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Taking European integration seriously: competitiveness, imbalances, and

economic stability in the Euro Area

Stefan Collignon

The Euro crisis presents a challenge nor only to policy makers, but to economic theory as well. The

explanation of a problem often traces already the path for its remedy. But if the diagnosis is

mistaken, the medicine could kill the patient. Economic theory plays, therefore, an important role in

overcoming the Euro crisis, in preserving stability, and in keeping Europe together. Five years of

unabated crisis have eroded the trust of citizens that the euro will improve their prosperity and

welfare. The rejection of the euro and of European integration is gaining ground in public opinion.

Hence, if Europe has failed to end the crisis, it may have erred in explaining it. It is therefore time to

review the theory that has guided policies so far.

In this chapter I will first look at the link between competitiveness and macroeconomic imbalances

and in section 2 discuss the fallacies of this approach. Section 3 proposes flow of funds analysis as an

alternative to the current account based theories of the Euro crisis. Section 4 concludes.

1. Competitiveness and imbalances in the Euro Area

Economic models explaining financial crises in general and the Euro crisis in particular abound. Many

deal with money, foreign debt, exchange rates, and contagion in global financial markets; some deal

with domestic institutions, banks and local debt; but increasingly the focus is on competitiveness, or

rather the loss of competitiveness in Europe’s south.1 Unfortunately, most of these explanations are

mixing foreign and domestic aspects from different theories into inconsistent policy advice. This

amalgam reflects the complex governance of the Euro Area, where governments act as if they were

fully independent nations without considering the external effects of their policies on citizens living

in other member states. Competitiveness is a prime example for such interdependence, for the

competitive gain of one party is the loss of another. Reforms improving competitiveness in one

country will inevitably deteriorate relative conditions in another. Because policy makers are ignoring

the systemic changes and interdependencies caused by monetary integration, they are unable to

adopt coherent strategies for overcoming the crisis. The shortcomings in the way governments have

handled the crisis throw a shadow on the future of the euro and European integration. This chapter

is an invitation to reconsider one important dimension of the crisis explanation: competitiveness.

Macroeconomic imbalances in the Euro Area are related to competitiveness. At first, blame for the

Euro crisis was put on public debt and fiscal irresponsibility, in particular on the violations of the

Stability and Growth Pact. Greece was the paradigmatic case. But soon a new aspect emerged: in

some countries, notably in Ireland and Spain, private debt, granted by commercial banks, had been

excessive, and when the economy slowed down banks got into trouble. Governments needed to bail

out their banks to preserve financial stability and private debt spilled over into public debt. When the

sum of public deficits and private investment exceeds national savings, the gap has to be financed by

borrowing from non-residents and this is recorded by national current account deficits. Because it

1 The “South” covers Italy, Spain, Greece, Cyprus, Portugal and when data available Ireland

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was observed that most crisis countries had accumulated large current account deficits, the

emergence of excessive imbalances became the prominent explanation of the crisis.

Deficits increase the stock of outstanding debt; current account deficits increase foreign debt. The

sustainability of foreign debt requires, therefore, that the discounted value of all future current

account positions be equal to the outstanding value of foreign debt today. Hence, according to

standard international macroeconomics, countries with large foreign debt must generate current

account surpluses in the future, because that is how they earn the foreign currency necessary to

service foreign debt. Following this logic, the European Commission has designed a new policy

procedure aimed at reducing what it calls external imbalances within the Euro Area. It argues that

“nominal exchange rate devaluations are not an available policy tool for the correction of external

imbalances in EMU”, so that various “internal devaluation” measures must “mimic the effects of

nominal devaluations by reducing domestic prices and encourage expenditure-switching effects”

(European Commission, 2011:21). In practice this means that austerity is the main tool for correcting

“external” imbalances and promoting net exports from southern states.

Austerity means cutting public expenditure, reducing wages or lowering statutory wage costs by tax

and welfare reforms. Whether current account imbalances are corrected by cutting aggregate

demand or changing relative costs and prices may depend on where one sees the causes of the

imbalances, but in any case different policies must be applied in deficit and surplus countries.

Eurosceptics have always insisted that with respect to monetary policy “one size does not fit all”, and

even the German Chancellor Merkel seems to have been convinced by them.2 The Walters’ critique

had argued long ago that in high inflation countries the unified nominal interest rate in monetary

union would lower real interest rates below the Euro average and thereby fuel local demand booms

and re-enforce relative price distortions. Mongelli and Wyplosz (2008) have rightly objected that this

disequilibrium would be corrected by the negative effects on competitiveness, because rising prices

will bring the demand boom to an end. A better explanation for diverging booms and busts in the

Euro Area is, therefore, the convergence of nominal interest rates that has followed the creation of

monetary union. It has made credit cheap in the south which has caused the over-accumulation and

waste of capital resources (Sinn, 2013; Giavazzi and Spaventa, 2010) and the excess demand that has

pushed inflation over and above the Euro average (Wyplosz, 2013). A variant of this argument

focuses on the cost side and especially on unit labour costs and wage bargaining. “Irresponsible” and

“uncoordinated” price and wage setting behaviour is then blamed for the crisis (Flassbeck and

Spiecker, 2011). The boom was not sustainable because the deteriorating competitiveness and the

slow growth during the crisis have widened budget deficits. However, regardless of what kind of

explanation one favours, both approaches share the idea that current account deficits are a good

indicator for emerging macroeconomic imbalances within the Euro Area.

The recent re-consideration of current account imbalances between member states of the Euro Area

represents a significant shift in political thinking. In the early years of monetary union, rising current

account deficits were actually seen as beneficial, because they reflected deeper financial integration

and the more efficient allocation of resources across the Euro Area (Blanchard and Giavazzi, 2002).3

2http://www.faz.net/aktuell/wirtschaft/europas-schuldenkrise/vor-ezb-zinsentscheid-merkel-fuer-

deutschland-muessten-zinsen-hoeher-sein-12161702.html 3 Of course, markets are not perfect, as monopolies, politics and institutions may also generate waste and

misallocated resources. The point is, that lifting the foreign exchange constraint opens the possibility to more efficient allocation of resources and, as the European Commission (2012b:11) recognizes: “Current account

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Capital markets could allocate savings to where they would yield the highest return within the single

currency area, and the Euro Area was seen as an integrated monetary economy. After 2009, this

interpretation was abandoned. Member states were again represented as separate jurisdictions, in

which local governments had to minimize risk exposure for local tax payers rather than maximise the

welfare of all citizens. The resulting lack of political coherence is one of the main causes for the

continuous deterioration of the crisis.

The European Commission took the lead in this new interpretation by inventing the Macroeconomic

Imbalance Procedure (MIP), modelled on the Stability and Growth Pact. It aims “to prevent and

correct the harmful macroeconomic imbalances by identifying potential risks early on”.4 The so-

called surveillance mechanism starts with the Alert Mechanism Report, which uses a scoreboard of

indicators to identify where and when an “in-depth review” is necessary. If the situation is deemed

unsustainable, the Excessive Imbalance Procedure sets up rules for member states to remedy the

situation. The score board indicators combine stock and flow data to capture deteriorations of

imbalances, but the main focus is on correcting current account deficits and external debt caused by

distortions in relative prices.5

In principle, having a tool for avoiding excessive imbalances is progress in the Euro Area’s economic

governance. If properly used, it could have helped to prevent the overaccumulation crises in the

south. In practice, however, the new procedure’s focus on current accounts and external debt is

harmful and misleading. Today’s adjustment policies in the Euro Area stand in the context of

optimum currency area (OCA) theory, which has influenced debates on European monetary union for

a long time.6 This theory interprets a currency area as a fixed exchange rate regime and calculates its

benefits as the balance between gains from lower transaction costs and the loss of the exchange rate

as an adjustment tool (de Grauwe, 2007). It argues that if a country is hit by a negative shock, say a

recession or deteriorating competitiveness, and it has its own currency, it can use the exchange rate

to adjust the country’s relative prices. This depreciates domestic wealth relative to the rest of the

world, but at least the economy can maintain domestic demand and add to it additional demand for

exports. By contrast, in a fixed exchange rate regime, one cannot use the exchange rate to devalue;

with inflexible prices and wages, a prolonged recession with high and persistent unemployment

would follow. Furthermore, the higher external debt levels of a country are, the steeper should be

the real depreciations in order to “put the price watch back” (Sinn, 2013). Hence, giving up the

possibility of correcting the exchange rate is costly. The negative effects of regional recessions could

be mitigated by a Transfer Union, where the surplus countries subsidise the deficit countries; but this

solution is resisted by voters in the prosperous north of Europe. Hence, prices and wages are the

main adjustment tool in the Euro Area, and OCA theory has made labour market flexibility the

principal criterion for judging the optimality of currency areas. In this model, the net benefits of

monetary union will become negative if labour markets are rigid and shocks are large. However, the

role of financial markets and the central bank is rarely discussed in this context. I will show below

deficits and surpluses are not necessarily macroeconomic imbalances in the sense of developments which are adversely affecting, or have the potential to affect the proper functioning of economies, of the monetary union, or on a wider scale.” 4See: http://ec.europa.eu/economy_finance/economic_governance/macroeconomic_imbalance_procedure/index_en.htm

5 See: http://ec.europa.eu/economy_finance/economic_governance/macroeconomic_imbalance_procedure/mip_scoreboard/index_en.htm

6Collignon and Schwarzer (2003) have shown how OCA theory became influential among academics, and

politicians who used it to keep member states out of the euro, but less so among policy makers and the business community, who were interested in solidifying the single market.

