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De Grauwe moment: an impressively prescient prediction of the Eurozone balance of payments crisis

Sergio Cesaratto (Guest blogger)

In an article in the Financial Times written one year before the onset of the European currency union, Paul De Grauwe presented a farsighted conjecture of what could follow, something most economists have only recently realised.[i] Indeed, with the benefit of hindsight, the European crisis appears now as the nth ‘this time is different’ episode of the financial liberalisation sequence cum fixed exchange rates, capital flows from the centre to the periphery, housing bubble, current account (CA) deficit and indebtedness, default. Although I find Reinhart and Rogoff (2009) to be a poorly organised account of the history and nature of defaults, their title really conveys the sense of a recurring pattern of unfortunate events. The title of a seminal paper ‘Good-bye financial repression, hello financial crash?’ (Diaz-Alejandro, C. 1985) also sums up the essence of those events. In order to better appreciate prof. De Grauwe’s insight I introduce his article with some notes from a just published WP of mine “Controversial and novel features of the Eurozone crisis as a balance of payment crisis”.

Popularized by Martin Wolf (2012), the interpretation of the European crisis as a balance of payment (BoP) crisis is becoming dominant. Accordingly, the cause of the crisis must be found in the easier access for a number of peripheral EMU countries to the European financial markets at low nominal interest rates. Financial liberalisation and the removal of the exchange rate risk encouraged massive capital flows from core to periphery countries in the ‘periphery’ (e.g. Merler and Pisani-Ferry 2012). Credit-financed autonomous consumption determined a growth both of domestic demand and of nominal wages higher than in core-EZ. Higher inflation rates in the periphery determined low real interest rates, a further support to domestic demand. The growth of domestic demand was associated to a housing bubble in Spain and Ireland, and to the growth of public spending in Greece. This sequel of events, and its consequences, foreign indebtedness and ‘sudden capital stops’ are basically not so different from those that typically took place in developing countries and ended in sovereign defaults (Frenkel, Rapetti 2009: 688-89; Reinhart 2011: 27-9).

A traditional objection to the interpretation of the EZ crisis as a typical ‘this time is different’ crisis is that there cannot be a BoP crisis in a currency union. The question is that the EZ is a hybrid between a full currency union (which also implies a fiscal union) and a traditional fixed exchange agreement. One main difference with the latter is that in a currency union capital flights are automatically compensated by the CB, in the EZ by TARGET 2 (T2) (Febrero et al. 2012). As everybody knows, assuming zero variation of foreign currency reserves, the BoP sheet would read: CA + KA = 0, where KA is the capital account. Normally, in a two countries world, if country A has (all magnitudes are balances) a negative CAA-, country B symmetrically shows CAB+, then KAA + and KAB- (country B is lending to country A). Suppose country B does not lend to country A (so the CA flow imbalance is not financed), and even worse that there are capital outflows from country A (so the stock of debt acquired by B in the past is not rolled-over as it expires). Then both CAA- and KAA-, so that CAA + KAA < 0. What happens in a currency union is that through T2: CAA + KAA + T = 0, where T > 0 means that country A is overdrawing from its CB account. It is as if the ECB were creating foreign currency reserves in a fixed exchange rate system (Leppanen 2012); or as if the deficit countries were creating the international reserves, like the U.S. in Bretton Woods (I or II) (Kohler 2012); or better still, it is as if the EMU worked in an ultra-Keynesian fashion as an International Clearing Union (ICU), with even less prudence than Keynes envisaged (I suppose I am the first to note this similarity).[ii] With T2, the EZ country A has indeed an infinite overdraft possibility (Milbrandt 2012 CESifo). What has happened in the periphery from 2007/8 is that CAA- and KAA -, T+ and symmetrically in the core: CA +, KA +, T- (core-banks receiving hot money from the periphery and reducing their overdraft at their NCB).

Not so paradoxically, given the hybrid nature of the EMU: ‘If, in the framework of a political union, the euro central banks were integrated as dependent branches of the ECB, the consolidation of the branches would dissolve the Target balances in thin air.’ (Neumann 2012; also Ulbrich & Lipponer 2012 CESifo Forum). This makes clear that through T2 the ECB is acting as a regular CB: normally banks rely on the interbank market to finance their imbalances (when they fall short of reserves); if, in exceptional circumstances, this does not work the ECB just fills the gap. As Eladio Febrero wrote to me: ‘If you move your savings from a deposit in Banca Intesa to Unicredit, and the former has no reserves deposited in the Banca d’Italia, the latter would create money and then credit the reserve account of Unicredit so your money would be there now. Then Banca d’Italia would acquire a claim on Banca Intesa. …It should be noted that if Banca d’Italia in the example just above, or the European System of Central Banks (in this discussion on T2) does not provide the banking system with liquidity, the latter would collapse: there would be a bank run and the whole economic system would have very serious problems.’ So, in this respect EMU is not like, say, the EMS. If the ECB interrupts T2 (i.e. it stops acting as a CB with the peripheral banks) this is the end of the EMU. Of course, T2 is not the cause of the problems, but it prevents the EMU from exploding as the EMS did in 1992.

In this regard one might think that if the EZ was a real Federal State, the financial crisis would be a ‘normal’ domestic crisis: if some local banks and some local governments (deprived of monetary sovereignty) are not solvent, nobody would talk of a BoP crisis. Even considering the grand scale of the EZ crisis, a ‘normal’ state would intervene by socializing part of the local government and banks’ debt, imposing austerity and balanced budgets on them; saved banks would be nationalised, restructured or shut down. The CB would cooperate by sustaining the sovereign/federal debt. At the same time the Federal administration would use fiscal transfers to attenuate the crisis. Fine, but this is not Europe! If it were, it would manage to solve the situation without too much hardship.

