Tag Archives: balance of payments

Imbalances Looking For A Policy

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… and not Infernal Muddles

Readers of this blog may be aware of my fanhood for Wynne Godley and the title of this post is from a paper by him from 2004, although it was US-centric. This post is on imbalances in the Euro Area.

Wynne had not only always foreseen crises, but also knew about the muddle in the public debate and in academia both before and after the crises and the policy space available to resolve the crisis. Here’s from the short paper:

The public discussion is fractured. There are vacuous suggestions coming from sections of Wall Street that Goldilocks has been reincarnated and everything is fine. There are right-wing voices calling unconditionally for cuts in the budget deficit. The Bush administration seems complacent and, thank goodness, is not being convinced about cutting the federal budget deficit any time soon. Many are concerned about the current account deficit. Some of them fear a big and “disorderly” devaluation of the dollar while others think the dollar isn’t falling enough. No one has a clear idea about what can actually be done, by whom, and when. I have no sense that anyone who pontificates on these matters (outside the Levy Institute!) does so with the benefit of a comprehensive stock-flow model—the indispensable basis for competent strategic thinking.

In his 1983 book Macroeconomics, with Francis Cripps, he wrote:

… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do not know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.

Eurostat, the statistical office of the European Union published for the first time today the indicators of the “Macroeconomic Imbalances Procedure Scoreboard”.

The Headline Indicators Statistical Information release provides detailed data (since 1995) for current account imbalances, the net international investment position, share of world exports, private credit flow (net incurrence of liabilities discussed in the previous post), private debt and the general government debt for the EU27 countries not just EA17. People a bit familiar about Post Keynesian Stock-flow coherent macro models will be aware of the connection between these.

The flow accounting identity

NL = PSBR + BP

where NL is the Net Lending of the private sector to the rest of the world, PSBR is the Public Sector Borrowing Requirement, equal to the government’s deficit and BP is the current balance of payments (or simply the current account balance) adds to stocks of assets and liabilities via the short-hand equation (also mentioned in the previous post)

Closing Stocks = Opening Stocks + Flows + Revaluations

and hence the connection between the stocks and flows mentioned by Eurostat. The report also provides data for Real Effective Exchange Rates, Normal Unit Labour Costs, evolution of House Prices (which rise faster in booms and do the opposite in busts) relative to prices of final consumption expenditure of households.

The Euro Area was formed with the “intuition” that by having a single currency, among other advantages – the nations would not have balance-of-payments problems at all.

Wynne Godley saw this muddle as early as 1991:

(click to expand in a new tab)

Writing for The Observer where he said:

… But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.

Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.

and that:

… If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.

The Eurostat is a statistical organization and its job is to report and maybe suggest some policies to the policy makers. It has rightly identified the imbalances which are looking for a policy. Unfortunately, these imbalances are typically brought to a balance (or at least attempted to) by deflating demand and hence reducing output and increasing unemployment. The recent treaty changes with a new “fiscal compact” shows what the policy makers are trying to do. But they do not realize its implications!

Here’s from a 1995 article A Critical Imbalance in U.S. Trade written by Godley:

Refuting the “Saving is Too Low” Argument 

It is sometimes held that, in the words of the Economist (May 27. 1995, p. 18), “America’s current account deficit is enormous because its citizens save so little and its government spends too much.” The basis for this proposition is the accounting identity that says that the private sector’s surplus of saving over investment is always equal to the government’s deficit plus (or minus) the current account surplus (or deficit). As this relationship invariably holds by the laws of logic, it can be said with certainty that if private saving were to increase given the budget deficit or if the budget deficit were to be reduced given private saving, the current account balance would be found to have improved by an exactly equal amount. But an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.

and also in The United States And Her Creditors: Can The Symbiosis Last? (link) from 2005:

A well-known accounting identity says that the current account balance is equal, by definition, to the gap between national saving and investment. (The current account balance is exports minus imports, plus net flows of certain types of cross-border income.) All too often, the conclusion is drawn that a current account deficit can be cured by raising national saving—and therefore that the government should cut its budget deficit. This conclusion is illegitimate, because any improvement in the current account balance would only come about if the fiscal restriction caused a recession. But in any case, the balance between saving and investment in the economy as a whole is not a satisfactory operational concept because it aggregates two sectors (government and private) that are separately motivated and behave in entirely different ways.