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that the existence of a single lender of last resort makes monetary union much more robust than an

ordinary fixed exchange rate regime.

No doubt, macroeconomic imbalances must be corrected. The question is how this can be done with

minimal welfare losses. If current accounts are the target, austerity is inevitable because “excessive”

domestic expenditure must be cut back. However, the burden of such welfare losses depends on

who is doing the adjustment. Member states with current account surpluses favour asymmetric

adjustment, where the brunt of the correction must be borne by “non-competitive” deficit countries,

while they themselves can continue with their “competitive” performance as before. Of course, the

reduction of deficits in the south is incompatible with the maintenance of surpluses in the north, but

few policy makers seem to notice the inconsistency of their demands. By contrast, deficit countries

seek more symmetric solutions, where surplus countries increase spending on goods from deficit

countries, hoping to soften thereby the adjustment pain. Sinn (2013:2) has summarized the

argument by saying that “Europe needs austerity in the south and inflationary growth in the north to

improve the competitiveness of the south and to structurally improve the current account

imbalances”. Similarly, Flassbeck and Spiecker (2011:186) have argued that “wages in Germany have

to rise for a considerable amount of time by more than is warranted by the traditional wage rule

(national productivity growth plus the common inflation target) and the Southern European

countries must pursue the opposite strategy.” While leaning towards asymmetry in the official policy

documents submitted for approval by the Council, the European Commission has favoured in its

analytic studies a more balanced approach.7 However, whether symmetric or asymmetric and

whether based on aggregate demand or relative prices, most policy recommendations end up with

proposing the correction of member states’ current accounts.

The focus on current accounts implies that national investment must be financed by national savings.

There is no good reason for such a proposal in a currency union. It violates the basic principles of a

single market and creates financial fragmentation. The prevailing policy consensus has the

unintended consequence of unravelling the European edifice. Furthermore, balancing current

accounts between member states also means that adjustment must work through the tradable

goods sector. A real depreciation shifts the competitive advantage in favour of exports, so that the

trade balance improves. When countries have their own currencies, a nominal devaluation can

support adjustment at least in the short run, but we know from a long history of adjustments in the

global and European economies that such policies often cause substantial welfare losses. Nominal

devaluations seem initially less painful, but over time they will import inflation, which will annihilate

the competitive cost advantage. By contrast, shifting relative prices in favour of tradable goods

without adjusting nominal exchange rates may be initially more painful, but might be more

sustainable in the long run. Europe’s experience with flexible exchange rates from the 1970s to the

1990s has shown that exchange rate flexibility is not compatible with a fully integrated internal

market in Europe (Collignon and Schwarzer, 2003; Padoa-Schioppa, 1987). Furthermore, a nominal

devaluation will reduce the value of domestic assets, liabilities and income and that makes residents

poorer. Hence, it is not surprising that southern member states resist leaving the euro as this would

reduce their welfare.

However, if prices are not flexible and devaluations are ruled out, adjustment seems impossible and

monetary union may be doomed. Referring to fixed exchange rate systems like Bretton Woods,

7 For the first see European Commission 2012, for the second 2012b.

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Flassbeck and Spiecker (2011:181) have argued: “persistent divergences of inflation rates inside the

monetary union are fatal because the differences in the cost and price level among the member

countries accumulate over time and produce real exchange rate appreciation and depreciation, or, in

other words, unsustainable over- and undervaluation for currencies that no longer exist.” Sinn and

Wollmershaeuser (2011) also compare the Euro Area with the fixed exchange rate system of Bretton

Woods and then talk of inexistent currencies, namely “German” and “Irish euros”. This is odd. Why

should anyone bother about ghost currencies that no longer exist? Clearly, there is a theoretical

inconsistency in these models.

I will now argue that a currency area is not a fixed exchange rate arrangement and imbalances

between members of the same currency union must not be treated like “external” imbalances in

international economics. Shifting incentives in favour of exports is less important in a monetary

union than in international economics, because growth in the non-tradable sector can compensate

some of the welfare losses. Instead, the primary economic policy objective must be balanced growth

as already postulated in the Treaty on the European Union, article 3.3. Investment is a crucial

variable in this context and a better indicator for imbalances are the flow of funds between

institutional sectors of the Euro Area.

2. Fallacies in the debate on macroeconomic imbalances in the Euro Area

It would be a mistake to believe that because it emerged from the European Monetary System where

exchange rates were fixed but adjustable, European Monetary Union is nothing else but a permanent

locking of national currencies to a common currency. This view, widespread as it is, does not take

into account how a monetary union works. I will therefore first review how a currency area functions

and then discuss the role of the often neglected non-tradable sector, before drawing the conclusions

for the macroeconomic adjustment programs in the Euro Area.

1.1. Monetary union as a payment union

A currency area is a payment union. It is defined as the territory where credit contracts can be

enforced and extinguished by paying the legally defined and generally accepted currency.8 In other

words, everyone has to use the same currency for making payments. The Euro Area functions exactly

like any other currency area. When European Monetary Union started on 1 January 1999, the euro

became legal tender in the participating member states (TEU, art. 3.4). Previously existing monetary

laws in member states were abrogated and the European Central Bank (ECB) was set up as the

directive organ and head office for the conduct of monetary policy. The existing national central

banks (NCB) were merged with the ECB to form the Eurosystem.9

The central bank is the bank of banks. Money, i.e. legal tender, is created by the central bank when it

is granting credit to the domestic banking system or buying foreign assets. The central bank’s assets

8 The IMF (2009: 44) defines: “For an economy, a domestic currency is distinguished from foreign currency.

Domestic currency is that which is legal tender in the economy and issued by the monetary authority for that economy; that is, either that of an individual economy or, in a currency union, that of the common currency area to which the economy belongs. All other currencies are foreign currencies.” 9 See Collignon, 2012. The IMF (2009:261) distinguishes between centralised (African and Caribbean currency

unions) and decentralised currency unions (Euro Area). Their main variance consists in whether the central bank has a single balance sheet or a consolidated balance sheet with national monetary agencies, but from an economic point of view there is little difference between the two.

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are therefore claims against domestic and foreign economies. Central bank money is credited to the

accounts in which commercial banks hold their reserves with the central bank; money is therefore a

liability by the central bank, but also a claim (an asset) by banks10 on the central bank. Against their

reserve holdings, banks can also draw bank notes which they put into circulation among their clients,

but this fact is analytically less interesting and we can concentrate our discussion on central bank

money. Thus, in the Euro Area, domestic money, i.e. the currency of the currency area, is the liability

of the Eurosystem.11 Contrary to the assumption of ghost-currencies, there is no “national” euro.

Money proper is central bank money, also called narrow money. Broad money is defined as currency

and bank deposits held by non-financial agents (corporations and households). It consists essentially

of liabilities of commercial banks. Commercial banks hold reserves of central bank money in

accordance with legal requirements (minimum reserves) and their own liquidity preferences, and

they create broad money when they give credit to the other economic sectors. When economic

agents make payments in the Euro Area, they transfer these liabilities to each other.12

By contrast, payments outside the currency area are made in foreign currency. Foreign currency

cannot be created by the domestic central bank. The money readily available for making foreign

payments consists therefore of reserve assets held by the central bank in foreign currency.13 As the

name indicates, these reserves are recorded as assets in the central bank’s balance sheet. Thus,

there is a clear categorical distinction between domestic money (a liability) and international money

(an asset). It follows that a currency area is defined by the fact that it has a central bank whose

liabilities serve for making payments and extinguishing debt. The abrogation of national monetary

laws has lifted the distinction of monetary jurisdictions and turned the Euro Area into an “economic

country”. To analyse monetary transactions between residents of different member states in the

Euro Area as if they took place between independent “foreign” countries is therefore no longer

appropriate.14 Within a monetary union, trans-border payments have the same status as payments

within a nation state.

