ECONOMICS' DIARY IN THE EURO AREA BETWEEN EVIDENCE AND MYTHS

1. THE SYLLOGISM

(Aristoteles, 384 BC - 322 BC)

Major premise: All humans are mortal. Minor premise: All Greeks are humans.        Conclusion: All Greeks are mortal.

For years citizens in the Euro area have been informed that only by pursuing policies of rigour the economies of the countries with large public debts would have  increased.  

Although their crushing effects, on the base of this reasoning still now the austerity policies are widely implemented in the euro area (EA). 

We can see in Figures 1-4 the ratio of public debt to GDP and the GDP growth rate for some countries compared to the averaged series of the EA countries in the period 2000-2013.  

Figure 1. Ratio public debt to GDP: EA vs. rest of the world (2000-2013).

Figure 2. Ratio public debt to GDP within EA (2000-2013).

Figure 3. GDP growth rate: EA vs. rest of the world (2000-2013).

Figure 4. GDP growth rate within EA (2000-2013).

After the 2009 collapse all the EA countries (except for Greece) reacted and reverted the trend. But, Greece, Spain and Italy have not yet escaped the recessive dip and the other countries seem to have run out that booster shot. Outside the euro currency area, the courses of the GDP growth rates have been sustained and after the 2009 downfall they all recovered positive values. India and China have absorbed the shock quicker and more effectively than the other countries (indeed the two big asian countries did not experience negative rates)

Figure 5. GDP growth rate vs. ratio public debt/GDP 

By comparing different countries (Brazil, China, EA, Russia, USA) between 2007 (pre-crisis) and 2012, we notice that all of them (except for the USA) have sharply decreased their growth rate, but only EA and USA have significantly increased their ratio public debt / GDP. 

2. CHANCE AND NECESSITY  

So as to make the conclusion robust, the major premise must be consistent. In 2010 Kenneth Rogoff and Carmen Reinhart, both professors at Harvard, in their work "Growth in the time of debt" [here] compare the GDP growth across varying levels of debt for forty-four countries over the period 1946-2009. Their major findings are that the low-indebted countries (i.e., with the ratio public debt to GDP < 30%) have grown at the average rate of 4.1%, the middle-indebted countries (i.e., with the ratio public debt to GDP from 30% to 90%) have grown at the average rate of 2.8%. The countries with the ratio public debt to GDP above 90%, which are classified as high-indebted countries, have scored the less rate of growth: -0.1%. Therefore, these results would support the theory that high-indebted countries need reduce their debt level for returning to grow. The supporters of the measures of austerity  have found in this work of Rogoff & Reinhart the "scientific" basis, for their economic "belief system". So, they did not let get away this chance of representing the implementation of the rigour measures as a "necessity" proved by scientific evidence. 

(Marcus Tullius Cicero, 106 BC - 43 BC)

The wise are instructed by reason, average minds by experience, the stupid by necessity and the brute by instinct.

3. ANANKE AND NEMESIS


The logical conclusion, i.e., the necessity of reducing deficits by the combination of raising revenue and/or cutting the government spending has been recently proved to be false.  
In 2013 Thomas Herndon, Michael Ash and Robert Pollin, from the University of Massachusetts Amherst, have tested the findings of Rogoff & Reinhart. By using the same data set they have verified that the average GDP growth of the high-indebted countries is not dramatically different than that of the less indebted countries [here].The study of Herndon, Ash and Pollin reveals that the calculation of Rogoff & Reinhart was wrong because of the selective bias introduced by the exclusion of some countries and some years from the computation caused by missing data and algorithm bugs. The revised computation of Herndon, Ash and Pollin reports that the average growth rate of the high-indebted countries over the period 1946-2009 equals to 2.2%.                                                                                                                              

                                                                                              (Nemesis, Alfred Rethel 1834, 

Ermitage Museum, St. Petersbourg, Russia)

However, it is confirmed that  the less indebted countries tend to grow at higher rates. Also Paul Krugman has criticized the work of Rogoff & Reinhart [here]. Some doubt that the deflation policy in recessive economies does not facilitate the GDP growth has risen even within the IMF [see Blanchard & Leigh (2013). Growth Forecast Errors and Fiscal Multipliers. 3 January here]. After having promoted for years the correlation between rigour policy and GDP growth, the IMF officials notice that they underestimated the macroeconomic multipliers and realize that any cut of public expenditure in recessive period affects the GDP growth more than normally expected.

