EUROPEAN DEBT CRISIS: THE CURRENT ACCOUNT BALANCE IS AN EARLY WARNING SIGNAL

Often the financial/economic crises  in the Euro-zone are attributed to government budget deficits in excess of the values stated in the Stability and Growth Pact (SGP)  [SGP regulation] , and the Maastricht Treaty  [see the EU document], but we'd better take  the external debts of the European countries as at the core of the current crises. 


"Because they carry obligations to make future payments, external debt liabilities have the potential to create circumstances that render an economy vulnerable to solvency and liquidity problems. Moreover, as experience has shown, external vulnerability can have widespread economic costs, and not just for the initially affected economy. It is clear, therefore, that external debt needs to be measured and monitored." [see here the IMF guide on external debt] 


Under this perspective, it will turn easy to realize that the most important variable to assess the financial health of a country is given by the current account balance (CA) [see, e.g., J.L. Stein here ].  

In the introduction below on the meaning of the current account, we will see how it links  some macroenomic variables which are at the base of the financial health of a country.

1. The Current Account Balance

The current account of balance of payments records the international trade in goods and services, and the income and current transfers [see below equation 1]. 
A negative balance (i.e., a current account deficit) indicates that a foreign country spends more than it earns from transactions with other economies and therefore is a net debtor to the rest of the world.
Overall, the current account sheds light on the economic position of a country compared to other countries, recording all transactions occurring between resident and non-resident units. Equation 1 summarizes the content of  the current account:

                  1) CA = (X - M) + NIA

where (X - M) is the balance of trade or net exports, that is the difference between the value of the goods and services producted in the country (X) and the value of the demand of goods and services bought from abroad (M). NIA is the net income from abroad, that is the net flow of income and financial assets from abroad. 

The net financial components of the account (i.e., direct investment, portfolio investment, financial derivatives, other investment, and official reserve assets) rather than the net incomes are expected to form the greater part of the NIA.   
Negative values of  NIA  indicate net payments of interest and profits to foreign capital, that is, interest on external debt.

From another point of view, we  can also consider the NIA as the complementary amount of income to be added to the Gross Domestic Income (GDP) to form the Gross National Income (GNI):

                  2) GNI = GDP + NIA

Let's now explicit GDP into equation 2, that is: 

                  3) GNI = (C + I + X - M) + NIA

where C and I represent, respectively, the value of the domestic consumption and investment. Therefore, by recalling the equation 1: 

                   4) GNI = C + I + CA               →          5) CA = GNI - C - I = NS - I

Equation 5 shows that the current account balance is the quantity of the national savings (NS) which remains from the payment for the investment expenditures. If this difference is positive, then the surplus of NS may be invested in activities abroad through the international financial markets. Otherwise, if the national savings do not suffice to cover the investment expenditures  (NS - I < 0), the country needs turn to external financing. In the former situation the current account balance marks a net external credit and in the latter a net external debt. 
So, while in the equation 1 the current account balance reflects the net trade activity, in equation 5 we can see its financial counterpart, that is the net external position (NEP) (credit/debt). 

                   6) CA = (X - M) + NIA = NS - I

The accumulation of the net external positions over the time produces the stock of external debt, ED, and, of course, a positive value of the sum yields the stock of external credit. 

We obtain a further interpretation of the current account balance by  introducing the public sector into the equation 5 and by decomposing the national savings so that NS can be seen as the sum of the private savings (PS) and the government (i.e., public) savings (GS). Hence we write

              8) NS = PS + GS                →            9) CA = NS - I = (PS - I) + GS  

The quantity GS is the primary balance, that is the difference between the general government revenue (T) and the general government expenditure (G). 

            10) CA = (PS - I) + (T - G)

Equations 9-10 provide another relevant key point for supporting the role of the CA as the fundamental macroeconomic quantity. In fact, they allow to assess the contribution of both the private sector and the public sector to the formation of the current account balance.   