10

The official denomination is monetary and financial institutions (MFI), but the name “banks” or “commercial banks” conveys the underlying function more intuitively. 11

“The effects of the Eurosystem’s monetary policy operations appear on the balance sheets of a number of central banks. Given that the Eurosystem conducts a single monetary policy, its financial statements should reflect the financial impact of, and describe, the operations conducted by all euro area central banks as though they were one single entity. Consequently, the preparation of the Eurosystem’s financial statements requires the consolidation of all NCB and ECB data.” ECB Monthly Bulletin April 2012: 88. 12

“The currency issued in a CU *currency union+ is the domestic currency of the CU. It should always be considered a domestic currency from the viewpoint of each member economy, even though this currency can be issued by a nonresident institution (either another CUNCB [CU national central bank] or the CUCB [central bank]). One consequence is that, in a CU, from a national perspective, holdings of domestic currency can be a claim on a nonresident.” IMF, 2009:257. 13

Foreign exchange reserves are the equivalent of narrow money in the international context. Of course, economic agents can also draw on foreign assets they own, which is a form of “broad international money”. 14

The wide-spread confusion of economic countries and member states of the Euro Area results probably from the fact that as juridical entities member states still record national balance of payment statistics which summaries the economic relationships between residents and non-residents of an economy, while currency areas with a centralized government do not do so. However, even this convention has some arbitrariness. The System of National Accounts (United Nations, 2008:17) defines residency in non-jurisdictional terms: “The concept of residence in the SNA is not based on nationality or legal criteria. An institutional unit is said to be a resident unit of a country when it has a center of predominant economic interest in the economic territory of that country; that is, when it engages for an extended period (one year or more being taken as a practical guideline) in economic activities on this territory.” The difficulties of allocating all payments to regional

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Intra-currency area payments

The distinction between payments within the monetary union and the rest of the world (RoW) can be

shown by a stylised example.15 Let us assume our currency area consists of only two countries,

Germany and Italy. It operates through the Eurosystem, in which the European Central Bank (ECB) is

integrated with national central banks (the Bundesbank and the Banca d’Italia). The ECB decides on

monetary policy and manages the foreign reserve assets for the Union. National central banks act as

intermediaries that hold the deposit accounts of commercial banks16 and have a net claim on the

ECB’s reserve assets.17 Now imagine someone in Italy imports goods from Germany for an amount of

€120.18 The transaction is settled in domestic currency through the banking system. The importer’s

local bank makes a transfer to the exporter’s bank through the payment system of the Eurosystem:

the Italian bank’s account with the Banca d’Italia is debited by €120, while the German bank’s

account with the Bundesbank is credited by the same amount.19 Hence, the claims of the German

economy on the Eurosystem increase by €120 and the net claims of Italy decline as a result of

debiting the Banca d’Italia accounts. For Germany,20 the reserve asset claim on the ECB increases and

as a balancing item bank deposits (i.e. the broad money component held in German banks) increase

as well; by contrast, in Italy, the claim by Banca d’Italia on the ECB is reduced and so is local money

supply.21 However, the transaction is neutral for the Eurosystem as a whole; the overall amount of

foreign reserve assets and money supply does not change. See Table 1. This is how payments are

made within a currency area.

residents within the currency area are substantial, and while they can possibly be solved for trade flows (IMF, 2009), they are literally impossible for movements of cash (Jobst, 2011). Balance of payment statistics are much more reliable for international payments between territories with different currencies, because commercial banks acquire foreign currency for their clients from the central bank and these transactions are well documented. 15

The following is based on IMF, 2009:265-268. 16

According to the ECB, there are three main reasons for having a “system of central banks” in Europe instead of a single central bank: (1) The Eurosystem approach builds on the existing competencies of the NCBs, their institutional set-up, infrastructure, expertise and operational capabilities. Several central banks also perform additional tasks beside those of the Eurosystem. (2) Given the geographically large Euro Area and the long-established relationships between the national banking communities and their NCB, the credit institutions should have an access point to central banking in each participating Member State. (3) NCBs are better suited to deal with the multitude of nations, languages and cultures in the Euro Area instead of the supranational ECB. See: http://www.ecb.int/ecb/educational/facts/orga/html/or_002.en.html 17

National central banks are remunerated for these claims. 18

The same logic would apply if we consider the net purchase of German securities by Italian investors. 19

These claims show up in the ECB balance sheet as “intra-Eurosystem claims” which are netted out in the consolidation of the Eurosystem balance sheet. Sinn and Wollmershaeuser (2011) have interpreted the claims by national central banks on the TARGET2 payment system as reflecting current account payments. In our simplified example here, where no autonomous financial transactions are taking place, this would be valid, but when one takes cash payments (Jobst, 2011) and autonomous credit and payment flows between banks (Collignon, 2012) into consideration this is no longer correct. It is also worth noting that intra Eurosystem claims can only be interpreted as potentially risky if the commitment by political authorities to sustain monetary union is put into question. Economically, they have no significance. 20

It is useful to recall that all transactions are made by individual actors; Germany or Italy do not exist as actors. These are simply names for a group of actors who happen to live in the jurisdiction of a state. 21

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Inter-currency area payments

Next, we look at international payments into a different currency area. Assume Germany exports

goods worth €150 to the United Kingdom. The transaction is settled in GBP, which implies that the

German exporter sells his foreign exchange receipts to his German bank and his account is credited

€150. The bank sells now the foreign currency to the Eurosystem and its account with the

Bundesbank is credited by the equivalent amount. Thus, the ECB increases its reserve assets and the

account of the Bundesbank with the ECB is credited by €150. Net claims by Germany on the ECB have

increased and so has broad money supply in Germany. Nothing has changed in Italy, but for the Euro

Area as a whole reserve assets and money supply have increased. See Table 2. Of course, a net

import from the rest of the world into the Euro Area would have the opposite effect of reducing

reserve assets and money supply, assuming that the ECB does not sterilise the variations in reserve

assets. However, if the ECB had reasons to be concerned about price stability, it would tighten

monetary policy by selling domestic assets equivalent to the foreign assets it bought. In that case,

monetary tightening would negatively affect growth in the non-exporting member states. For our

argument here we can assume that prices remain stable and the ECB accommodates the growth-

induced demand for liquidity. Export-led growth in Germany is then compatible with relative

stagnation in Italy.

Table 1. Intra-Euro Area payments

Bundesbank opening balance sheet Banca d'Italia opening balance sheet Eurosystem opening balance sheetAssets Liabilities Assets Liabilities Assets Liabilities

Net claim on ECB 200 Banknotes 1000 Net claim on ECB 200 Banknotes 600 Net claim on ECB 400 Banknotes 1600

(reserve asset) (reserve asset) (reserve asset)

Domestic assets 950 Bank deposits 150 Domestic assets 550 Bank deposits 150 Domestic assets 1500 Bank deposits 300

(claims on German residents) (claims on Italian residents) (claims on Italian residents)

Total 1150 Total 1150 Total 750 Total 750 Total 1900 Total 1900

Balance of PaymentsGermany Italy

credit debit credit debit

Current account Current account

goods 120 goods 120

Financial account Financial account

reserve asset 120 reserve asset 120

Bundesbank closing balance sheet Banca d'Italia closing balance sheet Eurosystem closing balance sheetAssets Liabilities Assets Liabilities Assets Liabilities

Net claim on ECB 320 Banknotes 1000 Net claim on ECB 80 Banknotes 600 Net claim on ECB 400 Banknotes 1600

(reserve asset) (reserve asset) (reserve asset)

Domestic assets 950 Bank deposits 270 Domestic assets 550 Bank deposits 30 Domestic assets 1500 Bank deposits 300

(claims on German residents) (claims on Italian residents) (claims on Italian residents)

Total 1270 Total 1270 Total 630 Total 630 Total 1900 Total 1900

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This analysis throws an interesting light on the role of balance of payments for the Euro Area: if

Germany is the export champion into the rest of the world, it earns the foreign currency which other

net importers in the Euro Area can spend without running into balance of payment crises. This is

clearly a win-win situation, for it allows to allocate resources efficiently (buying cheaply abroad) in

deficit economies, while it increases net financial wealth in surplus countries. Hence, by lifting the

foreign exchange constraint on deficit countries, European monetary union is trade-creating in the

global economy. These benefits are a major reason why small countries have an interest in joining

and staying in the monetary union. One may argue, however, that the export strength of Germany is

keeping the euro-exchange rate against the rest of the world higher than is advantageous for the

deficit countries. However, that raises again the question of how adjustment within the Euro Area

affects member states.