"...earlier analysis by the IMF staff suggests that, on average, fiscal multipliers were near 0.5 in advanced economies during the three decades leading up to 2009. If the multiplier underlying the growth forecasts were about 0.5 as this informal evidence suggests, our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession" [Blanchard & Leigh (2013)]

4. THE NEIGHBOR'S GARDEN IS ALWAYS MORE ... GRAY

Therefore, the paradigm of the fiscal policy should be revised. But the supporters of the austerity and of all the collateral measures of income drainage, do not resign themselves to the evidence. We have already reported [here] the comment of the Eurogroup President and Minister of Finance of the Nederlands, Mr Jeroen Dijsselbloem, about the Cyprus' rescue program   

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." 

The Minister of Finance of Germany, Wolfgang Schaeuble is defending and repeating [here] the same concept of the dutch homologous: 

"the involvment of owners, bondholders and uninsured depositors has to be the norm if a financial institution runs into trouble"

Honestly, such a proposition is one of the most illogical that I've ever heard from a Minister of Finance. Not by accident Great Britain has managed to hold off the trap of the euro currency. 

(dreaming a free land)

Strange times these we are living. Something of unexpected is overhanging the core countries of the EA. For example, what's going on in the Nederlands? Figure 6 plots the house price change over the period 1998-2012.

Figure 6. House Price change (% change over a year earlier) in the Nederlands: 1998-2012

Source: [here]

The Netherlands is facing a potential economic crisis on  the back a severe housing price correction, whereby house prices fell by -8% in the  year to December 2012 to be down -18% since prices peaked in 2008, pulling many  Dutch households into negative equity. 

Figure 7. Unemployment rate in the Nederlands: 2011-2013

The labour force data indicate that the Netherlands’ economy has deteriorated further, with Dutch unemployment increasing to 8.1%. The industry sector that has suffered from the largest leakage is the building industry. 

Another warning signal comes from the data of growth rate:

Figure 8. GDP annual growth rate in the Nederlands: 2007-2013

Of course, the increase in the unemployment rate relates to the worsening of the economy. Since the second half of 2011 GDP has declined (from +1.6% in Q3 2011 to - 1.2% in Q1 2013). 

Financial Times (18 April 2013) reported that just two years ago, at the beginning of the austerity plague, the Nederlands had the lowest unemployment rate. 

But the euro crisis has striken an economy where the housing policy for years have boosted easy credit and inflated the housing bubble (a third of mortgages guaranteed by the government, mortgage interest tax relief, and other forms of subsidies to the home market). This pace recalls something similar which happened in Spain:  

Figure 9. House Price change (% change over a year earlier) in Spain: 1994-2012

Source: [here] 

With bankrupticies ramping at record levels in February and with unemployment exceeding the expectations, will the Minister of Finance, Mr Jeroen Dijsselbloem, change his own perspective on the austerity faith ? In the worst scenario of crisis of the domestic bank system, will he make the Dutch citizens prove the same foolish model of bank restructuring that has been used for Cyprus and that he blessed as a good model ?  

Germany, is living the euro crisis with no apparent drama. At a first glance it seems all right in Berlin, doesn't it? But can really Germany  keep safe while even more EA countries are burning?  

( Nero Claudius Augustus Germanicus, 37-68)

Although the unemployment rate has kept on decreasing and now is stable at 5.4%, the labour force is partitioned.

Figure 10. Unemployment rate in Germany: 2011-2013

The 22% of the employees work in the so-called mini-jobs most of which involve low-skill positions. A special tax regime holds for the mini-jobs: they are exempted from tax and social insurance payments (for salaries up to 400 euro). The employers pay contributions for the social insurance of the mini-jobbers that are lower than those for homologous regular jobs, therefore mini-jobbers lose the benefits of building up pension claims. Certainly, they have contributed to the restraint of the labour unit cost making Germany more competitive and still now they are a pillar of the deflation policy.

A study of the university of Duisburg-Essen [here] has showed that mini-jobs produce wage "traps". 

"Stagnating wages and increasing shares of low-wage and

precarious employment provided a weak basis for domestic growth" 

Research material on the mini-jobs issue  also [here], [here] and [here].