The European Commission has taken the report and produced another titled “Alert Mechanism Report” which has this table called “MIP Scoreboard” which highlights the imbalances in grey:

(click to expand in a new tab)

and makes observations on many individual nations – e.g., for Spain:

Spain: the economy is currently going through an adjustment period, following the build-up of large external and internal imbalances during the extended housing and credit boom in the years prior to the crisis. The current account has shown significant deficits, which have started to decrease recently in the context of the severe economic slowdown and on the back of an improving export performance, but remain above the indicative threshold. Since 2008 losses in price and cost competitiveness have partially reversed. While the adjustment of imbalances is on-going, the absorption of the large stocks of internal and external debt and the reallocation of the resources freed from the construction sector will take time to restore more balanced conditions. The contraction in employment linked to the downsizing of the construction sector and the economic recession has been aggravated by a sluggish adjustment of wages, fuelling rising unemployment.

The above is reminiscent of the Monetarist experiments of the 70s and the 80s where wages are squeezed by deflating demand (resulting in reducing employment instead of increasing it). No suggestion is made on how wages are to be negotiated. While I do not yet the best way to say the following, here it is: while wages are cost to firms, they are incomes to households and this strategy puts higher pressure on the fall in demand and creates a more recessionary scenario.

The Euro Area had no central government which is responsible for demand management in the broadest sense and individual nations having forgotten Keynesian principles, had haphazard policies from the start. In some nations, governments had a more relaxed fiscal stance but it was not seen in their budget balances because the domestic private sectors were happily involved in having its expenditure higher than income – adding to stronger growth and hence higher tax revenues. Thus the budget balance was seen under control. In others, this may have been the result of the private sector itself contributing to most of the increase in domestic demand by high net borrowing. The high growth in private sector incomes also led to deterioration in external balances of the weaker nations and the whole process was allowed to go due to irresponsible behaviour of the financial sector which was underpricing risk. Everyone was acting as if there was no balance-of-payments constraint (sectoral imbalances in general) which will hit hard someday.

When the crisis hit, governments realized that they had given up the ultimate protection (and simultaneously the lenders to governments) – making a draft at their home central bank.

Let me offer an intuition on sectoral balances in general and not just for the Euro Area. While it is true that a “good” sectoral balance is one in which all the “three financial balances” are near zero, it is important that policy be designed (and bargained at an international level) so that these balances are brought to their preferred paths of staying near zero in the medium term without affecting the aim of full employment.

So imagine a closed economy. Most economists would suggest that – under certain conditions – the government should design policy to aim to reach a budget surplus (or a primary surplus) but this comes at the cost of lower demand and higher employment and hence a poor strategy. A higher fiscal stance – as opposed to targeting a balanced budget – will automatically lead to primary surpluses in the medium term because of the increase in demand and national income leading to increases in the government’s tax receipts. In open economies this gets complicated. Under the current arrangement a unilateral fiscal expansion by a nation such as Spain is ruled out because this will bring about a return to high current account deficits because of a faster rise in domestic demand than domestic output putting the nation on a different unsustainable path.

