The answer to this question is an unambiguous “yes”. It is not possible, it is true, to have a currency crisis inside a currency union, provided the currency union is credible, though currency risk returns, implicitly, as soon as it is not. But balance-of-payments and currency crises are NOT the same thing. A balance-of-payments crisis can show itself in a currency union in one (or, more likely, both) of two ways: as a credit crisis or as a regional economic slump.
The fundamental point was made by the British economist, Tony Thirlwall, in a column entitled “Emu is no cure for problems with the balance of payments”, in the Financial Times of October 9 1991. In this he was responding to the then widespread argument that “we don’t talk about the balance of payments difficulties of Scotland, Wales and the North of England, or of Sicily and Apulia. But this does not mean that they don’t exist.”
Let us start at the most basic level: that of the individual. Can individuals have a balance of payments crisis? Certainly.
Such a crisis was defined by Wilkins Micawber, a character in Charles Dickens’ David Copperfield. The Micawber principle is:
“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Of course, we would not think of this as a balance-of-payments problem, but rather as a budget problem. If one has expenditures that seem necessary, but are impossible to finance, one has a budget problem. If one is poor enough, one can die of one’s budget problem. Billions of human beings are still vulnerable to this threat today.
The Micawber principle suggests that running a financial surplus is good, while running a deficit is bad. Most people understand this idea. Yet, interestingly, literature offers us a more general budgetary principle. This comes from Polonius, in William Shakespeare’s Hamlet.
Polonius advised his son Laertes:
“Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.”
The Polonius principle is in Micawber’s terms: Annual income twenty pounds, annual expenditure twenty pounds, result happiness; Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result unhappiness (since one is likely to lose both the money one lends and the friendship of the person to whom one lends it); Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery (due to looming bankruptcy).”
Of course, the Polonius principle would be modified if one had a store of value that was not itself based on debt. Austrian economists will point out that such a store does exist: gold. But gold is an unproductive asset. The more general point is that the spending should properly include investments in productive assets.
Anybody who looks at the eurozone today will understand that the Polonius principle has proved cogent. The creditors are, it is true, more powerful than the debtors, as Micawber recognised. But how much happier are they? They are, after all, well on the way to losing the money they lent and the friendship of those to whom they lent it, as Polonius warned. Polonius is at least partly right: lend much less and at least lend much more wisely than creditors have been doing.
Micawber and Polonius were, of course, propounding budgetary principles for individuals. But the balance of payments constraint is no more than a budget constraint for an aggregate of people living within a defined area.
A country is an aggregate of people living and working side by side within a given physical area. What defines a country, for our purposes, is the absence of fiscal transfers across borders, but their presence within them. Normally, there is also some degree of stickiness in the flow of factors of production — labour and capital — across national borders and some residual obstacles to cross-border transactions.
Inside a country, people will engage in two kinds of production — of tradeables and non-tradeables. The former will consist of goods and services that can be shipped easily outside the country. The latter will consist of goods and, especially, services, that can be consumed easily only by those present inside the country. Tourist services will consist of services consumed by foreigners who visit the country, for precisely that purpose.
A country’s consumption of tradeables must equal its production of tradeables, plus net sales of financial claims and real assets to foreigners, mostly by borrowing or lending. A country’s production of non-tradeables must equal its consumption of non-tradeables: by assumption, non-tradeables cannot be obtained elsewhere.
A country has a balance-of-payments constraint if it cannot sell financial claims sufficient to cover its shortfall in production of tradeables, relative to desired consumption of tradeables. How then must a country respond to such an inability to finance its desired spending on tradeables? Individuals (and companies) within the country must spend less.
If people do spend less, they will normally lower their spending on both tradeables and non-tradeables. The reduction in spending on non-tradeables will result in unemployment, while the reduction in spending on tradeables will reduce the trade deficit (on the assumption that domestic import substitutes can be readily exported).
An important aspect of this process of adjustment to the disappearance of balance-of-payment financing is the that producers of non-tradeables have no market other than their close neighbours. That is what makes what they produce non-tradeable.
As the economy adjusts to the inability of previously creditworthy residents to finance earlier purchases of tradeables, one will also see a downward spiral of spending on non-tradeables. Look at Greece today. Part of this reduction will occur because of lower private spending and part will occur because of reduced government spending, in response to a larger fiscal deficit, itself the consequence of declining output and incomes.
The broad conclusion is that if a country runs an unfinanceable balance of payments deficit, it will need to cut spending on tradeables and, in the process, will find itself suffering higher unemployment. Whether it has a currency of its own is neither here nor there, from this point of view. The balance of payments constraint bites because budget constraints bite on the aggregate of individuals and businesses operating inside the country.
For a country without a currency of its own, the constraint will show itself in the worsening credit status of the country’s borrowers (including the government), not in a currency crisis. Whether that is a superior alternative depends on whether one thinks the possibility of currency adjustment is helpful in securing necessary changes in relative prices — above all, the rise in the relative prices of tradeables — that must follow a reduction in access to external finance. I do. Others differ.
Now consider a region. This may be defined, for simplicity, as an area like a country, except that there are cross-border fiscal transfers, in response to shocks. In that case, a cut-off of private finance for the budgets of residents, perhaps because of a change in perceptions of future growth prospects and asset prices, would be partly offset by increased fiscal transfers.
The good aspect of such transfers is that they cushion the shock to regional spending, by sustaining incomes. The bad part is that they reduce incentives for adjustment. In the case of the eurozone, as I have argued previously, these transfers do exist, but they are largely being arranged by the European Central Bank.
The main point of this argument is quite simple. Balance-of-payments — or, if one likes, aggregate budget — constraints have not been removed, in any way, inside a currency union. They are exactly as before. The difference is that one adjustment mechanism — the currency — has been removed. But an adjustment mechanism may also be a source of crisis. So that possibility has also been removed.
The evidence is now clear, however, that the shift from currency to credit crises creates greater risks, because the latter threatens to bring down any highly integrated financial system. A currency crisis does not normally do so, unless countries borrow heavily in foreign currencies. That has frequently been the case for emerging countries. It was not historically the case for European countries.
So the vulnerability of eurozone members to serious crisis has been increased, not reduced, by membership. Moreover, as things stand, the eurozone has no workable mechanism for dealing with the creditworthiness crises triggered by shifting balance-of-payments constraints (or, more precisely, the shifting ability of residents to obtain finance in world markets). Unless and until it does, the viability of the currency union will be permanently in question.