2. Considerations

• Strictly speaking, the current account balance is the pivotal quantity that links the balance of trade to the stream of the net financial assets  by triggering a loop like this: a net exporter country (X - M > 0) will take advantage from increased national income (see equation 3). This will improve the net external position (equation 5) which, correspondingly, raises the NIA and hence the GNI (equation 3). 
• But a globalized economy behaves as a conservative system, therefore the existence of a net exporter country implies the existence of one (or more) net importer country. This obvious implication of symmetry is often forgotten by some common information network, politicians and analysts and someone seems to give a positive moral attribution to export  and a negative attribution to import. Possibly, at the same time they also would greet enthusiastically the inflow of capitals from abroad. How to say, they worry with expenditures (direct cost of import) but they do not with debt (interests on the foreign liabilities).   
• Along with a "global" level of equilibrium of the CA among the countries, we can also consider a tendency towards equilibrium in a longitudinal (i.e., time) scale of the CA within each country. In fact, in the middle-long run, it becames harder to sustain large CA, because at higher incomes will correspond higher consumption and investments  expenditures (equation 4). Hence import will tend to increase and national savings to decrease. This "natural" balance needs increased levels of consumption and investment correspondingly to the increase of CA. 
• In front of strong imbalance among the balance of payments of countries belonging to a (quasi-)homogeneous currency area, like the Euro-area, symmetrical mechanisms for managing (either by expanding or by restraining) the aggregate demand should be implemented by the pool of the countries of that area accordingly to the sign of their current account balance and to the amount of external debt (credit). Countries with large deficits in the balance of payments are asked to cut their expenditures and/or raise the taxation and/or restrain the domestic payroll in order to improve the balance of trade. These measures aim at producing  a deflation effect by which the import of foreign goods and services is disadvantaged, while the export would be facilitated by the improvement of the competitiveness induced by lowered costs of production. Of course, this is a tough policy that involves social costs, e.g., in terms of unemplyoment, enderemployment, job underpayment. But, in order to get effective benefits from these measures, it is necessary that the countries of the same currency area with large positive surplus in the balance of payments should be willing to facilitate the importation by letting the general level of their domestic prices raise for a limited time. 
• Otherwise, it seems unfair that a group of inherently heterogeneous countries share  the same currency if the underlying purpose for holding that currency is inspired by mercantilism rather than to be addressed to reinforce some common ideals and interests of that area. 

EURO CRISIS: THE CYPRUS PLOT TWIST

And so, finally the financial system of Cyprus, has been secured. Or not? 

The current Eurogroup President, Mr Jeroen Dijsselbloem, who is also the Minister of Finance of the Netherlands, hailed the agreement between the government of Cyprus and the troika (EU-ECB-IMF) about the bank rescue as a template for bank restructurings:

 "The agreement reached tonight puts an end to the uncertainties of Cyprus and the euro zone, "said the President of the Eurogroup, who explained that" the agreement avoids the tax, and allows a thorough restructuring of the banking sector in Cyprus." 

 According to the understanding reached between the troika and prime minister Anastasiades, the Laiki Bank will be closed through a controlled process and its assets will fall into a "good bank" and a "bad bank." The good assets will end up in Bank of Cyprus, as well as emergency liquidity from the ECB, which must be returned. 

 The threshold of € 100000 has been defined as the amount of deposits in current accounts above which the planned measures will operate: they will be frozen and likely converted into government bonds. The events that are occurring in Cyprus represent another struggle for the existence of the Euro. But as any battle, it demands its victims. 

 Seemingly, because of the adopted threshold, the bailout plan would strike only the bigger account holders. The consideration that a large part of the deposits above € 100000 belongs to Russian citizens would have helped the adoption of this measure by the EU burocrats. A part from the fact that the idea of shifting the obligation for rescuing the banks to the customers, per se, is horrific, the action casts some doubts on the capacity of the Euro-zone leaders to looking beyond the present crisis. In one fell swoop, the likely consequences are:

1.      infringement of the principle of equality (the law grants the privilege in order to the cause of the credit. Inside each class, all creditors must be managed the same way, that's why it is talk about “par condicio creditorum”). This is extremely evident since the foreign (extra-EU) account holder have been discriminated. 

2.      For the people of Cyprus the future will not change in better conditions: for almost a couple of years to get a credit (or a job) from a bank will be practically impossible because the main sources of income in Cyprus are tourism - which requires credit - and to be employed in bank. That's way the rescue operation in Cyprus was successful, but the Cypriots will not really take advantage from it.

3.     There will soon be many activities and houses for sale in very, very few euro. The wealth of Cyprus risks to be depreciated.