This analysis does not imply that member states in the currency area are able to run deficits without

constraints. If regional economic growth slows down below the rate at which the debt service can be

assured, the risk of debt defaults increases rapidly. Once the solvency of debtors in stagnating

regions is in doubt, financial markets will massively shorten their exposure to private and public

debtors residing in these states. The resulting financial outflow will aggravate the problems of

economic growth and cause a negative feedback loop. Thus, fundamental factors and market

expectations may mutually reinforce each other and political conflicts will further enlarge these

effects. There is evidence that in the Euro crisis financial markets have responded more to political

news and uncertainties than to economic fundamentals (Collignon et alt. 2013). This fact points at

the need to reform the governance of the Euro Area, but it says little about the need for adjustment

within a currency area.

1.2. The role of the non-tradable sector

The truth is that monetary union provides its own adjustment mechanism, which is robust in

economic terms, but likely to create political problems. This mechanism is often overlooked in the

literature and in public policy discussions. As we have seen in Table 1, the effect of a regional current

account deficit without a compensating capital inflow is an outflow of money from the deficit into

the surplus area. Ceteris paribus, this reduction in money balances will endogenously generate

Table 2. Outside Euro Area payments

Bundesbank opening balance sheet Banca d'Italia opening balance sheet Eurosystem opening balance sheet

Assets Liabilities Assets Liabilities Assets Liabilities

Net claim on ECB 200 Banknotes 1000 Net claim on ECB 200 Banknotes 600 Net claim on ECB 400 Banknotes 1600

(reserve asset) (reserve asset) (reserve asset)

Domestic assets 950 Bank deposits 150 Domestic assets 550 Bank deposits 150 Domestic assets 1500 Bank deposits 300

(claims on German residents) (claims on Italian residents) (claims on Italian residents)

Total 1150 Total 1150 Total 750 Total 750 Total 1900 Total 1900

Balance of PaymentsGermany Italy

credit debit credit debit

Current account Current account

goods 150 goods 0

Financial account Financial account

reserve asset 150 reserve asset 0

Bundesbank closing balance sheet Banca d'Italia closing balance sheet Eurosystem closing balance sheetAssets Liabilities Assets Liabilities Assets Liabilities

Net claim on ECB 350 Banknotes 1000 Net claim on ECB 200 Banknotes 600 Net claim on ECB 550 Banknotes 1600

(reserve asset) (reserve asset) (reserve asset)

Domestic assets 950 Bank deposits 300 Domestic assets 550 Bank deposits 150 Domestic assets 1500 Bank deposits 450

(claims on German residents) (claims on Italian residents) (claims on Italian residents)

Total 1300 Total 1300 Total 750 Total 750 Total 2050 Total 2050

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macroeconomic adjustment. The money outflow will depress demand and reduce prices and wages

in the deficit economy; the inflow of money into the surplus economy is stimulating growth there.22

Thus, current account imbalances will not last for ever, although the adjustment process may be

slow. This built-in adjustment mechanism is at work in all currency areas, whether nation states or

monetary unions, but not in fixed exchange rate systems. This is precisely why multi-currency

systems, contrary to monetary unions, need the “exchange rate instrument” of nominal

devaluations, while currency unions do not.

Yet, this built-in adjustment mechanism is not pleasant. It causes what Olivier Blanchard once called

“rotating slumps”. These slumps may have disruptive social consequences, which, given that member

states retain authority for policies, may lead to anti-European backlashes.23 Furthermore, recessions

in member states will raise the probability of the regional cumulation of debt defaults. The

conventional policy response is to blame deficit countries and to impose internal adjustment policies

on them; but austerity and drastic real exchange rate depreciations through lower wages are unlikely

to improve regional growth at least in the short and medium run. Germany, to take a prominent

example, has gone through nearly a decade of slow growth when pursuing such adjustment strategy.

The European Commission’s (2012) has acknowledged that European adjustment policies have

weakened economic growth, but it claims that “progress in re-balancing will open up the way for

growth and convergence”. In other words, adjustment is painful, but once the “external” balance is

restored, growth will return.

We now know that this policy view is extremely costly in welfare terms. The medicine could actually

kill the patient.24 The reduction in wages and in private and public spending will in the short run

reduce effective demand below the growth potential, and in the long run it will slow down the

potential growth rates themselves, because there will be more bankruptcies, less investment, and

rising unemployment.25 All this makes servicing debt more difficult. If the response to increasing

default risks is more austerity, the economy will collapse in a negative feedback loop, as one has

witnessed in Greece. The question is whether other policy options are available. This is where the

distinction between domestic and foreign currency becomes crucial. If a currency area runs out of

foreign reserves, its external debt will become unsustainable and a real devaluation must shift the

incentives toward generating net exports and attracting foreign investment. In monetary union, this

is certainly one policy option, but not the only one. What is needed is generating economic growth

out of which the debt can be serviced and it does not matter whether it originates in the tradable or

non-tradable sector. An alternative to “internal adjustment” is therefore to stimulate internal

demand in the non-tradable sector. I will now show that economic growth in member states can be

sustained by investment in the non-tradable sector without risk for price stability.

Because aggregate demand is related to the growth of money supply, the effects of stimulating

demand in the non-tradable sector can be shown by including the non-tradable sector into Table 1.

22

This mechanism resembles the classical specie-flow-mechanism of the pure Gold Standard. 23

For the destabilising effects of the crisis see Mongelli, 2013. 24

Interestingly, Dawson (2004: 246) has noted similar mistakes during the Asian crisis: “tight monetary and fiscal policies and immediate, radical restructuring of financial markets turned out to be the wrong medicine. Fund programs did not quickly restore confidence, and exchange rates continued their decline”. What seems to have helped to restore growth was “expanded flow of bank credit” and “the policy of credit ease pursued by the monetary Authorities” (p251). In Europe, political authorities under German leadership are killing the patient, while the ECB keeps him alive. 25

For econometric evidence that negative output gaps reduce long run growth, see Collignon, 2013.

11

By definition, this sector does not affect the balance of payments. For simplicity, we assume that the

Italian government borrows from commercial banks to finance local services. Commercial banks then

need to refinance themselves by obtaining liquidity from Banca d’Italia. Let this demand for

increased central bank money be €120. Referring back to Table 1, we see that domestic assets in

Banca d’Italia’s balance sheet will increase from €550 to €670 and Bank deposits will grow by the

same amount from 30 to 150. Ceteris paribus, domestic assets, as shown by the integrated balance

sheet of the Eurosystem, increase also by €120 and money supply in the Euro Area goes up to €420.

So far, this is a standard model of expansionary monetary policy. However, let us assume that

monetary policy is committed to price stability. As in the case of a current account surplus with the

rest of the world, the central bank has to decide whether it is willing to accommodate the increase in

money supply. If it considers this to be incompatible with price stability, it will raise interest rates and

credit demand will slow down. Given that public spending is less sensitive to interest rates than

private credit demand, we now assume that domestic assets and bank deposits will fall in Germany

by the same amount (€120) as they have increased in Italy, so that Euro Area money supply and

prices remain constant over the medium term. In this case the combined effect of an Italian trade

deficit plus stimulus in the non-tradable sector increases bank deposits in Italy to €150 (see Table 3)

and leaves Germany with bank deposits of €150, which was exactly the original position in the

balance sheets of Banca d’Italia and the Bundesbank shown in Table 1. Of course, in reality the

adjustment may not be as symmetric as in our example, but the point is to show that, in principle, it

is possible to compensate the depressive features of negative regional trade balances by stimulating

demand in the non-tradable sector without jeopardising price stability and the sustainability of debt

in deficit countries of monetary union.

For economists who believe that Italy and Germany are still separate economies - as they were until

1999 – this may look like voodoo economics. How can a country accumulate foreign debt without

paying it back by future surpluses? The miracle is possible because the debt is repaid not in foreign,

but in domestic currency available anywhere in the Euro Area. The sustainability is not assured by

gaining sufficient foreign currency, but by each debtor fulfilling the solvency constraint whereby

future discounted income matches the outstanding debt. In other words, debtors are responsible for

their liabilities not as a community but as individual borrowers. This is a fundamental difference

between a monetary union and a fixed exchange rate system. If a currency area would not work like

an integrated payment union in this way, no nation state would ever have survived. Italy’s north and

south would have separated, the United Kingdom would have split into England and Scotland, and

Bavaria would have introduced its own currency.

