The Euro Crisis’s New Clothes

Hans-Werner Sinn

Project Syndicate, July 24th, 2020.

The European Union's new €750 billion recovery fund is intended to tackle crises such as collapsing manufacturing output in southern member states like Spain and Italy. But money cannot solve the problem of distorted relative goods prices within the eurozone.

European Union leaders have reached agreement on a big 750 billion euros ($870 billion) recovery fund intended to help the EU member states hit hardest by COVID-19. But during the lengthy negotiations over the package, it became increasingly clear that Europe’s pandemic-induced economic crisis is an extension of the euro crisis that has been festering since the collapse of Lehman Brothers in 2008.

In essence, this is a competitiveness crisis brought about by the distortion of relative prices within the eurozone, which is a result of inflationary overpricing in southern European countries. This overpricing, in turn, stemmed from the flood of capital that entered these economies after they joined the euro.

The collapse of the euro bubble following the 2008 financial crisis reversed the direction of private capital flows, leading to several rounds of intense capital flight from the Mediterranean region to Germany. This was reflected in a surge in the so-called TARGET balances that measure net payment orders and provide a sort of public overdraft credit within the eurozone. And now COVID-19 has triggered another phase of capital flight that eclipses all the others.

After the pandemic struck earlier this year, international lenders refused to roll over their outstanding loans to southern European countries and demanded repayment, subsequently investing the money in the eurozone’s northern members, particularly Germany. Southern European investors also shifted their investments to Germany, and transferred corresponding amounts of money. These two streams of payment orders have forced the Bundesbank to tolerate open credit positions so far amounting to 1 trillion euro.

In March 2020, German TARGET claims increased by 114 billion euros — by far the biggest monthly rise since the euro’s introduction in 1999. Capital flight during two previous high points of the euro crisis, in September 2011 and March 2012, also caused Germany’s TARGET balance to spike, but by only 59 billion euros and 69 billion euros, respectively. Although capital markets cooled off slightly in April and May of this year, German TARGET claims increased again in June, this time by 84 billion euros. Between February and June, they rose by a total of 174 billion euros, to reach a record-high 995 billion euros.

Conversely, Italian and Spanish TARGET debts increased by 152 billion euros and 84 billion euros, respectively, during the same period. That implied debts of 537 billion euros and 462 billion euros, respectively, at the end of June — or 999 billion euros in total. Both this figure and the German claims number are so close to the 1 trillion euros threshold that one cannot help but wonder what secret forces in the background might have pulled the emergency brake.

Investors fled Spain and Italy because they no longer viewed these countries as safe bets. And the two countries’ central banks made their flight possible by providing extra liquidity via national printing presses.

Part of this liquidity came from the European Central Bank’s(ECB) various asset-purchase schemes, including the Pandemic Emergency Purchase Programme and the long-established Asset Purchase Programme, which the ECB has increased temporarily in response to the current crisis. Although these programs had envisaged symmetrical asset purchases by the ECB and all national central banks in the eurozone, these institutions bought a disproportionately large volume of Italian assets.

The additional liquidity also comes from a special Targeted Longer-Term Refinancing Operations (TLTROs) program worth more than 500 billion euros that the ECB made available to eurozone banks in mid-June. The -1 per cent interest rate on the TLTROs was extremely favorable — so favourable, in fact, that many banks borrowed the money and immediately re-deposited it with their own central banks at a rate of -0.5 per cent. This provided them with an immediate arbitrage gain that amounted to an open subsidy by the Eurosystem.

But Spanish and Italian banks needed the TLTROs in large part to compensate for the capital outflows. Or perhaps they used them simply to pay off private foreign loans that had less favorable terms. In that case, the loans that the Spanish and Italian central banks provided via their national (electronic) printing presses would not only have enabled capital flight, but also served as a means of driving private capital away by offering better terms.

Be that as it may, the eurozone remains internally unbalanced. This also becomes apparent if one looks at manufacturing output in Southern Europe. Unlike domestic sectors, the region’s manufacturers must compete internationally, and therefore have suffered the most from high relative prices. Even before the coronavirus crisis, manufacturing output in Italy was 19 per cent below its level in the autumn of 2007, just before the real economy reacted to the financial crisis; in Spain, it was 21 per cent lower. The downward trend has continued during the pandemic, widening the output gaps to 35 per cent and 34 per cent, respectively.

The new EU recovery fund is meant to address this fiasco, but money cannot solve the problem of distorted relative goods prices within the eurozone. Fixing it requires an open or real devaluation. But no one wants to talk about that. Instead, the EU’s strategy seems to be based on hope and prayer.

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