4.     The myth of the single currency was tied to that of well-being. Without well-being, what does it remain of the myth of Europe?

5.     There are now many more countries to question the austerity policies as a way to achieve a balanced budget and in many to wonder whether it is worth paying such a high price for a single currency that benefits only four partners of seventeen, while ten others of EU countries do not participate.

Justification of the forced withdrawal from the bank accounts has been given by reporting that the banking system in Cyprus was someway involved in the money laundering which in large part could be of  russian origin. 

This statement sounds a bit discordant from the analysis of the Cyprus financial and economic system that was necessary for obtaining the accession to the Euro currency system. And the final decision dates from 2008 !! [here the Council Decision for Cyprus admission to the Euro zone]. Did Cyprus become a tax haven just after 2008 ? 

It appears the Cypriots (or more likely the European leaders) do not appreciate the extent to which Russia has propped up the local economy. 

In this kind of euro-drama we lack for nothing ! Here comes the plot twist... 

If the acessory purpose for striking the Cyprus financial system was simply to punish the "bad" Russian oligarchs who dared holdto hold huge deposits in the Cyprus' biggest banks, then there is the possibility that the measure will fail. A note from the Reuters' agency says:

While ordinary Cypriots queued at ATM machines to withdraw a few hundred euros as credit card transactions stopped, other depositors used an array of techniques to access thei money. 
No one knows exactly how much money has left Cyprus' banks, or where it has gone. The two banks at the centre of the crisis - Cyprus Popular Bank, also known as Laiki, and Bank of Cyprus - have units in London which remained open throughout the week and placed no limits on withdrawals. Bank of Cyprus also owns 80 percent of Russia's Uniatrum Bank, which put no restrictions on withdrawals in Russia. Russians were among Cypriot banks' largest depositors .

[see Reuters here]

History has teached that one can not joke with Russia. 
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DECISION UNDER UNCERTAINTY AND THE BAYESIAN BRAIN: A NOTE ON THE CONCEPT OF DETERMINISM

In a previous post [here] it was addressed the issue of bayesian modality of information processing into the brain. 
The main purpose was focused on the biological palusibility of the bayesian approach in decision making under uncertainty as reported by several authors in books and in leading journals of neuroscience. 
Now let's see an elucidation on  the concept of determinism. It has different meanings [see also]:

1. Causal Determinism (or Nomological Determinism) states that all events have a cause and effect therefore future events are explained (caused) by past and present events combined with the laws of nature.  
2. Logical Determinism is the notion that all propositions (i.e. assertions or declarative sentences), whether about the past, present or future, are either true or false. 
3. Environmental Determinism considers that the physical environment, rather than social conditions, determines culture.
4. Biological Determinism relies on the thesis that all behaviour, belief and desire is genetically fixed.
5. Theological Determinism is the belief that there is a God who determines all that humans will do, either by knowing their actions in advance (predestination) or by decreeing their actions in advance. (see also the Jansenism theology).
6. Emergentism (or Generativism) argues that free will does not exist, because all the actions and behaviors are just a realization and interaction of a deterministic process, that is, a finite set of rules. 

According to the Newtonian physics a set of fixed, knowable laws rule the universe, therefore once the initial conditions of the universe have been established, then the rest of the history of the universe follows inevitably. Any uncertainty was always a term that applied to the accuracy of human knowledge about causes and effects, and not to the causes and effects themselves.

Since the beginning of the 20th Century, quantum mechanics has revealed previously hidden aspects of events, and Newtonian physics has been shown to be merely an approximation to the reality of quantum mechanics (at atomic scales, for instance, the paths of objects can only be predicted in a probabilistic way).
Some argue that quantum mechanics is still essentially deterministic; some argue that it just has the appearance of being deterministic; some that quantum mechanics negates completely the determinism of classical Newtonian mechanics.

I considered the approach of Wolgang Pauli to the determinism-dilemma. He wrote [1]: 

The simple idea of deterministic causality must, however, be abandoned and replaced by the idea of statistical causality. [1] 

Actually, "the concept of causal relation have been modified because of the advances in the physics: it has been found necessary to abandon the idea of deterministic causality and substitute in its stead relations that are only determined with a certain level of probability" [2].  