Table 3. Balance sheet position after non-tradable credit expansion in Italy

1. Ater the initial credit expansion

Bundesbank balance sheet Banca d'Italia balance sheet Eurosystem closing balance sheet

Assets Liabilities Assets Liabilities Assets Liabilities

Net claim on ECB 320 Banknotes 1000 Net claim on ECB 80 Banknotes 600 Net claim on ECB 400 Banknotes 1600

(reserve asset) (reserve asset) (reserve asset)

Domestic assets 950 Bank deposits 270 Domestic assets 670 Bank deposits 150 Domestic assets 1620 Bank deposits 420

(claims on German residents) (claims on Italian residents) (claims on Italian residents)

Total 1270 Total 1270 Total 750 Total 750 Total 2020 Total 2020

2. After tightening money supply

Bundesbank balance sheet Banca d'Italia balance sheet Eurosystem closing balance sheetAssets Liabilities Assets Liabilities Assets Liabilities

Net claim on ECB 320 Banknotes 1000 Net claim on ECB 80 Banknotes 600 Net claim on ECB 400 Banknotes 1600

(reserve asset) (reserve asset) (reserve asset)

Domestic assets 830 Bank deposits 150 Domestic assets 670 Bank deposits 150 Domestic assets 1500 Bank deposits 300

(claims on German residents) (claims on Italian residents) (claims on Italian residents)

Total 1150 Total 1150 Total 750 Total 750 Total 1900 Total 1900

12

A common objection to this view is that nation states and federations are sustained by the solidarity

of fiscal transfers, which citizens are willing to pay within their nation, but not for others. Yet, the

cohesive power of solidarity quickly fades when economic benefits are in doubt, as one can witness

in Flanders, Lombardy, Scotland, Catalonia or Bavaria. More importantly, as Fatás (1998) has shown,

the stabilising effects of automatic interregional transfers are grossly overvalued. If this is so, the

monetary adjustment mechanism explains how the payment union is sustained.

1.3. Implications for economic adjustment

We can now sum up how macroeconomic imbalances work out in a monetary union: a current

account deficit within the currency area shifts the distribution of wealth and money supply from the

net importer to the net exporter, but does not affect macroeconomic aggregates of the area. The

distributional effects are not banal: surplus countries increase their financial net wealth, while

deficits countries become financially poorer – although they may gain from the more efficient

allocation of resources and capital that over time could narrow the gap between high and low

income countries. Nevertheless, the monetary union is robust, because deficit countries cannot run

out of reserves. Foreign reserves are irrelevant for the transactions between member states. For

domestic transactions, money balances are needed and they are obtained either by borrowing from

commercial banks in the surplus countries, or from the Eurosystem, which guarantees equal access

to liquidity for all solvent banks in the Euro Area. As long as this is compatible with the money supply

polices, the outcome is Pareto optimal; if the ECB tightens monetary policy in order to preserve price

stability, export-oriented economies have a comparative advantage. Hence, the fragility of the Euro

Area is not in the economics, but in the politics of monetary union: distributional conflicts may

undermine the popular acceptance of the euro and the policies by which it is ruled.

While one may agree that current account deficits are irrelevant for the payment mechanism within

the monetary union, one could argue that the accumulation of large “foreign” debt positions will

become problematic. Indeed, a large negative net international investment position, which reflects

the accumulation of past current account deficits, may not be sustainable. However, liabilities within

the Euro Area are not “foreign” debt and should not be counted as a component of the international

investment position. We have seen that intra-Euro Area deficits do not build up external

indebtedness, because they are domestic borrowings, which are repaid by transferring domestic

money. The only international investment position that matters is the foreign debt of the Euro Area.

This makes a huge difference for the adjustment mechanisms.

The overall purpose of adjustment within a currency area is to guarantee the stability of the financial

system. Intertemporal solvency requires that the discounted value of future income is equal to

today’s debt. Domestic debt solvency requires income in domestic currency, while liabilities to the

rest of the world must be paid in foreign currency. Hence, intra-Euro Area debt is settled by drawing

on deposits in local banks and it makes no difference for the sustainability of domestic currency debt

where the source of future domestic income is located.26 Domestic income may be generated by

exporting to other member states (improving the trade balance) or by economic growth originating

in the non-tradable sector. But as long as the domestic solvency constraint is met, there is no need to

switch expenditure from the non-tradable to tradable goods sectors. For example, Italy may have a

26

However, the loss of deposits may destabilise banks in the region, as they become more dependent on liquidity borrowed in the interbank market or from the Eurosystem. We cannot pursue this logic here, but is a powerful argument for a banking union in Europe.

13

fast growing non-tradable service sector, which imports capital equipment from Germany. If this

investment is financed by bank credit, it will at first increase money supply in Italy, while the

payments to German suppliers will reduce money holdings in Italy again. Thus, the credit-financed

investment in the non-tradable sector can compensate the outflow of money balances from the

deficit country. As long as profits in the non-tradable sector are sufficient to service the debt,

solvency is assured.

In aggregate, this logic requires that the economic growth rate in the region is larger or equal to the

average interest rate in order to fulfil the solvency constraint. But this means also that, contrary to

the claims by new mainstream orthodoxy, one cannot judge competitiveness by developments in the

tradable sector alone. Instead, competitiveness must be measured by the overall profitability of the

national capital stock, because that determines whether the region is able to attract new investment,

and whether the contracted credit liabilities are sustainable. How to use this criterion for assessing

competitiveness empirically will be shown in the next chapter. Here, we need to insist that balance of

payment accounting is not the appropriate instrument for detecting imbalances in the Euro Area. The

proper tool for analysing payment flows in a monetary union is flow-of-funds analysis which gives a

more differentiated picture of macroeconomic imbalances in the Euro Area. By using flow of fund

analysis we will also discover that simply comparing returns to capital is not sufficient for a full

picture of competitiveness.

2. Flow of funds in European monetary union

Flow of funds analysis measures payment flows across the economy and presents the financial assets

and liabilities of all institutional sectors in the Euro Area, i.e. households, financial and non-financial

corporations (NFC), government and the rest of the world. Similar to profit and loss, cash flow and

balance sheet statement in business accounting, flow of funds accounts provide a coherent and

integrated picture of the financial wealth of an economy and its variations. They are tracking funds as

they move from sectors that serve as sources of capital, through intermediaries (such as banks,

mutual funds, and pension funds), to sectors that use the capital to acquire physical and financial

assets (Teplin, 2001). Because changes in competitiveness will inevitably affect payments, the flow of

funds is a useful tool for analysing imbalances in the Euro Area.

2.1. The conceptual framework

One distinguishes between economic and financial accounts. The economic accounts record “real”

economy transactions in accordance with the European System of Accounts (ESA)27 and show how

various categories of income (GDP) are first allocated as primary income to labour and property

(national income) and then reallocated through the secondary distribution of transfer payments.

Disposable income (retained earnings for the corporate sector) is either spent on consumption and

investment or saved and lent to other agents, which means savings are used to purchase financial

assets. The financial accounts, on the other hand, are a picture of the financial wealth and record the

balance sheet positions of assets and liabilities in the different sectors and their variations over a

period of time. These variations are split into changes due to transactions which reflect the balance

of the economic accounts, and other changes which represent write-offs or changes in values of

assets and liabilities. The financial transactions indicate, therefore, how the financial net wealth of

27

See United Nations, 2007 and also any of the General Notes in the ECB’s Monthly Bulletin.

14

institutional sectors and economies change. The link between the economic and financial accounts is

the capital account.

Because transactions are recorded as net purchases (or net sales) at the current market prices,

exchanges within a sector—for example, the sale of equities by one corporation and the

corresponding purchase by another corporation — cancel each other out and do not show up in the

sectoral accounts. Transactions between sectors, on the other hand — such as the sale of equities by

a household to a mutual fund or the purchase of government bonds by households or banks — are

recorded as a negative value for the sector selling the instrument and a positive value for the sector

purchasing the instrument (Teplin, 2001:433). For the same reason, transactions within the same

aggregate sector but between different national sectors, say between Italian and German non-

financial corporations, may appear as imbalances in national accounts, but they cancel out in the

Euro aggregate. Hence, nationally disaggregated flow of funds statistics can reveal macroeconomic

imbalances not only with respect to borrowing or lending between different member states (i.e.

current account positions), but also between institutional sectors within the currency area. However,

most importantly, flow of funds accounts present a fully integrated picture of an economy, because

the lending of one sector must have a borrower in another sector as its counterpart. To clarify the

principles, we will first concentrate on the Euro Area as a whole.