Now this may sound like TINA – but it is not if one thinks of alternative strategies which are aimed at bring the three financial balances from getting out of hand but with a coordinated fiscal reflation. However, this is difficult without there being institutional means of achieving the desired outcome and hence there is an urgent need for a more integrated Europe with higher spending and taxing powers for the European Parliament (unlike the 2% budget rule of Charles Goodhart) which will be induced in substantial fiscal transfers. Competitiveness also needs to be addressed but the powers of the government go beyond fiscal policy alone and policies need to be designed in a more integrated Europe which reduce transfer addiction such as a common wages policy as suggested by George Irvin and Alex Izurieta in their article Fundamental Flaws In The European Project (August 2011):

Policy action is necessary if these trade imbalances are gradually to disappear. Crucially, labour productivity must increase faster in the deficit countries than in the surplus countries, an aim difficult to achieve unless proactive fiscal policy and infrastructure investment trigger a modernising wave of “crowding in” private investment. This means that Europe must redistribute investment resources from rich to poor regions. In addition, if higher labour productivity growth is to be achieved in the periphery, a “common wages policy” (not to be confused with a common wage) must be adopted which better aligns wage and productivity growth and sustains aggregate demand. This will not be achieved with wage disparities exercising a deflationary impact on the union. In the absence of national exchange rate realignment, adjustment must take place through a regional wage bargaining process.

Update: The European Commission background paper “Scoreboard For The Surveillance Of Macroeconomic Imbalances” is available at here.

Kaldorians

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In an article (obituary), Nicholas Kaldor, 12 May 1908-30 September 1986, Geoff Harcourt said:

Nicholas Kaldor’ resembled Keynes more than any other twentieth-century economist because of the breadth of his interests, his wide-ranging contributions to theory, his insistence that theory must serve policy, his periods as an adviser to governments, his fellowship at King’s and, of course, his membership of the House of Lords.

I was reading this article (for the 3rd time!) Kaldor And The Kaldorians by John E. King. It appears as a chapter in the book Handbook Of Alternative Theories Of Economic Growth edited by Mark Setterfield.

I came across this strong Kaldorian view (which I share):

How, exactly, does the constraint [balance-of-payments constraint] operate? Three mechanisms can be distinguished. First, in extreme cases like Cuba in the 1990s and Zimbabwe in the 2000s, a shortage of foreign exchange makes it impossible fully to operate the existing capital stock (since spare parts can no longer be imported), and growth declines or becomes negative. Second, during the fixed exchange rate regime imposed by the Bretton Woods system (1945–73), governments were forced to implement deflationary monetary and fiscal policies to protect the currency in face of often quite small payments deficits. This generated the “stop–go” cycle that Kaldor regarded as the principal cause of Britain’s poor growth performance in this period. Third, in a floating exchange rate regime, the principal constraint on output growth is the rate of growth of export demand. Kaldor himself came to believe that exports were the only source of autonomous aggregate demand, since all other categories of expenditure were fully determined by income: consumption directly, investment indirectly through the accelerator coefficient, and government spending indirectly through taxation receipts, themselves a function of income. This is a characteristically extreme position, which is difficult to justify. But it is not necessary to deny the existence of some autonomous consumption, investment and government spending in order to recognise the importance of export demand as a factor in economic growth. For most small countries, and for all regions within countries, exports are indeed the most important factor.

I am not sure if King’s description of Kaldor and the Kaldorians is the best but a decent one. So, as King hints, Kaldor fully understood the injection to demand due to government expenditure and private sector borrowing. In fact, one whose views closely resembled that of Kaldor was Wynne Godley.

How are exports determined?

Nicholas Kaldor, Geneva, 1948

Picture source: Economica

Kaldor had the following to say:

The growth of a country’s exports should itself be considered as the outcome of the efforts of its producers to seek out potential markets and to adapt their product structure accordingly. Basically in a growing world economy the growth of exports is mainly to be explained by the income elasticity of foreign countries for a country’s products; but it is a matter of the innovative ability and adaptative capacity of its manufacturers whether this income elasticity will tend to be relatively large or small.

in “The role of Increasing Returns, Technical Progress and Cumulative Causation in the Theory of International Trade and Economic Growth”, Economie Appliquée, 1981

This is oft-quoted by economists who are inspired by Kaldor’s work. This may look straightforward but in my opinion, it is not so in practice. There are just too many different kinds of stories one hears about the external sector from economists. In stock-flow-consistent Post Keynesian macro modelling literature, one sees equations such as

The algebra is involved and there are many more equations than the above two. To get exports and imports, one has to multiply the x£ and im£ by prices. Refer Godley&Lavoie’s text Monetary Economics, oft referred in this blog.