The Bayesian use of the word probability refers to a form of reasoning and not to a factual statement. Used in that sense, assigning a probability to an event expresses a rational judgment on the likelihood of that single event, based on the information available at that moment. Note that one is not interested here in what happens when one reproduces many times the ‘same’ event, as in the objective approach, but in the probability of a single event.

Probabilities enter situations where our knowledge is incomplete and Bayesian methods allow us to make the most rational predictions in those situations. 

Now, suppose we want to explain some phenomenon when our knowledge of the past is such that this phenomenon could not have been predicted with certainty. That knowledge, although partial, is sufficient to ‘explain’ that phenomenon if we would have predicted it using Bayesian computations and the information we had about the past. That notion of ‘explanation’ incorporates, of course, as a special case, the notion of explanation based on laws. Also, it fits with our intuition concerning, for example, the coin-tossing situation: being ignorant of any properties of the coin leads us to predict a fraction of heads or tails around one-half.
Hence, such a result is not surprising or, in other words, does not “need to be explained”, while a deviation from it requires an explanation. 

A basically similar form of explanation is used in macroscopic physics, for example when one wants to account for the second law of thermodynamics, the law of increase of entropy. We do not know all the microstates of, say, a gas; nor do we know their evolution.
But we can assign, in a Bayesian way, a probability distribution on microstates, given some information that we have on the initial macrostate of the system. Since, for each microstate, the deterministic evolution leads to a well-defined evolution of the macrostate, we can, in principle, compute the probability, relative to our initial distribution on the microstates, of a given macrostate. If it happens that the one which is overwhelmingly probable coincides with the one which is observed, then one can say that the latter has indeed been accounted for by what we knew on the initial macrostate and by the above reasoning [3].

Therefore, the probabilistic (bayesian) laws play a major role in front of conditions which drive the system outside of the "comfortable" perfect cause-effect scheme (at micro and macro-level). 

GOVERNMENT DEBT, PRIVATE DEBT & CURRENT ACCOUNT BALANCE IN EURO ZONE: A MANIFESTATION OF THE CYCLE OF FRENKEL

The balance of payments is the statistical statement that systematically summarises, for a specific time period, the economic transactions of an economy with the rest of the world. The Balance of Payments is broken down into three broad sub-balances: the current account, the capital account, and the financial account. 

Current account is the major driver of net lending/net borrowing of an economy; it provides important information about the economic relations of a country with the rest of the world. It covers all transactions (other than those in financial items) that involve economic values and occur between resident and non-resident units. 


By analyzing [source of data] the performances of some countries in the euro area (Germany, Italy, Spain, France, Greece and the Nederlands) in three different periods (1995:2000; 2001:2007; 2008:2011) we can note that: 

A) the northern countries (Germany and the Nederlands) have had significant benefits from the introduction of the euro, generating huge surpluses in the balance of payments (and in the trade balance). This  effect on the balance of payments sustained their gross domestic product, and allowed the reinforcement of their ratio of debt over gross domestic product. 

B) The peripheral nations, have had serious drawbacks by the introduction of the euro, with strong negative outcomes in the balance of payments (and in the trade balance). The consequence was either the  blowing up of the private debts, which in turn became public debt in recent crises (clear case of Spain and Greece, but similarly we would conclude about Portugal, Ireland), or the depression of the gross domestic product and the real economy and production (as happened in Italy).


Figure 1. Current Account Balance vs. government debt. 

In the period prior to the introduction of the euro (from 1995 to 2000), all the reported countries (except from France) showed a decrease of the current account balance (CAB) in percentage of the gross domestic product (Y). Germany presented an increase (around +5%) of the ratio debt/Y (B/Y) while Greece recorded +6,4%. Interestingly, Italy reached -12,4%. The performance of the Nederlands (-22,3%) was the most progressing. Things became to change in the successive period (from 2001 to 2007) where Germany (+7,4%) and the Nederlands (+4,1%) experienced the reversal of ratio CAB/Y, Spain and Greece enlarged the decrease (beyond -5%) of this ratio. Italy almost controlled the unbalance of the ratio CAB/Y around -1,6%. France turned to negative area of CAB/Y (-2,7%). The government debt over the gross domestic product still increased in France and Germany and Greece, while further reductions took place in Italy (-4,9%), and in the Nederlands (-5,4%). Spain produced the largest shrinkage (-19,3%) of the ratio B/Y (from 55,6% in 2001 to 36,3 % by the end of 2007) !! Along with the big-crisis (last period 2008:2011) the ratio B/Y increased in all the countries. But for Greece and Spain we need to describe it in dramatic terms: +57,7% Greece, +29,1% Spain. Amazingly, these two countries also showed positive values of their CAB/Y ratio. Likely, it might derive from the massive reduction in their aggregate demand and hence of their imports and by the net outflow of financial resources. Italy nearly balanced its current account (-0,2%), but the ratio B/Y rose 14,6% and reached the alarming level of 120,7% by the end of 2011. 

