The great Scottish philosopher and economist David Hume understood all too well how national boundaries and balance-of-payment statistics affect and even determine flows of international trade. Where national boundaries exist, customs offices and government bureaucracies assiduously monitor the flow of goods and assets between countries. Surpluses and deficits are seen by politicians as a sign of national pride or shame. Hume criticised the mercantilist view but was optimistic that trading patterns would ultimately right themselves. In 1752 he wrote:
“Where one nation has gotten the start of another in trade, it is very difficult for the latter to regain the ground it has lost.... But these advantages are compensated, in some measure, by the low price of labour in every nation which has not an extensive commerce, and does not much abound in gold and silver. Manufactures, therefore gradually shift their places, leaving those countries and provinces which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labour; till they have enriched these also, and are again banished by the same causes. And, in general, we may observe, that the dearness of every thing, from plenty of money, is a disadvantage, which attends an established commerce, and sets bounds to it in every country, by enabling the poorer states to undersell the richer in all foreign markets.”
In principle, the vaunted “Hume mechanism” should operate within the Eurozone. Countries which export less than they import should lose euros to surplus countries, unless offset by private capital inflows. Euro outflow leads to a scarcity of money and credit, less lending for consumption and investment, a slowdown in activity and falling prices. Chronic deficits will imply higher interest rates and declining creditworthiness for both sovereign and private borrowers. But declining domestic absorption and non-traded goods prices ultimately bring wages back into line with productivity and restore competitiveness. Similarly, chronic surplus countries should accumulate euros and domestic bank lending should expand, leading to more demand and inflation there relative to deficit countries.
Hume’s insights are as relevant today as they were 250 years ago. Recession and concomitant reduction of income and prices in the Eurozone periphery are painful, but necessary conditions to recover export capacity and restore growth and sustainable public finances. Tight fiscal policy is necessary to accelerate the process. Already, Ireland, Spain, and Portugal have made progress in this regard. Relative price levels in the deficit countries must fall further for imbalances to equilibrate and for private capital to return. The flip side is also true. Germany, the Netherlands, and Finland will have to accept a good dose of wage and nominal income growth – and even higher inflation. With any luck, they may well get it.
But the Hume mechanism is slow to work, most of all because prices need time to adjust and are driven by stubborn expectations. Another reason is that flaws in the construction of the Eurozone hinder the Hume mechanism. Current-account deficits are not bad per se – especially if they tide over consumption in a temporarily bad year, or finance capital goods imports in response to productive opportunities. Yet since the financial crisis, Eurozone countries with chronic current-account deficits have also experienced significant capital outflows and balance-of-payment deficits. In the days of Bretton Woods system before 1971, the IMF would put out such fires with fiscal stabilisation programs; the UK and Italy are two memorable examples. Chronic payments imbalances were not tolerated because no sovereign country was expected to fund permanently deficits of others.
In the Eurozone, there is no authority to regulate imbalances between sovereign nations:
- The Maastricht Treaty did not explicitly provide for IMF-style intervention.
- The Stability and Growth Pact, designed to prevent government-driven imbalances, obviously failed.
- As private capital flows to these countries dried up and turned into capital flight, the ECB has involuntarily financed the resulting balance-of-payment deficits with monetary clearing credits, the so-called Target2 system (see Buiter et al 2011).
These bookkeeping entries in the balance sheets of national central banks have become the subject of heated discussion in Germany (Sinn 2012, Dullien and Schieritz 2012, Tornell and Westermann 2011).
By passively monetising intra-Eurozone imbalances, the ECB has put Hume on hold, postponing necessary adjustment of relative prices between regions. Dismissed at first by most economists, the elephant in the room is now too big to ignore. Bundesbank surpluses with the ECB have swelled to well over €700 billion, or about 30% of German GDP. Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.
In a world without national boundaries and without national central banks, balance-of-payment deficits cannot occur – current-account deficits are always financed by private capital. As long as the members of the monetary union accept it, changing tides of trans-European ownership of national assets should be perfectly acceptable and left to owners of capital flows. Governments should prevent bad mistakes of private banks and investors from becoming the liability of taxpayers. The ECB should refrain from allocating liquidity directly to any particular market. Yet as long as economic nationalists continue to pay attention to them, national balance-of-payment deficits and surpluses will continue to play a role in the formulation of policy. In the case of a breakup of the Eurozone, the book-keeping Target2 entries become explicit national assets and liabilities, opening the way for further recriminations and deterioration of economic and even political relations.
In the end, the euro’s founders committed an egregious error by ignoring this not-so-minor detail that Hume certainly would have caught. By not abolishing national central banks irrevocably, the back door was left ajar for national interests to interfere with the natural workings of the financial system and Hume’s mechanism. This oversight, combined with the failure to establish a European Banking Authority with real teeth, has left a gaping hole in European monetary and financial integration and will come back to haunt us in the months and years to come.
References
Buiter, Willem, Juergen Michels, and Ebrahim Rahbari (2011). “Making sense of Target imbalances”, Vox column, VoxEU.org, 6 September.
Dullien, Sebastian and Mark Schieritz (2012). “German savers should applaud the growing TARGET balances”, VoxEU.org, 7 May.
Hume, David (1752), "Of Money", in Essays, Moral, Political, and Literary.
H.-W. Sinn und T. Wollmershäuser (2011), "Target Loans, Capital Flows, and Current Account Imbalances: The ECB’s Hidden Rescue Facility”, CESifo Working Paper 3500, June 2011.
Tornell, Aaron and Frank Westermann (2011). “Greece: The sudden stop that wasn’t”, VoxEU.org, 28 September.