Maybe some ripple effect is beginning to seep through the overconfidence on the german solidity.

Figure 11. GDP annual growth rate in Germany: 2007-2013

The GDP growth rate has lost 4.6 percentage points from Q1 in 2011 to Q1 in 2013. This result relates to the negative GDP perfomances of many trade partners in EA whose markets are now less receptive to import. Besides, the "quantitative easing" measures of USA and Japan contribute to overvalue the euro currency on the international markets.  thus undermining the market penetration of the german export. 

Figure 12. Value of german export (billion euro): 2007-2013 

The time course of the value of export (Figure 12) confirms the break of the export rally (started in 2009). We can see a similar pattern in the series of the housing prices:

Figure 13. House Price change (% change over a year earlier) in Germany: 2007-2013 
Source: [here]

It would be beneficial for the whole EA to find an agreement and review the rigour policy. In this phase of the economic cycle it is necessary for the European Union sake to implement measures which improve the GDP along with eliciting new passion for the idea of Europe. 

ANALYSIS OF THE CURRENT ACCOUNT BALANCES: GREECE, SPAIN AND ITALY

We have already seen [here] that the difference between national savings and investment  corresponds to the current account balance. A country  gets into debt with foreign countries if it saves too little (i.e., if it consumes too much) or if it makes too many capital expenditures. 

Let's see now the time course of the current account under its possible different perspecitives for some euro area (EA) countries whose financial status and outlook are suffering (Greece, Spain, Italy).

Data have been collected from the IMF: World Economic Outlook October 2012 [here]. The synthetic matrix of the elaborated data for all the countries of the EA is downloadable here.

1. GREECE

The first country that we consider is Greece, which has been the earliest to be exposed to the financial crisis within the EA. Greece, often is represented as the bad model.

Figure1-3. The current account and its components (1991-2013): Greece. 

Since 1991 the level of total investment (I) has always exceeded the amount of the national savings (NS). This excess  of investment needed to be financed by asking for external loans. By observing the time series of the current account (CA) we see a great worsening of the net external position after 2004 (interestingly, in 2004 the Olympic games took place in Athen). The downward jump of the CA between 2005 and 2007 amounted to 10 percentage points of GDP ! This derived by the decrease of the national savings (-5%) which in that period overtook the increase of the investment (+2%). Since 2005 therefore it should have been clear that Greece was really in deep water. Besides, a warning signal had been already made evident by the CA dynamics from 1998 to 2000, when the net external position passed from -4.4% to -7.8%. It is worth pointing out the erososion of the national savings that from the 20% to GDP have fallen to 4.7% in 2011. 

In Figure 2 the CA is represented along with the balance of trade (BoT) and the net income from abroad (NIA). From 2001 the NIA has steadily decreased and reached a minimum in 2008 (-3.26%). If we considder that NIA is the net interest on the external liabilities, we can realize at what extent the financial exposition have deteriorated. The deflation policy ("austerity") which have been adopted since 2010 have produced some effects on the side of the balance of trade: the contraction of the domestic demand have reduced the trade deficit from -8.72% (2009) to -3.64% (2012). But the debt service has not followed the same rate of change, in fact it remained almost stationary around 2.5% of GDP in the same period 2009-2012. Between 2000 and 2004 both the CA and BoT improved of 3 percentage points from -8.2% to - 5.2%, but the NIA worsened of almost 1.5 percentage points. That is, interest on the debt dragged away the 50% of the improvement in the balance of trade !

"In other words, since 2004 one could see quite clearly that Greece was deep in external debt: half of the improvement achieved on foreign accounts was eroded by the payment of interest abroad. The debt, in theory would have been virtuous, because addressed more to an increase in investment rather than to a decrease of savings"  [1] (as shown in Figure 1).

By comparing the CA with the government structural balance (government savings GS) and the private savings after investment expenditures (PS - I) it is possible to represent the role of the public and/or private sector in the evolution of the current account balance. The government savings have been always negative in the period 1991-2013). During the  years before the acception to the EA (2001), the  private savings have been positive until 1998. Hence, between 1991 to 1998 the deficit of the CA was driven by the government deficit. The series of GS and PS-I appear quite symmetric with respect to a line parallel to the abscissa at the level -2.5%. Since 1993 GS began to increase while PS-I did otherwise. In the interval 1999-2001 GS was greater than PS-I. Therefore the deterioration of the CA in the period 1998-2000 that has been commented in Figure 1, was mainly due to the decline in the private savings. Yet the path of the private savings characterized the deterioration (9 percentage points) of the CA  observed from 2004 to 2007. In fact, the loss in PS-I was of 7 percentage points, while the loss of GS was of 2 percentage points. 