The transaction balances between institutional sectors are easily derived from the standard national

income identity, whereby income reflects expenditure on consumption, investment and net exports:

Y = C + I + X – M

Amalgamating first for simplicity the financial and non-financial corporate sector, we show in Table 4

how the four institutional sectors of the economy interact.28 The bottom line is the sum of all sectors

of the economy. Y1 is the factor income earned by households (wages, rents, etc.). Y2 stands for

corporate profits plus rent, Y3 for the same by government enterprises. After the generation of

primary income by the factors of production, income is redistributed between sectors by the

payment of transfers (T), which increases or reduces disposable income in the sectors. For example,

the corporate sector pays social security contributions, which benefit households. Obviously, the sum

of all transfers is zero. C1 and C3 are consumer expenditure by households and government and the

difference between income and consumption is gross savings. The I’s reflect investment in the

different sectors, but usually the corporate sector is driving investment.

Reading across the rows of Table 4, it is apparent that individual sectors may have a surplus or deficit

of savings over investment. In the flow of funds statistics of the European Union the financial

28

This exposition is based on Fleming and Giugale, 2000. Later we will separate financial and non-financial corporations.

Table 4. Basic accounting identities of national incomeIncome Transfers (net) Consumption Investment Trade balance = Financial surplus / deficit

Households Y1 + T1 - C1 - I1 = F1

Corporate sector Y2 + T2 - I2 = F2

Government Y3 + T3 - C3 - I3 = F3

Rest of the World Y4 + T4 - I4 - X + M = F4

Total Y 0 - C - I - X + M 0

15

surplus/deficit is called net lending (+) or net borrowing (-) of the different sectors. Because saving is

income minus consumption, the financial balance of a sector is in surplus if its savings exceed

investment. Wealth owners will then acquire financial assets (claims on other sectors or cash) instead

of real resources for productive purposes.29 The mirror image is net borrowing (incurring net financial

liabilities) by a sector where investment exceeds savings. However, for the economy as a whole,

domestic and foreign savings must be equal to total investment.

The transactions in the fourth sector are entered from the point of view of the rest of the world, and

not from the point of view of the domestic economy. (Y4 + T4) is income and transfers claimed by the

rest of the world, while (X – M) is net exports. Thus, if the foreign sector is in surplus (F4 > 0) , the

domestic economy must make payments to the rest of the world that are larger than the earnings

from net exports; thus, the rest of the world is lending and the economy’s current account balance is

in deficit. In that case, part of GDP will be owned by non-residents. On the other hand, if the trade

balance is positive and few external liabilities exist (F4 < 0), the domestic economy is lending to the

rest of the world and building up financial claims against non-residents. This is why current accounts

in surplus are often associated with high competitiveness.

3.2 Financial flows in the Euro Area

Standard text books assume that households’ revenue exceeds their expenditure, so that they are

net lenders to the rest of the economy. Non-financial Corporations are supposed to be borrowers

because they do not cover their investment out of cash flow. They must therefore finance at least

part of their investment by borrowing from other sectors. Financial corporations are intermediaries,

which lend out the resources they borrow. Ideally, the government and the external sector are in

balance. However this is rarely the case. In Europe, governments usually borrow (i.e. run deficits),

and the Euro Area in aggregate has at times been a lender and at others a borrower vis-à-vis the rest

of the world.

Figure 1 shows the evolution of the financial surplus/deficit for the four domestic sectors of the Euro

Area and for the rest of the world.30 Before the crisis, balances were relatively stable. When the so-

called dot.com bubble in the IT sector burst and the attacks of September 11 destabilised financial

markets worldwide, monetary policy became very accommodating. However, the excess liquidity

then generated the next credit boom which crashed in 2007-8. During that early easy money period,

Euro households were saving less and many borrowed to invest in the real estate boom, especially in

the south. Non-financial corporations, which had previously cut down on their investment, now

started to borrow again. By contrast, governments reduced their deficits, although arguably not

enough to bring their debt levels significantly down.

The global financial crisis started with liquidity problems at Bear Sterns in August 2007 and fully

erupted with the Lehman bankruptcy in September 2008. After this event, all economic agents

changed their behaviour. In Europe, households’ savings increased strongly, reflecting their risk-

averse behaviour in a climate of general uncertainty. Companies stopped borrowing instead of

29

When firms are repaying debt, this can be interpreted as acquiring a debt claim from creditors against themselves. 30

As pointed out above, the rest of the world (RoW) is the mirror image of the aggregate balances of the Euro Area. A positive value for RoW indicates lending by non-residents, which is equivalent to a current account deficit.

16

investing their retained earnings. In 2010, non-financial corporations even became net lenders,

which means they used their profits to repay debt and deleverage their balance sheets. Governments

were negatively affected by the sudden drop of GDP in the crisis; the associated loss of revenue

increased budget deficits, but this fact also stabilised the Euro economy because governments

borrowed the excess savings from households and NFCs. After the election of a new government in

Greece in late 2009, the sovereign debt crisis pushed policy makers in the Euro Area into precipitated

fiscal consolidation. With all the main domestic sectors – households, corporations, governments –

increasing their savings and no one borrowing, the Euro Area fell into its second recession which

translated into a prolonged depression in the southern member states. The external accounts of the

Euro Area with the rest of the world (RoW) had remained largely in balance before the Euro crisis,

but now they turned into surplus. Given the difficult international environment, borrowing by non-

residents also remained sluggish so that foreign investment presented few alternative outlets for

domestic euro savings. Instead, the combined excess savings of households, corporations and

governments were used to reduce outstanding domestic and foreign liabilities. This fact may have

helped to improve the Net International Investment position of the Euro Area, but when the

corporate sector does not invest in the formation of domestic capital, economic growth will come to

a halt (Ahearne and Wolff 2012). The question is then why did the non-financial corporations in the

Euro Area stop investing and borrowing from the other sectors?

Figure 1.

3.3 Competitiveness and investment

The classic argument for explaining investment is that companies invest in order to make a profit.

They allocate funds to those projects, which yield the highest return. Thus, the capacity to earn high

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12

HH_RATIO NFC_RATIO

MFI_RATIO GOV_RATIO

ROW_RATIO

Flow of Funds: Euro Area

Gross lending (+) / net borrowing (-) by institutional sectorsfour quarters cumulated sum as percent of GDP

Lehm

an

LT

RO

17

returns to capital reflects high competitiveness. However, at the time a firm makes the decision to

invest, the future returns are uncertain. The larger the chance that the future returns will be

different from what is expected, the larger the risk. If firms are risk averse, higher returns may not

automatically guarantee higher investment, employment and growth. Additional funds will only be

invested, if the return to capital exceeds the cost of capital plus the risk premium. Companies have

the choice of borrowing and buying real resources for productive purposes or of using their cash flow

for redeeming liabilities or acquiring financial assets (including cash holdings). A comprehensive

concept of competitiveness must take the effects of risk on corporate decisions into account.31

Figure 2 shows the risk-return trade-off in a simple stylised form.32 The steepness of the trade-off

curve indicates the degree of risk averseness. The return for riskless assets at the intercept of the

required return axis reflects liquidity preference, because by definition liquid assets (money) are the

least risky assets. The risk premium is the difference between this risk-free required return and point

on the trade-off curve. If the expected return on capital is below the trade-off curve, no investment

will be forthcoming. Thus, if the perceived risk in the firm’s environment increases, or if risk

averseness or liquidity preference increases, higher returns to capital are required in order to cover

the higher risk premium. If the firm wants to remain competitive, i.e. maintain the firm’s share in the

economy’s long term growth, it must increase the return to capital. The degree of uncertainty in the

environment within which firms are operating is then an essential part of competitiveness.

Figure 2.

In a financial crisis, the sudden drop in aggregate demand and the increased perception of risk are

raising the preference for holding wealth in liquid form rather than investing it in resources. The crisis

is therefore a cause and not only the effect of lower competitiveness. With persistent uncertainty,

risk-averse entrepreneurs will also seek to reduce outstanding liabilities. This deleveraging process

will become the dominant corporate strategy in financial crises, because the value of assets is

deteriorating while liabilities are nominally fixed, so that corporate equity will be reduced (Koo,

2002). Paying back debt will then help to restore shareholders’ wealth, but it may have the

unintended aggregate consequence of lower output and employment.

