The euro zone is stuck in a deep balance of payments crisis of a sort typical of fixed-exchange-rate systems. Faced with fleeing capital that does not want to finance the import overhang, the deficit country’s central bank helps out by printing fresh money. As always, the crisis arises from the fact that the capacity of the other countries to absorb the inflow of outside money reaches its limit.

By March 2011, the central banks of the GIPS countries (Greece, Ireland, Portugal and Spain) together had created and lent out an extra 314 billion euros to finance their respective national balance of payments deficits, that is, to enable a net acquisition of goods and assets of this magnitude from other euro-zone countries. This extra money, which is reported as “Target balances” in the national central banks’ balance sheets, accounts for 59% of the entire stock of central bank money created in the euro zone, or for 90% of the portion originating in the GIPS, as shown in a recent CESifo Working Paper (No. 3500).

The inflowing central bank money has crowded out one-to-one, at the rate of some 100 billion euros annually since 2008, the base money created through refinancing credit in the core countries of Europe, primarily the former deutschmark zone. Given that the remaining stock of this credit had already shrunk to 180 billion euros by the end of 2010, at this rate it would be depleted in 2013. In such case, the European Central Bank (ECB) could no longer reach the banks in the core countries with its main refinancing rate and would thus lose its most important monetary policy instrument.

This is the reason why Greece, Ireland and Portugal were pushed from the ECB’s implicit rescue facility into the official rescue facilities of the euro countries, and it also explains why the latter were set up at all. Together with the IMF, the euro countries have authorised to date 273 billion euros for these three countries; a further 120 billion are to follow for Greece, until the European Stability Mechanism starts to operate in 2013 as a permanent facility that can be expanded at will from its initial 700-billion euro funding. In the nick of time, the ESM will provide the follow-on financing of the balance of payments deficits of the periphery countries. It will offer the ECB, which long since turned into a player with its own interests in the European rescue poker, a way out of the cul-de-sac it got itself into.

The Bundesbank was only an auxiliary actor, devoid of any say-so, in financing the balance of payments deficits by giving credit to the ECB system. Through the operation of the ECB’s Target system it was forced to shift to the GIPS countries more than 300 billion euros in refinancing credit that it would otherwise have made available to the German economy. Although the credit flowed through the ECB and is guaranteed by all the euro countries in proportion to their share in the ECB’s capital, it is akin to a fiscal rescue operation by the Bundesbank: if the Bundesbank had purchased short-term Eurobonds bearing 1% interest from the Luxembourg facility, whose proceedings were passed on to the GIPS economies and governments, exactly the same credit flow, allocation of base money, liability and flow of goods between the euro countries would have occurred.

A similar development would not have been possible under the American system. In the US there are twelve Fed districts which, in terms of their economic power, are comparable to the euro-zone countries. The district federal banks have no links to the federal states and they do not collectivise their mutual credit relationships. In particular, a Fed district reserve bank wishing to finance its district’s balance of payments deficit by creating additional money would have to compensate the district Fed the fresh money is flowing to with marketable assets bearing the normal market interest rate. It could not, as in Europe, simply borrow from other reserve banks at the main refinancing rate. The self-service through the printing press is simply not available in the US. The fact that central bank credit is not available at below-market interest rates for financing balance of payment deficits forces a deficit district to lower the prices of its assets, goods and labour, until it once again becomes attractive to private capital and its balance of payment deficit disappears.

In the Eurosystem, strong political forces want to impede by all means this self-correction of the market in order to protect banks and other asset owners against capital losses and keep the population of the countries concerned from lowering their credit-financed living standard. This requires huge public credit flows, which could ultimately amount to trillions of euros.

Each rescue package makes it more difficult for the core countries to free themselves from the periphery’s debt trap, because the dire scenarios of what could happen after a selective default can be painted in ever more disastrous colours. But metamorphosing into the transfer union to which Europe is headed would be even worse, since it would cement the southern countries’ lack of competitiveness and burden the core countries permanently with higher taxes. The sooner the politicians find the courage to limit the public lending through community instruments such as the ECB or the Luxembourg rescue facility, the earlier the countries concerned will begin the unavoidable process of real depreciation and the more lightly the euro zone will get off.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

Published as “Keine maßlose Rettung!”, Die Zeit, No. 29, 14 July 2011, p. 33.