Therefore, the events that have driven down the foreign debt of the country were determined by a decline in net private savings, while the public remained essentially unchanged or slightly increasing.



2. SPAIN

The course of the CA of Spain during the period 1991-2013 is similar to the one showed for Greece: CA have always run in the negative area, with two deep downward jumps in the intervals 1997-2001 and 2003-2007. 

Figure 4-6. The current account and its components (1991-2013): Spain. 

The total investment have been always larger than the national savings. The growth rate of the investments presented two accelerations: one in the period 1998-2000 and the second in the period 2002-2007, meanwhile the rate of the national savings remained stationary around 20% during 1991-2002 and afterward it began to decrease. Therefore the CA has reflected these dynamics by loosing 5 percentage points in 1997-2001 and 10 percentage point in 2003-2007. The effect of the crisis is well represented by the retreat of the investment rate since 2009. This has allowed the change of direction of the CA course which is now approaching the equilibrium line of 0% to GDP .

The balance of trade had been positive only in the period 1994-1997. A first decline of BoT (a loss of almost 4 percentage points between 1997 and 2000) had been only partially recovered by the increase of export during 2000-2002 (the BoT passed from -3.1% to -1.7%). In fact, the payment for interest on the foreign debt which was necessary for supporting the expansion of investment, doubled (from 0.8% to 1.5%). The second downward jump that occurred in the period 2003-2007 reflected both the accrual of external debt (from 5% to 10% of GDP) and the worsening of NIA. The sudden stop (since 2008) of the foreign capitals  has caused the fall of investment and of the domestic demand. As the import volumes have been drastically reduced, so the balance of trade has improved.   

"What is the problem in Spain? It started with a classic housing buble financed by foreign capital, and as a textbook would predict, once the inflow of foreign capital stopped and the bubble burst, unemployment soared and the financial system went bust as well" [2]

The external debt keeps on rising because the CA is still in deficit. Therefore the service of the debt has not changed proportionally to the quick current account adjustment. In the last three years the rate of NIA has shifted to -2% of GDP. 

Large fiscal deficits arise from a huge drop in tax revenues after the housing bubble burst and a significant increase in spending for social/welfare measures (e.g., unemployment benefits). Private savings have steeply climbed down for five years 1995-2000 from +3.9% to -2.8%. The transition from the positive area to the negative area occurred between 1998 and 1999. The accession to the euro currency has allowed to stop only provisionally (until 2003) this falling, but the decline  has gone on over the next period 2003-2008 when the lost in the rate of private savings has amounted to -6.3%. On the contrary, the government balance has improved in the period 1991-1997 (from -7.5% to -1.2%) and it has remained stationary over the decade 1997-2007 (-1.26% ±0.29%). We can also point out that since 1999 the CA deficits have been caused by the negative rates of the private savings rather than by the government structural balance. The collapse of GS since 2008 has been caused by the large intervention of the public sector to the bailout of the spanish banking system. The reduction of domestic demand and of import as well as the contraction of total investment has made possible the comeback of the balance of the private sector into the positive area. 

3. ITALY

Although (or because of) the severe deflation measures adopted in the latest years, for Italy it is not yet time to have a rest. In the bailout-lottery of the EA, Italy and Spain share the troublesome position of nominated but unwilling players. Italy represents the third economy and the second manifacturing industry in Europe and the default of Italy would drag through the mud the whole EA. 

  Figure 7-9. The current account and its components (1991-2013): Italy. 

The national savings showed a slight downward trend until 2007 (passing from 22.5% to 20%). The global crisis since 2008 has caused a downward shift of the saving rates at the average level of 17.1% ±0.9% in the last period 2008-2012. The total investment rates have gone beyond the saving rates since 2002 and the gap has become growing up to around 3% (2008-2012). Accordingly, the current account balance has performed deficits since 2002 and has reached its minimum peak at -3.55% in 2010. 