The question is that the EZ is a hybrid, in between a fixed exchange rate system among independent countries and a fully integrated economy, sharing the possibility of a BoP crisis with the former and national banking principles with the latter. In this spurious set up the ECB has acted somewhat similarly to the FED: through T2 and LTRO it is injecting liquidity and absorbing toxic assets as collateral, letting insolvent local banks and governments survive (although the lack of direct ECB intervention to sustain sovereign debts is putting the solvency of the Spanish and Italian governments in jeopardy by letting the sovereign spreads to explode affecting the in turn the solvency of domestic banks that carry plenty of their bonds).[iii] A fiscal pact has been imposed, but there is no Federal government assisted by a SCB on hand to heal the local states and banks. To sum up, the EZ crisis is not a classical fixed exchange rate crisis (as De Grauwe foresaw) ; it is not a domestic financial crisis; it is what it is: a BoP crisis in an imperfect currency union. If the union were perfected, the crisis could be solved in the same way as a traditional domestic crisis. If it is not perfected, it is an unedited BoP crisis with a still unwritten final.


CESifo (2012), Forum Volume 13, Special Issue January.

De Grauwe Paul (1998), The Euro and the Financial Crises, Financial Times, February.

Diaz-Alejandro, C. (1985)Good-bye financial repression, hello financial crash, Journal of Development Economics 19, 1-24.

Febrero E., Uxó J., Bermejo F. (2012), El funcionamiento del sistema TARGET2 desde la Gran Recesión. Una aproximación desde la óptica del circuito monetario, XIII JORNADAS DE ECONOMÍA CRÍTICA, Sevilla, February.

Frenkel R. and Rapetti M. (2009) A developing country view of the current global crisis: what should not be forgotten and what should be done, Cambridge. Journal of. Economics. (2009) 33 (4): 685-702.

Keynes, J.M. 1980. Activities 1940–1944. Shaping the Post-War World: The Clearing Union, Collected Writings of John Maynard Keynes, A. Robinson and D. Moggridge (eds), volume 25. London: Macmillan.

Kohler K. (2012) The Eurosystem in Times of Crises: Greece in the Role of a Reserve Currency Country?, in CESifo (2012) 14-22

Leppänen O. (2012) Eurosystem TARGET balance deviations call for cautious changing of the EU banking landscape,
Merler S., Pisani-Ferry J. (2012), Sudden stops in the euro area, Bruegel Policy Contribution, March.

Milbradt G. (2012) The Derailed Policies of the ECB, iun CESifo (2012), 43-49.

Reinhart C.M., and Rogoff K.S. (2009) This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton.

Reinhart C.M., (2011) A Series of Unfortunate Events: Common Sequencing Patterns in Financial Crises, Rivista di Politica Economica, Vol 100 Nopp. 11-36

Ulbrich J. and Lipponer A. (2012) Balances in the Target2 Payments System – A Problem?, in CESifo (2012): 73-76.

Wolf M. (2012), Why the Bundesbank is wrong , Financial Times 10 April.


[i] Hat tip Paolo Borioni and Ronny Mazzocchi.

[ii] Indeed Keynes regarded the ICU as an extension of the principles that govern a national banking system, the same principle that informs T2. In 1941 he even called it ‘Currency Union’. In famous passages, he wrote: ‘In short, the analogy with a national banking system is complete. No depositor in a local bank suffers because the balances, which he leaves idle, are employed to finance the business of someone else. Just as the development of national banking systems served to offset a deflationary pressure which would have prevented otherwise the development of modern industry, so by extending the same principle into the international field we may hope to offset the contractionist pressure which might otherwise overwhelm in social disorder and disappointment the good hopes of the modern world. The substitution of a credit mechanism in place of hoarding would have repeated in the international field the same miracle, already performed in the domestic field, of turning a stone into bread’ (CW 1940-44: 75). But he was also very cautious: ‘In only one important respect must an International Bank differ from the model suitable to a national bank within a closed system, namely that much more must be settled by rules and by general principles agreed beforehand and much less by day-to-day discretion. To give confidence in, and understanding of, what is afoot, it is necessary to prescribe beforehand certain definite principles of policy, particularly in regard to the maximum limits of permitted overdraft and the provisions proposed to keep the scale of individual credits and debits within a reasonable amount, so that the system is in stable equilibrium with proper and sufficient measures taken in good time’ (CW 1940-44: 45).

[iii] The Greek, Irish and Portuguese governments are already insolvent. Note also that the solvability of Spanish banks is anyway precarious after the burst of the housing bubble.


  1. Nice post Sergio.

    Yes definitely an internal balance of payments crisis. This can also be seen by looking at the net international investment position (which is the sum of cumulative current account balances, if revaluations are ignored) and the worst are for Portugal (minus 103% of gdp), Ireland (minus 95% of gdp), Spain (minus 93% of gdp), Greece (minus 92% of gdp) using Q3 2011 data.

    (Ireland had okay CABs but revaluations played a huge role.)

  2. You don't have to resort to the ‘this time is different’ crisis interpretation of the EZ crisis as a typical to object to Wolfs explanation, because its has been shown time and time again that Austrians got it all wrong, and that their theories have no explicable power.

    Wolf premises were all wrong, first before 1999 the interest rates were already low in the periphery,second the capital inflows are a consequence of the trade balance, not the opposite.

    We are living in a time that is the negation of the Austrian explanations, We have low interest rates and yet no credit bubbles, and the same holds for the BdP explanations.

    Fixed exchange rates are the problem because they don't allow exchange rates to reflect the relative competitive positions between countries, this leads to unbalances and capital flows, if you stop capital flows by raising interests in the periphery you don't stop the problems, because you do nothing to the periphery competitive position.


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