The above equation assumes important causalities. Exports of a nation depends on prices of exported products relative to domestic prices of products in the foreign country, for example. In addition, exports also depend on demand and income in the foreign country(y$). The parameter ε2 (and μ2 from foreigners’ viewpoint) is what Kaldor is talking of in the quote above. The more competitive producers in the £-country are, the higher ε2 will be. Of course, this is not the only important thing, and prices are also important. (For example, if the GBP starts appreciating, UK exporters will face pressures in selling their products in the US).

The above equation also shows that if there are injections to demand, such as from government expenditure or tax cuts or due to higher private expenditure (either by higher borrowing or an increased propensity to consume etc), imports will increase. Similarly, if there is a contraction, imports will decrease as was evident by the collapse of world trade due to recessions in many parts of the world during the “Great Recession”.

The purpose of my post was to highlight what importance economists give to price-elasticity and income-elasticity of exports/imports. Most economists worry too much about ε1 (and μ1) and Kaldorians pay much more attention to ε2 (and μ2) and what sorts of policies governments should follow based on this. For example, a nation’s government may be concentrating too much in promoting exports of goods and services where price-competitiveness plays a role. It may be beneficial if it switches to promoting exporting goods and services in which it has unique capabilities which if successful will greatly improve its external situation.

In fact, according to the work of Kaldorians such as Anthony Thirwall and John McCombie, growths of nations can be explained by the ratio of the rate of growth of exports to the income elasticity of its imports. In the stronger form, exports themselves depend on the income-elasticity of imports in the foreign nation – i.e., the “non-price competitiveness” of exporters.

The two authors wrote an excellent book in 1994: Economic Growth And The Balance-Of-Payments Constraint – considered one of the greatest books in Post-Keynesian Economics.

Some GIMP Fun With Spain’s Sectoral Balances

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… but not fun for the Spanish people.

In yesterday’s post Spain’s Sectoral Balances, I briefly discussed the sectoral balances of Spain and its connection with demand, income and output. Here’s the original graph from the Banco de España again with my viewpoints in the previous post.

I learned some GIMP from a friend some time ago and thought I’ll use it for some fun.

I consider two scenarios:

Suppose the Spanish government relaxes its fiscal policy (independent of other Euro Area governments’ policies) or does not tighten it. How do the sectoral balances look? Here’s a likely scenario:

(may not sum to zero because of drawing discrepancies)

The “projection” – not to scale since I had limited availability for space – implies the government deficit keeps rising and this is the result of the rising current account deficit. A higher fiscal stance leads to a slightly higher income and employment but the flip side of this is a rising indebtedness to the rest of the world caused due to the current account deficits. The public sector is incurring almost all the change in net indebtedness – i.e., its contribution to net borrowing from the rest of the world is the highest.

Of course, this process cannot go on forever as a rising indebtedness implies foreigners have to be attracted by hook or crook and interest rate paid on government debt and consequently all private sector debts will also keep rising leading to a deflationary bust at some stage.

Also note, the causality here is a bit opposite of what was described in the previous post! The causalities between the balances of the “three sectors” is complex and not so straightforward. Here a higher fiscal stance leads to a higher income and expenditure and a widening of the current account deficit which in turn widens the budget deficit.

To prevent such possible instabilities – at least their smell of such instabilities – the European leaders have imposed the “fiscal compact” on nations.

What do they aim to achieve? The following “projection” is a possible answer:

The above describes the possible outcome of a tight fiscal stance of the Spanish government. A tight fiscal policy leads to lower income and hence a lower current account deficit – because of lower expenditure on foreign products – but it is achieved via lower output and employment.

The above projections are not based on a specific model for the Spanish economy but some analysis based on familiarity with SFC modelling.

