of the public sector, corruption, tax evasion or anything else that is highlighted as the key reasons for Greece’s predicament. For a simple reason: they are irrelevant, directly at least.
Money supply in a euro country increases through the external sale of any asset, whether it is shares in the stock exchange, corporate bonds, bank loans or sovereign debt. Greece, Spain and Ireland attracted foreign investment in different ways which all had the same effect, increasing the domestic money supply. The type of investment is only relevant to the stability of the eurosystem when we consider the capital that banks are required to hold against it. Banks can much easier absorb losses on an equity portfolio than on a sovereign debt portfolio, simply because they are required to hold more capital against equity investments. As the crisis unfolds, sovereign debt is becoming more toxic than shares or corporate debt since it is not backed by any capital.
Then tax evasion and corruption also do not have an impact on the money supply of a country. Taxes simply move money from an individual’s bank account to the State’s bank accounts. Bribes move money to the bribee’s bank account. Only as a secondary effect can money supply decrease, if for example a person who makes some easy money by receiving a bribe spends it on luxury resorts abroad. But the direct monetary impact of bribes or tax evasion is exactly nil.
The ECB’s standing facilities
Even though the ECB can only control the money supply for the entire eurozone but not of each country, the eurosystem possesses a mechanism which allows for money to be temporarily transferred from Germany to Greece. I left this mechanism unexplained in the last diagram of the previous post, shown here again:
The circled black arrows show the utilization of the standing facilities of the ECB. The ECB’s operations through these facilities do have an immediate impact on the money supply of Greece and Germany. The German banks can use ECB’s deposit facility to deposit cash, thereby decreasing the money supply of Germany by reducing the credit provided to German residents. On the side of Greece, Greek banks can pledge Greek government securities as collateral to receive funding from the ECB’s marginal lending facility. Yet after the money is put into motion in the Greek economy it is again siphoned out of Greece and into Germany through the balance of payments.
So ultimately this mechanism increases the money supply of Germany, not of Greece as it would be intended. What’s more, it also faces a constraint which will make it useless very soon: it can only work for as long as the Greek banks find eligible assets to post as collateral (Greek government securities) and these assets are slowly being depleted.
The current situation in Greece, Spain and Portugal (the countries hardest hit so far by the crisis) is unique in the history of currencies and unique in the world. No country has ever before experienced a loss of its own money supply, of its own currency. And no economy in the world can function if its currency is drained in this way. Can you imagine for example using banknotes made of toilet paper, which wear off the more they get used? Would you like to be paid in these banknotes? I guess not!
Now compare the money flows of the Eurozone or of any other country in the world with the flows of Greece (or of any other eurozone deficit country):
It is simple for anyone to understand the unfairness of this system. Throughout history and around the world, people, companies and governments have learnt to operate in an environment of relative money supply and price stability. The eurozone on aggregate too, operates in the same way. But Greece, Spain, Portugal and other eurozone countries do not. Shouldn’t these countries maintain their right to get hold of their own money supply? How else can their governments raise tax revenue and provide their services, particularly to the poorer people who most depend on them?
Unfortunately, the European leaders still try to solve the eurozone crisis by following the path of fiscal “discipline” and austerity. Why do the Eurozone officials continue on this doomed-to-fail approach? Why do they ignore consistently the imbalances in the balance of payments and the shift of money supply from one country to the other? There are two possible reasons for that and they are mutually exclusive.
One is ignorance. We cannot really expect that the average European MP understands at all the money mechanics or the accounting shenanigans of central banking. Surprisingly, neither do the various economists, financiers or other “experts” who parade everyday in the news channels, full of worthless ideas, explanations, and propositions.
I find it though hard to believe that central bankers fall on this category, because if they do they should simply not be holding their current positions. And if they are aware of what is really happening, then most probably the top-ranked European politicians should be aware too.
If we rule out ignorance, then we can only get to the second possible reason. I do maintain the belief that it was wrong market expectations that lead to the eurozone running an unsustainable business model and that therefore no one specifically can be accused for its impending collapse. At the moment though that a bunch of leaders of the richer countries take control of the free market, if they are aware of the real causes of the crisis, then they simply become the masterminds of this unsustainable model.
In this case they knowingly and intentionally use this unique opportunity provided to them by the flaws in the euro’s design to achieve an unfair benefit for their own countries. If they succeed, this will only lead to a reduction of the overall wealth of the currency union, accompanied nonetheless by a transfer of capital from the poor deficit countries to the rich surplus countries. Thus, if we are not dealing with ignorance, then we are clearly dealing with outright fraud which unless it is stopped now it will be chronicled as the biggest heist in world history. And you can be sure that the ones who will enjoy the loot will not even be the poor people of the rich countries but the rich ones. Be damn sure about it!