Great Leap Forward

Cross Border Lending and Imbalances in Euroland

Sorry for delay on posts—am attending a conference in Euroland and I received no contributions this week in response to my challenge to Trolls. (I’m beginning to wonder if Trolls have anything to say, beyond sniping and name-calling?)

Yesterday one presenter at this conference provided a lot of interesting data on cross border lending by European banks, most of which consisted of lending to fellow EMU members. He showed a strong correlation between cross border lending and cross border trade. Hence, posited a link between flows of finance and flows of goods and services. So far, so good. He also accepted a comment from the audience that correlation doesn’t prove causation, and that flows of finance are orders of magnitude larger than trade in goods and services—in other words, most of the financial churning has nothing to do with “real” production.

What bugged me was the frequent reference to supposed “imbalances” within the EMU, so I tried to get him to explain what he meant. Readers will recall that last year I posted a keynote I gave that questioned the view that the Global Financial Crisis was due to “global imbalances” , here:

I won’t rehash that argument. Balances do balance, after all. For every current account deficit there’s a capital account surplus. It seems to me that the claim that the EMU suffers from “imbalances” is on even shakier ground. After all, they all use the same currency, so there’s no chance that an “imbalance” will lead to a run on the currency and to exchange rate depreciation (a usual fear following on from a current account deficit).

When I look across Euroland, I do see many problems: real estate booms and crashes in Spain and elsewhere; lots of other bad loans and troubled banks; and (of course) rising unemployment almost everywhere. The big banks made tons of bad bets and in some cases were bailed-out by their home countries. And, of course, a lot of those bad bets were made on the no longer sovereign government debts. There is an awful lot of lender regret, and determination to never again lend to Mediterranean borrowers.

Yes. But in what sense is that an “imbalance”? Look at it this way. What if instead of running up real estate prices in the sunny south—so that Brits and northern Europeans could enjoy vacation homes—the German banks had instead fueled a real estate bubble in Berlin? What if they had eliminated all underwriting standards and lent until the cows come home on the prospect that Berlin house prices would rise at an accelerating pace? Speculators from across the world would buy a piece of the bubble on the prospect that they’d reap the gains and sell-out at the peak. Construction activity would boom, workers could demand higher wages and would increase consumption, and Germany would have experienced higher price inflation than the rest of Euroland.

When the inevitable bust came, would we then say it resulted from imbalances? Would Germans be happier than they are now, with collapsing home values, rising delinquencies and defaults, abandoned homes, and rising unemployment? And wouldn’t the Spanish be happier, pointing their fingers at the profligate Germans and their banks?

Bad bank behavior can boom or bust an economy—with or without current account deficits. And that’s pretty much what happened in Spain and Ireland (and also in Iceland).

Ok, but what about Greece and Italy—whose government budget deficits exceeded Maastricht criteria? Well, part of the myth that fueled the drive to monetary union was that financial markets would more efficiently allocate finance across the union, seeking profits and narrowing spreads. And indeed they did, on the presumption that once a Greece or an Italy joined the union she would suddenly become more German. And spreads fell toward zero—apparently on the belief that we’re all Germans now.

But suddenly markets and Euroland leaders woke up one morning and were shocked, Shocked!, to find that there was corruption in some of these nations. Worse, the biggest global banks had helped these profligate governments to hide debt!  Who woulduv thunk that a government headed by the likes of Silvio Berlusconi (just sentenced to four years in prison) would condone corruption and dishonest accounting? I don’t know much about Greece, but having lived on-and-off in Italy, it is inconceivable that any of Euroland’s leaders did not know that all of Italy’s major political parties except the Communist party (which was never allowed to participate in government) were involved in major scandals during the years leading up to unification.

So the bubble burst. And now everyone claims it was due to a supposed “imbalance”?