Macroeconomics is not so easy – there are so many constraints – and governments have to strive to achieve the best optimal outcome. “Market forces” do not do that.

The second scenario can also be achieved by a coordinated fiscal expansion by the Euro Area nations. The sectoral balances may behave similar to the second scenario but in the expansionary scenario, output and hence employment is higher. Unfortunately there is no mechanism or institutional means by which fiscal policies are coordinated within the Euro Area (the exception is the recent “fiscal compact” which unfortunately misses the point). Even if there is an agreement on fiscal expansion, there is nothing to make sure that there is a constant management of the whole process – i.e., there are chances of failure.

There are various ideas one sees on proposing a solution to end the Euro crisis but almost none appreciate the real problems. In my opinion, there is no alternative to moving ahead with a European integration and granting more fiscal powers to the European powers – making it a central government – which is involved in fiscal transfers and a mandate to achieve full employment.

Spain’s Sectoral Balances

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The Banco de España released its Quarterly Economic Bulletin today and it had an interesting chart on the sectoral balances of the Spanish economy.

With a net indebtedness of €994.5bn – i.e., close to €1 trillion – as compared to the gross domestic product of €1.06tn (2010 figure) Spain has limited choices. Except via the possibility of expanding by another private sector led credit expansion which is highly unlikely, the Spanish economy faces the prospects of low output and demand. Increasing exports is another option but with all Euro Area nations’ governments being forced by a “fiscal compact” to contract, this is unlikely because of low demand in the rest of Europe.

The chart is really interesting as it illustrates some of the many causalities associated with the financial balances identity

NAFA = PSBR + BP

where NAFA is the Net Accumulation of Financial Assets of the domestic private sector, PSBR is the Public Sector Borrowing Requirement or the deficit and BP is the current balance of payments.

When the domestic private sector tries to increase its saving, there is a contraction of demand, income and output (unless exports increase). As a result imports too reduce (because income is lower). The higher propensity to save also leads to an increase in the government’s budget balance.

So in the chart you see a dramatic fall in the current account deficit and a huge increase in the government’s budget deficit. (The term “Nation” is used in the chart because the current balance of payments is the difference between the incomes and expenditures of all domestic sectors of a nation).

The situation is not atypical of recent (post crisis) behaviour of other nations’ sectoral balances but the fall in the external sector balance in this case is striking, though the same could be said for various deficit nations in the Euro Area.

The Banco de España – whose short-term projections are usually accurate – also said today that unemployment will hit 23.4% in 2012!

Z.1, Q3-2011

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The Federal Reserve released the Flow of Funds Accounts of the United States today.

The Flow of Funds Accounts provides one of the best snapshot of an economy. In an article appropriately titled ‘No one saw this coming’ – or did they? (see the full paper here), Dirk Bezemer correctly recognizes that the Economics profession’s ignorance of Flow of Funds had a big role to play in its inability to see a crisis coming. Bezemer says

We economists – and the policymakers who rely on us – ignore balance sheets and the flow of funds at our peril.

Of course, as Bezemer points out, there were exceptions. Post Keynesians were always aware of the flow of funds because monetary economy is a natural starting point in their theory. Wynne Godley and Marc Lavoie wrote a book (my favourite!) Monetary Economics: An Integrated Approach To Credit, Money, Income, Production and Wealth, Palgrave Macmillan, 2007, to unify Post Keynesian theory and the flow of funds approach, perhaps improving the presentation of the latter using something called the “transactions flow matrix”.

In my opinion, nobody even came close to Wynne Godley in not only predicting the crisis but the warning about the difficulties in resolving it.

One notable highlight of today’s Z.1 release was that

Household net worth—the difference between the value of assets and liabilities—was $57.4 trillion at the end of the third quarter, about $2.4 trillion less than at the end of the previous quarter.

A lot of readers will know about sectoral balances. How do we get that from Z.1? Table F.8 gives “Net Lending” of each sector of the economy. The difference in a sector’s income and expenditure is it’s “Net Lending”.