This places the competitiveness issue into a new context: firms may not invest because their costs

are too high and profits too low (see chapter 2), but also because they operate in an environment

31

See also Stiglitz and Greenwald, 2003: 175-182 32

For a formal model of this argument see Collignon, 2002b

18

that is too uncertain to justify spending money on capital accumulation. Of course, higher risks

require higher returns on capital in order to compensate for the potential losses, but at these high

returns there are usually less investment opportunities available. Furthermore, if uncertainty is very

high, it may be practically impossible to compensate the risk premium for investment by raising

profits in the corporate sector.33

How can an economy become more competitive? Our analysis says that firms should increase their

returns and policies should reduce uncertainty. In order to improve profits, firms could increase their

gross operating surplus by cutting wages, but from Table 4 it is clear that this would be

counterproductive when the reduction in Y1 is not fully compensated by an increase in Y2, which may

result from the fact that households have less income to spend and do not reduce savings sufficiently

to keep consumption stable. In that case, compensating public policies could substitute for the wage

reduction by increasing public consumption and a fiscal stimulus would increase corporate

profitability. Aggregate income would be stabilized as private consumption will be shifted to public

consumption. However, this raises distributional issues for the tax burden and its consequences for

investment.

Other than cutting wages, paying lower transfers could also increase profits in the corporate sector.

Structural reforms in the system of secondary income transfers can shift net benefits from

households to corporations and thereby improve competitiveness. Such reforms are typically

associated with the Hartz IV Reforms in Germany (see S. Dullien in chapter 8 of this book34).

However, while wages and gross operating surplus are key variables for the primary distribution of

income, one should not forget that the cost of capital, and in particular interest liabilities, need to be

serviced out of current cash flow. The balance of primary income, which takes into account the rental

cost of capital, or retained earnings, which are a measure of corporate income after the secondary

redistribution, are therefore better indicators for corporate profitability.

Which of these two dimensions, low profits or high uncertainty, provides a better explanation for

Europe’s lack of competitiveness and anaemic corporate investment performance? Flow of fund

analysis allows detecting the effects of corporate strategies and their consequences for other

sectors. Figure 3 shows corporate incomes and savings in the Euro Area as a percentage of GDP. The

gross operating surplus has risen during the pre-crisis boom, but it fell in the crisis. In 2010 it

improved, reaching levels of the early 2000s, but the austerity policy since 2011 has again reduced

net income for Europe’s non-financial corporations. Nevertheless, these developments were in part

corrected by the strong reduction in the cost of capital and especially the reduction in interest

payable, although the Euro crisis has pushed the cost of capital up again. As a result, corporate

primary income is now back to the level, where it was before the crisis. Furthermore, tax and social

transfer payments have also come down during the crisis, so that retained earnings of NFCs, which

are a good measure of corporate cash flow, are now higher than they were before the Lehman shock.

Yet, despite this improved financial situation, companies are not investing. Even the unconventional

monetary policies (LTRO) at the end of 2011/early 2012, which have responded to the high liquidity

preference of banks and other economic agents, did not stimulate demand for investment. The

investment ratio has fallen after Lehman by 3 percentage points of GDP and although it has regained

33

In most risk-return models, the trade-of curve is not linearly but exponentially upward sloping. See Collignon, 2002b. 34

S. Collignon and P. Esposito, Competitiveness in Europe, Routledge, forthcoming 2013

19

one point, it is still well below pre-crisis levels. Hence, net borrowing in the corporate sector has not

stopped because of insufficient profits or lack of competitiveness, but because in the prevailing

environment of crisis and uncertainty firms have deliberately used their cash flow to pay back debt.

The Euro Area is caught in a balance sheet recession.35 Hence, Europe’s crisis is less a consequence of

structural weaknesses than of uncertain expectations by investors. Restoring trust and confidence is,

however, the task of governments and in this they have failed miserably.36

Figure 3.

35

For the theory of balance sheet recessions, see Koo, 2002. 36

See for example Collignon et alt. 2012 for evidence how statements by the German Chancellor Merkel have pushed up the risk premia in bond markets.

18.5

19.0

19.5

20.0

20.5

21.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Gross operating surplus

7.0

7.5

8.0

8.5

9.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Net interests and property charges

10.5

11.0

11.5

12.0

12.5

13.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Balance of primary incomes

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Net taxes and social transfers

8.0

8.5

9.0

9.5

10.0

10.5

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Retained earnings / gross saving

9

10

11

12

13

14

99 00 01 02 03 04 05 06 07 08 09 10 11 12

INVESTMENT

Euro Area: corporate income and investment

Sept

11th

Lehm

an

LR

TO

in p

erc

ent

of

GD

P

Source: ECB

20

The reluctance to invest in real capital and the massive use of cash flow to reduce debt can be

explained by liquidity preference in an environment of great uncertainty. Holding cash and deposits

reduces the risk of running into liquidity problems when clients default on their obligations or banks

ration credit to their clients and refuse to roll over credit. Figure 4 presents the ratio of currency and

deposits held by NFCs relative to loan liabilities as a measure of liquidity preferences. Since the

Lehman crisis, the ratio has risen by nearly 25 percent. A closer inspection reveals that in the early

2000s and again after 2004 cash and deposits grew at a stable rate, but corporations increased their

borrowings more than cash. Hence, the ratio came down in those years. By contrast, after the

Lehman shock the volume of loan liabilities either stagnated or fell, while liquid assets still continued

to increase at a steady rate, so that the cash/loan liability ratio rose up.

Figure 4.

The European Commission (2013) has assessed the impact of uncertainty on consumption and

investment in the Euro Area. It found that uncertainty has increased not only in financial markets but

also for enterprises and consumers. Furthermore, the significant negative effect of uncertainty has

become stronger during the crisis. The study also found that this uncertainty is now at record high

levels in the southern periphery (including Ireland), but remains much lower in the core countries.

These observations explain why liquidity preference and debt de-leveraging have become such an

important factor in the slowdown of investment and economic growth in the southern crisis states.

Figure 5 presents evidence for individual member states. We are using here the disaggregated flow

of funds data provided by Eurostat, which aggregate to the Euro area data for all 17 member states.

Remarkably, the German corporate sector has been a net lender since the early days of monetary

union, although in small proportions. In France, NFCs have been net borrowing except during the

crisis years 2009-10. Spain and Portugal have been the largest corporate net borrowers during the

boom years; Italy borrowed before the crisis, too. But after Lehman and especially since the Greek

debt crisis, non-financial corporation in all six member states have reduced their external borrowing

and even started to repay their debt. Greece is a particular case, as retained earnings have always

exceeded investment to a very large degree. Since the start of the Greek crisis, however, companies

.19

.20

.21

.22

.23

.24

.25

.26

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Liquitity preference in the NFC sector

currency and deposits/loan liabilities

Source: ECB

Le

hm

an

LR

TO

9/1

1

21

have dramatically increased their profitability; retained earnings in NFCs are now nearly 20 percent

of GDP compared to 10 percent in Germany. However, investment has fallen to zero, so that the cash

flow of Greek companies is now nearly exclusively used to repay debt.

The broad picture is very similar in all member states: corporate retained earnings have improved,

but investment ratios have come down. The higher cash flow is used to repay corporate liabilities.

Hence, the Euro Area suffers primarily from insufficient investment and less from supply side factors

like rigid labour markets which prevent higher profits.

Maybe the biggest surprise is Germany’s lack of investment. The industrial hub of the Euro Area has

not invested in domestic production facilities, but lent its retained earnings to the rest of the world,

of which two thirds went to Europe’s south. Why? An obvious explanation is that structural reforms

and wage restraint have improved the competitiveness and cash-flow of German companies, but

local demand was insufficient to justify the expansion of local facilities, so that lending money to the

booming south seemed more attractive than real investment at home. Another explanation may be

that financial innovation in the deeper and more integrated euro market has promised higher returns

for financial assets than for real investment. Chapter 2 looks at the returns on capital in the Euro

Area. The facts reported there confirm this analysis for the early years of European monetary union,

but not for the years after the Hartz IV Reforms. By contrast, before the financial crisis, NFCs in the

south have been borrowing as economic textbooks would lead us to expect. However, the rapid

accumulation of capital generated diminishing returns, which has increased the pressures to

deleverage once the crisis had erupted and – unintentionally – pushed Europe into a balance sheet

recession.

22

Figure 5.