Let’s look at the issue another way. In the USA we of course “enjoyed” an experience quite similar to that of Euroland. Substitute Nevada for Spain. “Foreign” banks from across America lent to speculators who blew up Las Vegas real estate prices, lending without underwriting. Las Vegas workers temporarily enjoyed the boom, and now are dealing with high unemployment and collapsing prices. Local government has lost tax revenue and now has to deal with the costs of clean-up.

While we do not usually look at “current account deficits” across US states, it is conceivable that there were the same sorts of “imbalances” in states that experienced a real estate boom as high employment and rising wages and prices fueled “imports” from other US states.

But in the US we point our fingers (mostly) at bankers running amuck, at speculators driving up prices, at regulators who refused to do their jobs. Yes, some do blame the borrowers. But we do not claim that within the US it was current account deficits among the states that caused the global financial crisis. Why not? Because we all use the same dollar currency and because we’ve got a central bank system that clears the payments system across the US. There never was an “imbalance” in financial flows because the central bank system cleared all the accounts. Importantly, we do not provide a Federal Reserve Bank for each state, instead, we purposely drew Fed districts across state lines (with lines actually running through some states). Nobody even knows what the financial flows are across states.

In Euroland, all use the same euro currency, and clearing is accomplished among the central banks and through the ECB (that is where Target 2 comes in). It works about as smoothly as the US system. But here’s the difference: the ECB “district banks” are national central banks. It is thus easier to keep mental tabs on the “imbalances” by member states in the EMU than in the USA.

This was not considered to be a design flaw—it was to maintain the illusion of fiscal independence, while surrendering monetary policy to the ECB. The local central banks would be used to clear payments, borrowing reserves as necessary from the ECB. But, importantly, smooth Euro-wide functioning of the payments system effectively means the ECB cannot refuse to provide reserves on demand. And that effectively means the Maastricht criteria on budget deficits and debts would not bind.

So long as markets believed that Mediterraneans had become Germans, or that the ECB would always come to the rescue, it didn’t matter that almost all countries violated the Maastricht criteria almost all the time. Private banks (and others) would buy up the now non-sovereign debt, and could sell it on to national central banks as necessary to obtain reserves—or pledge it as collateral. Deficit spenders were supposed to be punished by higher borrowing rates, but spreads to German borrowing rates fell on the delusion that Euroland had become one big happy family.

But once markets took a long, cold look at finances, and at the design of the union, they realized the fatal flaw. The Maastricht criteria were already far too lax for countries that had given up currency sovereignty, because borrowing rates would be either determined by markets, or determined by willingness of the ECB to violate its own self-perceived mission to maintain fiscal prudence. And when deficits and debts exploded in those countries that had to bail-out their private banks, markets recoiled and spreads rose to levels that ensured explosive growth of budget deficits.

As we know from US experience, fiscal prudence means states need to balance government current accounts, and to keep debt ratios well below 20% of state GDP. Otherwise, they get into vicious interest rate-spiraling deficit traps.

That means it is not just the Mediterranean governments that had excessive budget deficits, but also the Germans. So, yes, ironically, Europeans really all are Germans; or to put it another way, they’re all Greeks now.

So, finally, the immediate cause of the crisis was the imprudent lending of (mostly) European banks (just as the US crisis was caused by imprudent lending of US banks), but the lasting flaw in the EMU is the separation of fiscal policy from currency issue. As I’ve said before, if there is an “imbalance” in Euroland, it is one of power, not trade flows.* With the Austerians in power, there will not be the capacity to mount a sufficient fiscal response to end the crisis.


*Warren Mosler addressed this issue in his usual cut-to-the-chase manner on his own blog:

in a monetary union like the US or EU, for purposes of this analysis the only kind of regional problem you can have is an unemployment problem. In other words, if there happens to be full employment in all regions there’s no problem, regardless of what the inter regional trade numbers happen to be. If there is unemployment, it’s a problem whether related to trade or not, and subject to the same adjustments regardless of source.