(click to expand, and click again to expand)

Before the crisis, the private sector had its income lower than expenditure and was financing the difference by borrowing from the other sectors. As the crisis hit, private sector expenditure retrenched – so you can see how the private sector has become a net lender from being a net borrower before the crisis. Because of this, the government’s borrowing increased from (line 49) $408.1bn in 2007 to $1,471.7bn in Q3 2011 (annualized). It was also due to a relaxation of fiscal policy during the crisis, in order to stimulate demand. The expenditure of the United States as a whole is higher than its income, and the difference is the current account deficit. This is financed by net borrowing from foreigners (line 42) – which was $446.7bn in Q3 2011 (annualized). This deficit was $715.9bn in 2007, bleeding demand at a massive scale from the US economy.

There are two more tables I see closely. The first is the net income payments from the rest of the world, which surprisingly remains positive, leading to a lot of literature about “dark matter”. (More on that some other time). This, according to the Z.1 is the “net receipts from foreigners of interest, corporate profits, and employee compensation”.

 The Levy Institute has been tracking this since 1994. Here’s a latest graph (from their March 2011 analysis)

There are discrepancies between BEA and Fed data. The other table which I rush to check, whenever the flow of funds data is released is the United States’ net indebtedness to the rest of the world – L.107:

which at the end of Q3 was $3,616bn, or 24% of GDP.

There’s a new table – L.108, Financial Business – which actually appeared first time in the previous release (Q2). This sector had $64,299bn in assets and $60,457bn of liabilities at the end of Q3!

Of course, I look at all the tables at some time or the other. Highly recommended.

The Eurosystem: Part 3

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In the previous post in this series The Eurosystem: Part 2, I discussed cross-border flows within the Euro Area. With exceptions, most of these flows are current balance of payments and balance of payments financing flows. Of course there are other flows with the world outside the EA17 and these flows flow via the correspondent banking arrangements banks have put in place and not the topic of discussion in this series.

The cross-border flows are important for the Euro Area since as a whole, the Euro Area’s balance of payments is almost in balance.

Source 

Source

So the Euro Area current account was in a deficit of €11.7bn in 2011Q3 and a net indebtedness of €1.35tn to the rest of the world at the end of Q3, or 14.5% of GDP. So most of external imbalances of the EA17 nations are within the Euro Area.

Back to TARGET2 flows: there was a debate among some economists on various matters related to these flows. Some even went on to suggest that these flow affect credit in Germany because the nation was financing the current account of the other nations. From an exogenous money viewpoint, this reduces banks’ ability to provide loans to their customers! (which is incorrect because money is not exogenous). The replies tried to disprove it by using the argument that attempted to prove that the NCBs were not financing the current account. Sorry no links.

This is a small post and my point is to show that since  TARGET2 is designed to automatically change the balance sheets of the NCBs, the debate whether the NCBs finance the flows or not is a bit counterproductive. Of course having said this, I wish to highlight the fact that the item “Claims within the Eurosystem” (in either assets or liabilities) is definitely recorded in the balance of payments and the international investment position as can be seen below for the case of Spain.

(Click to enlarge, Source)

(click to enlarge, Source)

Of course, the “Claims Within the Eurosystem” is just one item in the financial account and the international investment position, so not the whole of the current account deficit is financed this way. One minor advantage is that this part of the gross indebtedness of a whole deficit nation is at the ECB’s main refinancing rate, which is much lower than the effective interest rate deficit EA nations are paying on their gross liabilities to foreigners. This is not worthy of further attention, though.

How long can these flows continue? As long as the banks have sufficient collateral to provide to their home NCB. When banks run out of collateral (eligible for borrowing from the Eurosystem), emergency measures have to be taken and a future post in this series will discuss the Emergency Loan Assistance Program (ELA) used by NCBs.

[I welcome your comments. I have a “Zero Comments Policy” as opposed to a “No Comments Policy”. I like being notified of a comment.]