By analyzing the trade components of the current account we can note a quick upward jump from 1992-1993 (from -0.6% to +3%) and a further step up until 1996 (+4.45%). These peaks were facilitated by the temporary exit of Italy from the European Monetary System [3] (EMS). The consequent devaluation of the italian currency determined the positive performance of the italian export. The EMS agreement ceased in May 1998 and in 1999 it was substituted by the European Exchange Rate Mechanism (ERM) with narrower fluctuation bands (±1.5%). The balance of trade began to decrease and passed into the negative area after 2004. Since that year, the accrual of external debt grew up to -1.8% in 2006. A further sharp decrease in the balance of trade occurred in 2009. As we have observed for Spain and Greece, the patterns of the current account and of the balance of trade have change direction since the last three years. We can also see that the current account showed a relative minimum in 2008 when it was determined by the increase of the payments of the interest on the external debt rather than by the gap on trade. The deflation policy adopted since 2011 allowed the stabilization of the quote of interest around -0.64%.

"What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else's currency, with all the loss of flexibility that implies. [P. Krugman  [here]]" [4]  

Net private savings decreased at the average rate of -0.5% per year over the whole period of observation 1991-2013, while the government savings showed the symmetric pattern. All the efforts of the governement policies in the last two years have been addressed to get the primary budget surplus and by that way to stabilize the public debt. But the increase in the primary surplus in relation to GDP is attributable to the growth in revenue, which "rose from 46.6 in 2011 to 48.1% last year and exceeded the previous record of 1997 (47.4 %). Bank of Italy, writes in the monthly bulletin [here]. A further increase in 2014 will allow the "stabilization of the ratio of debt to GDP even if the latter's growth was modest." The erosion of the savings rates for Italy may be explained [5] by the level of the interest rates. 

4. EXTERNAL DEBT VS. GOVERNMENT DEBT


By the effect of equation  [here]

CA = (X - M) + NIA = NS - I 

the accumulation of the net external positions over the time produces the stock of external debt (ED), i.e., ED=sum of the CAs over the time. 

Gross external debt represents for a country the outstanding amount of  the actual current liabilities that require payment of principal and/or interest to non residents at some point in the future [6]. 

The stock of gross external debt informs the potential weakness of an economy in terms of accumulated imbalances, and the analysis of the net external debt signals the existence of such criticalities. In fact, large external debt deficits along with large interest payments may be considered as reliable indicators of the likely impairment in the solvency of a country. When the ratio of the net external debt to GDP exceeds the percentage of 50% the probability of external debt crisis is high. Moreover, countries were the ratio of the net interest payments to GDP is higher than 3% are highly exposed to the risk of external solvency issues (e.g., Argentina in 2001, Hungary, Ukraine and Iceland in 2008, Greece in 2010). 

Then the rule is: 

the combination of a net external debt ratio greater than 50% with a ratio of the net interest payments to GDP greater than 3% provides a significant indicator for potential external debt stress [6,7]

Let's see what has happened in the external debt variables compared with the government debt for the three countries. The difference between the gross external debt and the government debt enables us to estimate the minimum [8] portion of the whole external debt that is due to the private sector activity. 

Figure 10-12. External Debt vs. Government Debt (1991-2011): Greece, Spain, Italy

Source: IMF:World Economic Outlook October 2012 and [6]

The brown shaded area points out the time period when the gross external debt has remained above the gross government debt. The dotted line is drawn in correspondence of the accession of the country to the EA (indicated with the letter E in the abscissa axis).

The gross governemnt debt in Greece has been stationary until 2005 around 100% but it took off in 2008. In 2011 it scored the 165% to GDP !! Greece entered the EA in 2001, when the ratio of the net external debt to GDP was already the 46.5%. The year after this ratio passed the 50% warning limit. In 2011 it reached the value of 86% !! The gross external debt overtook the gross government debt since 2007. In 2009 the difference between gross external debt and the gross government debt was around 55%.

Spain showed the best performance of the gross government debt that has been always kept below (or nearby) the 60% level. The dynamics of gross external debt reveal that the majority of the external debt is due to the private sector. This trend began since 1997, but in 2009 the difference between gross external debt and the gross government debt amounted to 110% !! In 2004 even the net external debt overtook the gross government debt and the safe limit of 50% and in 2009 it jumped to 93% !!