When some regions are at full employment it can be problematic to simply increase aggregate demand at the macro level to sustain full employment in all regions. Should that be the case the ‘answer’ becomes ‘fiscal transfers’ where the central govt. directs public spending to the areas of high unemployment. While this works well to sustain full employment throughout the region, it’s unfortunately misunderstood as a transfer of wealth to the areas of high unemployment from the taxpayers of the low unemployment regions.

In fact, while it’s an addition of nominal wealth to the high unemployment regions, the production and exportation of public goods and services to other members of the union is in fact a reduction of real terms of trade for the high unemployment regions doing the production relative to the low unemployment regions doing the consumption, as exports are real costs and imports real benefits.

So while fiscal transfers for the production of public goods and services that serve the entire union are commonly presumed to be benefits to the high unemployment regions and costs to the low unemployment regions, in real terms the reverse is almost always the case.



4 Responses to “Cross Border Lending and Imbalances in Euroland”

Ed Dolan EdDolanOctober 27th, 2012 at 7:04 pm

"Yes. But in what sense is that an “imbalance”? Look at it this way. What if instead of running up real estate prices in the sunny south—so that Brits and northern Europeans could enjoy vacation homes—the German banks had instead fueled a real estate bubble in Berlin?"

Randall, you have really hit the nail on the head with this one! I'm here in Euroland, too, just finishing up a global macro course at a top-rated EMBA program in Riga. We spent much of the week talking about imbalances. Funny thing, tho, we never talked about "imbalances" between the US states. Nor did we talk about "imbalances" between Saxony and Bavaria. Nor did we talk about "imbalances" between me and my neighbor down the street–imbalances reflecting the fact that I am an old geezer who has paid off my mortgage and am a net saver, whereas neighbor is a young person who just borrowed for a first house. Why is that so different from the "imbalances" between the New Member States of Europe and the "old" EU-15?

We did talk a lot about "imbalances" in labor flows. Countries like Latvia that have net emigration are very distraught about it. Every person who gets an education at home and goes abroad to work is viewed as a traitor. Every person who goes abroad to get an education and stays there to work is viewed as a loss to the motherland.

So, where does that put me? I got a nice education in the ol' US of A, but I have spent the last 25 years teaching in Europe. Does that make me a traitor to my homeland? Funny thing, no American I have ever talked to has even hinted that they saw me as a traitor who took US tax money (yes, part of my education was at a state university) and then betrayed my country by bestowing my services on foreigners. When I tell people what I do for a living they just say "Oh, that must be interesting," and change the subject.

I love Europe, but the people who live here sure have some funny ideas about "imbalances." Thanks, great post!

L. Randall Wray L. Randall WrayOctober 27th, 2012 at 9:37 pm

Thanks, Ed. Agreed. Either we are one big happy family, or we are not. If not, don’t mingle the finances! Monetary union should have been the very last step, after an indisolvable marriage (of fiscal policy).

ThomasGrennesOctober 28th, 2012 at 1:15 am

Yes, imbalances are slippery. Since imbalances are loans, is the solution "Neither borrower,
nor lender be"? That would be a bit drastic, but lending can be excessive if one party guarantees to repay the loan of another party (moral hazard).Abandoning their established policy and bailing-out Greece was the first mistake by the EZ. The U.S. federal government
has protected itself from "imbalances" of state governments by refusing to take responsibility for debts of the states for over 200 years.If the Federal government would bail-out Illinois, California, etc.,the Federal debt problem would be much more serious.

ThomasGrennesOctober 28th, 2012 at 5:49 pm

"Imbalance" is a fuzzy term that seems to mean borrowing or balance of payments deficit.
If borrowing is always bad, one could follow the advice of the Shakespearean character and "neither borrower nor lender be". That would be rather drastic, since borrowing is frequently productive. However, borrowing can be excessive if one party guarantees the debt of another party (moral hazard). The Eurozone made its first mistake by abandoning its original no bailout policy when it bailed out Greece. The Federal government's no bailout policy toward the states is an important difference between the U.S. and the E.Z.

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