Figure 2. Current Account Balance vs. private debt. 

The dynamics of the private debt offer the key for interpreting the unbalanced euro-zone macroeconomics. The nullification of the risk of exchange rate and the approaching of the interest rates in the euro-zone countries towards similar low values leveraged the aggregate demand for consumption and investment of the private sector in the weaker economies (say, the peripheral countries). The inflow of financial investments from outer countries (say, the central countries) was necessary for feeding this expansion. 

From another point of view, the central countries financed the purchaise of their goods and services by the peripheral countries. This resulted in the improvement (worsening) of the balance of payments of the central (peripheral) countries and during the first stage of euro the peripheral countries did also profit by the improvement of their gross domestic product. But the global crisis of 2008 has triggered the shrinking and call back of financial funds such that the peripheral countries have lost large amount of resources for sustaining the expenditures of both the government and the private sector.   
  

The cycle of Frenkel enables us to realize the present division into the euro-zone macroeconomics.
According to the theory of Frenkel,  this situation as before mentioned benefits the center twice:

1. Because the interest rates are higher in the peripheral countries.
2. Because capital flowed in the periphery, induces it to borrow for the purchase of products from the center, without the risk of devaluation of the capital. 

Even the periphery appears to take advantage from this situation, which gives rise to a boom dummy, because increases its gross domestic product and public debt decreases. At this stage, however, there is a simultaneous increase of inflation which being cumulated over the years, determines a considerable loss of competitiveness (real appreciation); the result is a deterioration in the balance of trade. 

The peripheral country get into debt gradually towards the center. When lenders understand that it provided "too much", or because of the occurrence of external shocks, suddenly they stop the flow of capital and tend to abandon the periphery. Creditors considerably raise their interest rate, due to the increased risk factor. At this point the Government goes to the rescue of the banks, and other subjects in difficulty, and often "the debts that were originally private become public". 

Normally, the cycle ends with the abandonment of monetary parity and the return to exchange rate flexibility. 

In the eurozone the "spread", relative to government bonds, which are accentuated at this stage, are not due to excessive public debt, as usually stated , but the imbalances in trade balances, which would require currency devaluations to their readjustments (adoptable by peripheral countries, if they decide to leave the euro). The risk of depreciation of the securities, if they were renamed in the new currency, justifies the high interest rates.



Table 1. The ratios of current account balance, government debt and private debt over the gross domestic product: averaged values in the observed periods. 

This table shows that the imbalances of the current account affect the euro zone. Actually, deterioration of the ratio government debt/gross domestic product (B/Y) by itself would not suffice to explain the crisis within the euro zone (e.g., see the case of Spain). Rather, the private debt out of control might  contribute to the budget deficit. In fact, the current account balance is equivalent to the net flow of capital (i.e., difference between saving and investment): CAB = S - I, therefore if CAB is less than zero, the country spends more than it saves (I is greater than S) then it needs to obtain loans from outer. Neither, in this occurrence, the private sector could sustain the public sector expenditures. The budget deficit should be covered by bond issue to be sold at the international markets at the cost of possible growing interest rates.  
Observations about the effect of the private debt must consider the macroeconomic context.  In an expansive economic phase, private sector debt would signal in the short term the growth of the aggregate demand for consumption and in the middle-long term the return of the investment expenditure would benefit the economy (e.g., the Nederlands). On the contrary, in a recessive phase, a large imbalance of the private sector casts doubt on the sustainability of the financial sector and bottles up the long term growth (e.g., Spain).   

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