Italy is characterized by high level of gross government debt. The ratio to GDP have restarted increasing since 2008. On the contrary, the net external debt is still below the threshold of 50% and the majority of the external debt is due to the public sector.       

5. CONCLUSIONS

• Non homogeneous savings rates among the EA countries cause dispersion among their current accounts balances, as the differences in the savings rates are not corrected by similar dispersion of investment rates. 
• In a currency area without federalism the existence of long lasting [9] external imbalances (deficits or surpluses) is not sustainable because of the lack of funds transfer among countries. In the long run this condition produce accumulation of external assets and debts that will end with solvency crises. 
• The peripheral countries of EA are experiencing the situation which is known as cycle of Frenkel [10]. In countries with fixed exchange rates, sudden stops of capital inflows are expected to drain the foreign reserves, forcing the currency depreciation which facilitates the shifting of the current account toward surplus. But the sudden stop effect has not (yet) induced the peripheric countries to exit the EA and devaluate their currencies [11]. 
• the combination of a net external debt ratio greater than 50% with a ratio of the net interest payments to GDP greater than 3% can be considered a warning signal of a possible external debt crisis. 
• not all the countries which adhered the EA have took advantage from the common currency. On the base of the Marshall-Lerner conditions [12] some of them had better to leave the EA. 
• the inflows of external capital in the long run deteriorate the balance of payments of the borrower countries. 

EURO CURRENCY DOES NOT CIRCULATE IN AN OPTIMAL CURRENCY AREA

1. PRIVATE VICE, PUBLIC VICE

In the "Fable of the Bees" (1705) Bernard Mandeville represented the paradox "private vices, public benefits"[1].

He showed that actions which may be considered vicious from the individual perspective, give benefits for the collectivity. By rewording this sentence, one would say that prosperity relies on expenditure (vice) rather than on saving (virtue). And going a step further, if that  assessment were applied in terms of the whole private and public sectors, then one would expect that deficits of the private sector yields benefits to the public sector.  

Instead, this is not always the case. Especially when the imbalance in the private sector becomes too large. 

In a previous post [here] we introduced the fundamental identity of macroeconomics which allows to assess the contribution of both the private sector and the public sector to the formation of the current account balance: 

10) PS - I = CA + (T - G) 

where PS: private savings, I: investment, CA: current account balance, T: general government revenue, G: general government expenditures.

In other terms, it describes the interdependence among the imbalances of the public, private and external sectors, by means of the government structural deficit T-G,of the financing deficit of investment with the private savings PS - I, and the current account balance CA.   Actually, imbalances in the right side of the equation 10) may explain the crises in the private (say, banking) sector. For example, the occurrence of a negative current account balance, i.e., CA < 0, implies that: 

11) CA = (PS - I) - (T - G) < 0         

then 

11') PS - I < T - G

and consequently  either the public sector returns a budget deficit (T - G) < 0, or the investment outstrips the private savings (PS - I < 0) so as  to make  the general equilibrium in the economy reinstated. 

But since under recession it is more likely decreasing investment and increasing private savings (i.e., PS - I > 0), the government structural balance is expected to run in deficit. The larger the deficit in the private sector so much the bigger  this "shrinkage" effect by which the operators of the private sector deleverage their balance sheets. This would trigger (or accelerate) the downturn and the banking crisis because of the loss of liquidity in the banking system. Next, larger government budget deficits will be necessary to balance the economy  and to replace savings in banks. This is why big  private deficits turn into raising deficits of the public sector. The countries will have more problems to sell their assets and government bonds in the problem countries will be no longer perceived by the markets as risk free. 

The combination of weak macroeconomic basics and current account imbalances causes structural deficits in the public sector and banking crisis, even though there had been no "fiscal irresponsibility" (e.g., Ireland, Spain) [2].

2. EURO AREA: A DISHARMONIC UNION

Heterogeneity marks the euro area (EA). Seventeen countries shares the same currency, but  neither their income levels nor their economic structures nor their real inflation rates are as close as it would be required in a common currency area. Basically, we can recognize initially a core group of the northern countries with stronger economic and structural conditions relative to the group of peripheral countries (Italy, Spain, Portugal, Greece, Ireland, Cyprus, Malta, Slovenia, Estonia, Slovak Republic). The former group shows balance surpluses, while the latter suffers from balance deficits.