An Internal Balance Of Payments Crisis

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Economists are increasingly recognizing the Euro Area problems as a balance-of-payments crisis, in addition to realizing that the Euro Area national governments cannot finance their deficits by making a draft at the Eurosystem in extreme emergency.

The Economist has an article today Beware of falling masonry with the graph on the net asset position which I posted on several occasions in this blog.

With a few exceptions, the benchmark cost of credit in each euro-zone country is related to the balance of its international debts. Germany, which is owed more than it owes, still has low bond yields; Greece, which is heavily in debt to foreigners, has a high cost of borrowing (see chart 2). Portugal, Greece and (to a lesser extent) Spain still have big current-account deficits, and so are still adding to their already high foreign liabilities. Refinancing these is becoming harder and putting strain on local banks and credit availability.

The higher the cost of funding becomes, the more money flows out to foreigners to service these debts. This is why the issue of national solvency goes beyond what governments owe. The euro zone is showing the symptoms of an internal balance-of-payments crisis, with self-fulfilling runs on countries, because at bottom that is the nature of its troubles. And such crises put extraordinary pressure on exchange-rate pegs, no matter how permanent policymakers claim them to be.

The magazine also had another nice article recently: Is this really the end?. Here is a collection of covers from the magazine in recent times on the Euro.

Hungary?

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WSJ’s Marketbeat reports of troubles Hungary may be headed into. The blog post reports:

Hungary this morning had its own T-bill auction, just like Italy. It did not go so well!

Hungary’s auction had a bid-to-cover ratio of just 1.0, and it had to pay a 6.79% yield to move the debt.

I decided to do some basic analysis of what is going on. The Annual Report On Exchange Arrangements And Exchange Restrictions 2010 reports that

and also that:

FT provides the chart of EURHUF:

The depreciation got me even more curious. More screenshots from data sources below. The first one is Hungary’s current account balance as a percentage of GDP, courtesy IMF’s World Economic Outlook, Sep 2011.

(Click to enlarge)

So Hungary has been running a huge current account deficits since many years. A current account deficit means that a nation’s expenditure is higher than income and the difference has to be financed by net borrowing from abroad. During boom times, this may not be problematic but the accumulated debt has to be rolled by attracting foreigners by hook or crook. The route most chosen to prevent getting things out of control is be deflating demand. Only in a Mundell-Fleming fantasy world does the nation’s currency depreciate to bring the current balance of payments to zero and an equilibrium with respect to the external world.

Hungary is a small nation with GDP equivalent of €97b (in 2010, using an approximate average 2010 exchange rate of HUFEUR=0.0036. Note to self: This needs more correction). Due to deficits in the international current balance of payments, the nation has accumulated a debt equivalent of €113.59b (the negative of NIIP) according to the the release Hungary’s balance of payments: 2011 Q2 from Magyar Nemzeti Bank – Hungary’s central bank. With net foreign asset position worse than -100% of GDP, this puts Hungary’s economy in a terrible position. Recent data suggests an improvement in external trade but the international currency markets are not impressed.

According to this Wikipedia Map, Hungary is obliged to join the Eurozone, and has no opt-out option like UK. However, it has not satisfied the Maastricht criteria, and hence the Eurozone won’t let it in yet. Better not! As long as Hungary has its own currency, its government can make a draft at the central bank to finance a portion of its deficit and gives it a tool to protect itself in the short term. So Hungary is protected from being Greece as long as it is not in the Eurozone. But in the long run, Hungary’s growth will be constrained by its balance of payments.

Severe Imbalances Within EA17

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In a recent post Chart: Euro Zone Indebtedness, I graphed the Net International Investment Position (the negative of “external debt”) for EA17 nations to highlight the severity of internal imbalances within the Euro Area. I found a source of data for the current account balance as a percentage of GDP in the IMF’s latest World Economic Outlook and am posting a screenshot below of the table I am talking about.

(It’s a bit of hard work to get this otherwise). Click the image to enlarge. You can see that around 2007, the imbalances grew out of control but continued to grow in 2008.