3. Conclusion

The Euro crisis is a challenge on many fronts. Mistaken analysis causes bad policies and bad policies

make the economy worse. By putting competitiveness at the centre of the Euro crisis explanation,

the mainstream was not wrong. Competitiveness matters. But interpreting competitiveness

exclusively through the lenses of macroeconomic imbalances or relative cost distortions does not go

far enough. Because the European Commission largely identifies macroeconomic imbalances with

-8

-4

0

4

8

12

16

2000 2002 2004 2006 2008 2010 2012

Investment GERMANY

Retained Earnings GERMANY

Gross lending (+) / net borrow ing (-)

Germany

-4

0

4

8

12

2000 2002 2004 2006 2008 2010 2012

Investment FRANCE

Retained earnings FRANCE

Gross lending (+) / net borrow ing (-)

France

-4

0

4

8

12

2000 2002 2004 2006 2008 2010 2012

Investment ITALY

Retained Earnings ITALY

Gross lending (+) / net borrow ing (-)

Italy

-10

-5

0

5

10

15

20

2000 2002 2004 2006 2008 2010 2012

Investment SPAIN

Retained Earnings SPAIN

Gross lending (+) / net borrow ing (-)

Spain

-10

-5

0

5

10

15

20

2000 2002 2004 2006 2008 2010 2012

Investment PORTUGAL

Retained Earnings PORTUGAL

Gross lending (+) / net borrow ing (-)

Portugal

-5

0

5

10

15

20

2000 2002 2004 2006 2008 2010 2012

Investment GREECE

Retained Earnings GREECE

Gross lending (+) / net borrow ing (-)

Greece

Source: Ameco and own calculations

Retained Earnings, Investment and Borrowing in some Member States

in percent of GDP

Le

hm

an

LR

TO

23

current account deficits it neglects the imbalances between other institutional sectors in the Euro

Area. This leads them to recommend excessive austerity policies, which have made the crisis worse.

Fringe economists on the left and the right, by contrast, focus on relative price and cost indicators,

which are arbitrary in their construction and devoid of an equilibrium theory as benchmark (for

further evidence, see chapter 2). They therefore do not shy away from recommending a break-up of

the Euro Area. Both these approaches are not sustainable and risk destroying 50 years of European

integration.

The idea that current account positions member states of a currency area need to be balanced

violates the logic and undermines the functioning of an integrated European internal market for

goods and capital. It ignores that deficits within a currency area may reflect efficient resource

allocation; it also leads to the imposition of austerity policies, which not only undermine the

cohesion and support for European integration, but also threaten the stability of the financial system.

Amalgamating intra and extra-European current account balances in the Euro Area is sloppy

accounting, bad economics and dangerous politics.

Similarly, structural reforms of the welfare system and massive wage cuts to restore supposedly

unsustainable cost divergence, as has been advocated by some, are also counterproductive in today’s

European environment. Lower wage cost may improve the return to capital, but if economic and

political uncertainty is high, higher profitability will not necessarily translate into higher investment.

In fact, the mismanagement of the Euro crisis by national governments, which only considered their

narrow tax payers’ constituency instead of the common welfare, has pushed the risk premium up to

levels at which the volume of profitable investment has shrunk considerably. Cutting wages and

transfers to bring actual rates of return to the point where they would compensate entrepreneurs’

risk premia would reduce aggregate demand to levels of unbearable unemployment. These policies

make the crisis worse. They are the kind of policies, which have thrown Europe into turmoil before.

As Feldman (1997:854) concluded in his thorough study of the German economy in the 1920s:

“Germany’s leaders between 1930 and 1933 obviously miscalculated what massive

unemployment, a rollback of the social welfare system, and measures creating even more

extreme misery than 1923 and 1924 would bring. They also failed to realize that the

undermining of parliamentary democracy would create an unprecedented social and political

crisis and unleash forces and tendencies in the political culture quite beyond their control”.

Germany’s leaders seem to miscalculate again the damage austerity and disrespect for European

democracy could cause.

As an alternative to such misdirected policies, this chapter has suggested to take European monetary

union seriously and to analyse it for what it is: an integrated economic area with a payment union. It

was always clear that the single market would not survive without monetary stability in space and

time and the creation of the euro was the only feasible response to the desire of fully integrating the

European economy.

If this is properly understood, the policy discourse must change. It does not make sense to ponder

whether member states with severe debt and growth problems should leave the Euro Area, not even

temporarily. Private and public debt sustainability is to a large degree dependent on economic

growth and large growth differentials threaten the solvency of financial and non-financial

24

corporations. The primary objective for economic policy in monetary union must, therefore, focus on

maintaining balanced growth. Competitiveness in terms of cost and price differentials has a role to

play in maintaining stability, but it is not the only one. A number of important consequences follow.

First of all, stimulating growth in the Euro economy, especially in the peripheral regions, requires that

non-financial corporations start to borrow again in order to invest in real resources rather than repay

their outstanding debt. No doubt, the expectation of higher returns to capital would be an incentive

to invest, provided everything else remains unchanged. However, during the crisis, everything else

has changed. Uncertainty has lowered the propensity to invest and increased liquidity preference.

Improving the competitiveness of the European economy would, therefore, require to restore

financial stability as well and not only to focus on profitability and related structural reforms. The

European Union has privileged austerity as a tool for restoring confidence, but it has underestimated

the damage this has created in peripheral member states, where the slowdown of growth has

threatened the sustainability of private and public debt. By contrast, member states have been

dragging their feet with respect to the banking union, which could strengthen trust and confidence in

the European economy. The hesitations and the back and forth in negotiating positions are

prolonging uncertainty and block the way to recovery.

Second, the Euro crisis is not a balance of payment crisis because member states cannot run out of

foreign currency. Nor is there a problem of “sudden stops” (Calvo, 1998) of capital inflows into

southern member states, although there is a problem with money outflows. True, during the first

decade of the euro, the corporate sector in the north has lent to the south directly or through the

banking system, and these transfers have financed investment and consumer demand and enabled

huge current account deficits. It is also true that this large volume of lending has come to a halt

during the crisis (Merler and Pisani-Ferry, 2012). However, in a monetary union, the reduction in

lending from other member states could be compensated by lending from domestic banks which

refinance themselves through the Eurosystem – provided there is sufficient demand for borrowing in

the corporate sector. This is the quintessential difference to separate currency regimes, where the

expansion of domestic credit and the “printing of money” are causing the immediate depreciation of

exchange rates.37 The main problem of the Euro crisis has been the credit crunch and balance sheet

deleveraging. The crisis was, therefore, not caused by national balance of payments problems, but by

the fragility of the European banking system combined with excessive austerity, which has killed the

appetite for investment.

Third, macroeconomic imbalances in the Euro Area are not correctly represented by current account

positions, but by growth differentials. These divergences point at significant structural distortions,

which certainly need to be addressed. However, the harsh austerity policies imposed on deficit

countries have compounded the supply side problems, because the lack of demand has lowered the

willingness to invest (Collignon, 2013). Economic policies for the Euro Area must therefore

concentrate on balanced economic growth. Balanced growth is also a necessary condition to restore

a sense of social justice and fairness among European citizens. It would therefore sustain the politics

of monetary union.

37

For example during the Asian crisis, the “sudden stop” of foreign capital inflows led to domestic credit expansions in Thailand and Korea and drastic depreciations.

25

Forth, balanced growth implies balanced demand, even when lending from other member states

ceases. The automatic adjustment mechanism in the Euro Area is the outflow of money, unless new

credit is generated in the non-tradable sector. This reduction in money balances can cause “rotating

slumps”. Because monetary policy aims at maintaining price stability for the Euro Area as a whole,

the distribution of money balances becomes a zero-sum game. If Germany pursues an aggressive

export-led growth strategy toward the rest of the world, the burden of adjustment falls on the other

economies. On the other hand, if member states suffer from negative money flows and seek to

stimulate domestic demand by fiscal policy, they are constrained by Europe’s fiscal rules. The Euro

Area’s present fiscal policy framework is not sufficiently developed to deal with these issues. Instead

of imposing identical debt and deficit ratios on each member state, as stipulated by the Stability and

Growth Pact, a more diversified approach is recommendable that would take into account the

developments in the individual member states as well as the aggregate situation in the Euro Area

(Collignon, 2004). Yet, reform of the fiscal framework would need accrued powers at the European

level, which can only happen if European citizens could also exercise their democratic rights at the

European level (Collignon, 2002; Collignon and Paul, 2008).

Fifth, taking European integration seriously also has a political and cultural dimension. Because

people feel emotionally attached to “their” countries, governments use this emotional bond to

preserve their power, but the resulting collective action problems prevent the design and

implementation of policies consistent with the functioning of a currency area.38

We have analysed the mechanisms which turn a currency area into an integrated economy as if it

were one economic nation. But, of course, Europe is not one nation. Polities and civil societies are

fractioned. Policies diverge because there is no epistemic consensus. This is the Achilles heel of the

euro. Protecting the economic interests of European citizens from the disturbing interferences of

national governments is the real challenge revealed by the Euro crisis. It will require a genuine

European government, but that will be the subject of another chapter in Europe’s history.

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