These different macroeconomic and structural starting conditions activated the adverse mechanism which is known as cycle of Frenkel [here].  For a few years, from the accession to the euro, the peripheral countries have experienced decreasing interest and inflation rates, increasing levels of investment and consumption expenditures (supported by improved financial conditions). Over the time these scenario have caused the inflow of capital from abroad and current account deficits in the periphery, while the core countries have recorded surpluses in the balance of payments. High-risk borrowing and lending practices have also been encouraged up to 2008 [3]. Of course, the current account imbalances subsume as drawback the accumulation of foreign liabilities and hence the growing of the external debt. In a period of positive growth rate of the economy, the euro-system seemed to play its best performance. 
But the system was (and still is) inherently weak: they have not been provided rules for facing with downturn phases of economy and the European Central Bank is not a "lender of last resort". Thus, the occurrence of an external shock in 2008 (the U.S. subprime mortgage crisis) have found the EA exposed: huge resources have been drained away from the public sector to support the banking system (e.g., in Ireland the bailout of the banks has cost 80 percentage points of the ratio government debt to gross domestic product in the period 2007-2011which passed from 24% to 106%). Loss of liquidity has derived from sudden stop of capital flows and credit crunch which have reduced the capacity of holding the volume of production and of investment in the peripheral countries. Governments have been compelled to raise taxation and/or cut the expenditures. All these adverse conditions have changed the recession into economic depression.  


3. EFFECTS OBSERVED ON THE RELATIONSHIPS BETWEEN IMBALANCES OF THE PUBLIC, PRIVATE AND EXTERNAL SECTORS

The crisis and the effects of some measures (deflation) adopted to react, has deteriorated the macroeconomic fundamentals in the EA, especially in the peripheral countries. Since the current account balance is the pivotal quantity around which interact all the main macroeconomic identities, it seems worth to display the relationships between the imbalances of thepublic, private and external sector (see Figure 1 and Figure 2) in the EA  between 2007 (pre-crisis) and 2011 (overt crisis). 

Figure 1. The relationship between current account balance and government balance in the EA (2011 vs. 2007). 
Source: International Monetary Fund, World Economic Outlook Database, October 2012 [download dataset]

Figure 1 shows the government structural balances of the EA countries in function of the current account balances. Both the variables are expressed as percentage points to gross domestic product (GDP). The brown-shaded area highlights the countries exposed to the European Commission procedure for excessive deficit (EDP) [here the EU documentation] in correspondence of the threshold of -3% of government deficit. The green shaded area focuses attention on the best performing countries which are further on from the mentioned threshold of -3% and have surplus in the current account. The blu squares refer to the 2011 data while the red circle to the pre-crisis data (2007). The dotted lines are obtained by the linear regression fitting method (R²=0.4278 and 0.2963 for 2007 and 2011, respectively). We can note a significant down shift of the regression line from -1.933 ± 0.7147 (in 2007) to -3.832 ± 0.6146 (in 2011) (F = 4.2566, degreees of freedom = 1 and 27, p value = 0.0487). The slope of the lines is not significantly changed, therefore it is possible to calculate the pooled slope that equals 0.2835. In other terms, at each variation of 1 percentage point in the current account balance, we could expect a variation of 0.28 percentage points in the government deficit. The fundamentals of the Greece economy in 2007 were absolutely deteriorated (indeed warning signals have become evident since  the previous years). All the countries have government deficit, except for Luxembourg  (2007) and Finland (2007, 2011). The "austerity" measures allowed, in general, a mild improvement of the current account balance in the peripheral countries (but only Ireland pass through the negative area of the current account). The worsening of the government balance resulted particularly strong for Spain and Portugal and Cyprus. Slovenia and Slovak Republic reached the  zero cross line but payed the cost of trespassing the -3% limit for the government deficit. Italy and France show similar patterns in both years in an area around the -3% limit of the government deficit and the zero cross line of the current account deficit. From the group of core countries, only the Nederlands and Belgium have left the green area and fell in the brown area. The Nederlands, however, still remains with a strong surplus of the current account.   

Figure 2. The relationship between current account balance and private savings in the EA (2011 vs. 2007). 
Source: International Monetary Fund, World Economic Outlook Database, October 2012

Figure 2 shows the private savings balance of the EA countries in function of the current account balances. Both the variables are expressed as percentage points to gross domestic product (GDP). The green shadowed area represents the condition of jointly positive current account balance and positive private balance. The adopted deflation measures caused the decrease of the domestic aggregate demand in the peripheral countries. The balance of the private sector has moved to the positive area. This change has been particularly remarkable for Spain, while Ireland has entered the green area. The improvement of Greece did not suffice to pass through the negative area. Cyprus is absolutely the outlier of the EA, being stuck in a default dip. Cyprus accessed euro in 2008, but since 2007 (or even before) it should have been clear that the country was not ready yet. The core countries, with relevant surplus of the CA have not increased their domestic demand and keep on scoring high levels of positive private balance.               


4. EURO AREA IS NOT AN OPTIMAL CURRENCY AREA

The accession in the monetary union returns benefits in  terms of efficiency, but can also imply for each country the cost of renouncing to one  instrument of policy economic: the exchange rate, that is  a usual measure to stabilize employment and output in front of external shocks. The theory of optimum currency areas, formulated by R. Mundell in 1961[4] studies the conditions under which a country the benefits of monetary union are greater than the costs. In particular, concludes that the convenience to enter a monetary union is greater the greater the degree of trade integration already existing between the countries.

The benefits of the single currency are:

1. the elimination of transaction costs (the cost determined from the conversion of currencies represents a deadweight loss).
2. Reduction of price discrimination (if the goods have prices expressed in the same currency, it is more difficult to hide price differences in different countries).
3. The reduction of the variability of exchange rates (fluctuations exchange rate creates uncertainty for companies trading between EMU countries).

The most significant cost that an economic system must address in joining a monetary union is to give up their national currency and, therefore, the ability to determine independently its monetary policy and to take advantage of changes in the external value of the currency to the macroeconomic adjustments.

A group of countries with a high degree of trade integration, strong labor mobility, market integration securities and which is not exposed to shocks in aggregate demand asymmetric is defined optimum currency area (OCA).

The benefits of the single currency are larger the higher the degree of trade openness of countries forming the monetary union.


The degree of trade openness of countries (see Figure 3) can be calculated as the ratio:

12) 100*(Export + import) / GDP

The higher the degree of openness the higher the transaction costs, the efficiency losses due to the uncertainty of change and the probability that by joining a monetary union with stable prices even in the acceding country the prices will tend to stabilise.

Figure 3. The degree of trade openness in european countries (1995-2004).

Source: Eurostat

Many European countries have a high degree of openness to trade. However, labor mobility and flexibility of real wages (and flexibility of labor markets in general) tend to be low, and although the adoption of the euro has fostered the integration of markets
wholesale capital in the euro area, the retail financial markets remain strongly restricted at the national level [5]. Therefore, should they occur important differences between the economic cycles into the euro area, the lack of a policy monetary policy and exchange-rate independent would be felt strongly . 

Overall, the low labour mobility and the lack of fiscal federalism make the euro area not satisfying the conditions necessary for being considered as an optimal currency area. 






1. The Fable of the Bees: or, Private Vices, Public Benefits consisted of a poem, The Grumbling Hive, or Knaves Turn'd Honest, along with a prose Preface. The poem had appeared in 1705
2. P. Alessandrini, M. Fratianni, A.H. Hallett, A.F. Presbitero, (2012). External imbalances and financial fragility in the Euro Area. MOFIR (Money and Finance Research group) see here the document
3. IMF, Group of Twenty, 2012, Euro Area imbalances (Annex 2) see here the document
4. Mundell, R. A. (1961). "A Theory of Optimum Currency Areas. American Economic Review 51 (4): 657–665.  see here.  The theory, originally developed in 1961 by Nobel laureate in economics Robert Mundell, has been supplemented over the years by other leading academics, including Friedman and McKinnon. 
5. The retail financial markets provide services (such as transactional banking, savings and credit facilities) to individuals and small businesses, the wholesale financial markets support larger bodies - corporates, public sector organisations, governments, investors (e.g. pension funds) and financial institutions. Through these markets companies and governments can raise finance or acquire products that help them reduce the risk of doing business.
6. Having different national fiscal policies of the countries that form a monetary union can give rise to a problem free riding in the extent to which a country can issue a large amount of public debt at a rate of interest lower than that which would have to otherwise, causing his behavior with an increase interest rate for all other member countries.