External Imbalances and Fiscal Fragility in the Euro Area

Abstract

This paper presents two views of the European sovereign debt crisis. The first is that countries in the South of the Eurozone were fiscally irresponsible and failed to implement pro-competitive supply side policies. The second view holds that the crisis reflects a deep divide between the external surpluses of the North and external deficits of the South. Basic stylized facts cast doubt on the explanation based on the first thesis alone. A relatively simple model shows how poor fundamentals can create a debt problem independently of fiscal responsibility. The empirical analysis of the determinants of government bond yield spreads relative to Germany suggests that both views in fact provide useful insights into the roots of the current sovereign crisis. However, differences in growth and competitiveness and capital flows between North and South have assumed a much more dominant role since the onset of the global crisis.

Appendix: A Model of Current Account and Portfolio Balances

Consider a home country, say Spain, and foreign country, say Germany (denoted with a “*”), which are linked by the uncovered interest parity condition,

$$ \left(1+r\right)=\left(1+r\ast \right)E/{E}_{+1}^e $$

(2)

where r and r* are the home and foreign rates of interest respectively, E is the real exchange rate (defined as the price of home goods relative to foreign goods), and E ^e_+ 1 is the real exchange rate expected next period. Thus

$$ E=P/\left( eP\ast \right) $$

(3)

where e is the nominal exchange rate defined as the domestic currency price of foreign currency (dollars per euro if the US is the home country). In the case of Spain and Germany, e = 1. The home country accumulates net foreign debt according to:

$$ {F}_{+1}=\left(1+r\right)F+D\left({E}_{+1},{z}_{+1}\right), $$

(4)

where F is the net debt denominated in the home currency (the amount of domestic currency needed to pay them off).²⁰ D(E,z) is the trade deficit, which is a positive function of the real exchange rate. z is a shift variable describing the impact of a trade shock; a change in preference for home goods; or other changes in spending, or the pattern of spending, on those goods.

To allow for imperfect substitutability between national assets, let W be the total wealth of home investors, X the total stock of home’s assets, and F net debt position of the home economy (all in real terms). Thus:

$$ W=X-F,\kern1em \mathrm{where}\ \mathrm{F}\ge 0\ \mathrm{implies}\ \mathrm{net}\ \mathrm{debt}/\mathrm{liabilities} $$

(5)

Wealth of foreign investors, in home’s currency, is

$$ W\ast /E=X\ast /E+F. $$

(6)

The expected real rate of return from holding home’s assets relative to foreign’s is

$$ {R}^e=\left[\left(1+r\right)/\left(1+r\ast \right)\right].{E}_{+1}^e/E. $$

(7)

Home investors place a share α in home securities and 1-α in foreign assets; and α* and 1-α* are the corresponding shares of foreign investors in foreign assets. We assume that α is increasing in the relative rates of return on home assets, R ^e, and in s, defined as the preference for holding domestic assets including any home bias or safe haven effects. Symmetrically, α* is decreasing in those two factors. If home biases dominate the asset market, then α + α* > 1 Equilibrium in the market for home’s assets, and hence foreign’s assets, is given by the following portfolio balance (PB) equation:

$$ X=\alpha W+\left(1-\alpha \ast \right)W\ast /E=\alpha \left(X-F\right)+\left(1-\alpha \ast \right)\left(X\ast /E+F\right). $$

(8)

Unlike under perfect substitutability, the distribution of wealth between home and foreign is independent of shifts in the trade or current account balances (i.e. z). Instead the real exchange rate E, relative rates of return R ^e, and asset preferences s, all of which affect α, determine and are determined by the distribution of wealth holdings. Nevertheless, trade and current account balances do lead to changes in F, and hence to changes in the real exchange rate:²¹

$$ \frac{ dE}{ dF}=-\frac{\alpha +\alpha \ast -1}{\left(1-\alpha \ast \right)X\ast /{E}^2}<0\kern1em \mathrm{iff}\kern1em \alpha +\alpha \ast >1. $$

(9)

The portfolio balance relation is nonlinear in E-F space and is downward sloping as long as home biases persist α + α ∗ > 1. Under these conditions, higher debt at home requires a lower exchange rate (because the demand for home assets has fallen, a larger trade surplus is needed to meet interest payments); and real exchange rates respond less to current-account imbalances than to changes in portfolio preferences and the distribution of wealth.

If home and foreign goods are imperfect substitutes, and the trade balance D behaves as in (4), then home’s net debt in the next period will be:

$$ \varDelta {F}_{+1}=\left(1-\alpha \ast \right)\left(1+r\right)W\ast /E-\left(1-\alpha \right)\left(1+r\ast \right)W.E/{E}_{+1}^e+D\left({E}_{+1},{z}_{+1}\right). $$

(10)

That is foreign ownership of home assets (plus interest), less the value of home owned foreign assets plus interest, plus the next trade deficit. Rewriting with (5), (6) and (7):

$$ {F}_{+1}=\left(1+r\right)F+\left(1-\alpha \right)\left(1+r\right)\left(1-1/{R}^e\right)\left(X-F\right)+{D}_{+1}. $$

(11)

This is the current-account balance (CA) relation since CA _+ 1 = D _+ 1 − rF. The middle term reflects the changing evaluation of home-owned foreign assets due to differing rates of return (including risk premia). Policymakers have little control over F except by providing liquidity or loans in the face of sudden stops in capital or financing flows (i.e. when F is held constant), except through future trade balances and growth. The slope of the CA relation, in E-F space in the current period, is:

$$ \frac{ dE}{ dF}=\frac{-{E}_{+1}}{\left(1-\alpha \right)\left(1+r\ast \right)\left(X-F\right)}<0, $$

(12)

which depends on the size of the domestic asset base: a large asset base, X > F, means a shallow slope, a small asset base a steep slope. This is the normal state of affairs since, if F rises, it requires E to fall to create a move towards a trade surplus at home in order to generate sufficient extra revenues to pay for the higher net debt—the more so the smaller is the asset base relative to foreign ownership of domestic assets. That implies (12) will have to be negative.

The following condition, that the portfolio balance line is steeper than the CA relation, must be satisfied to ensure stability in both the trade and capital markets:

$$ \frac{\left(1-\alpha \right)\left(1-\alpha \ast \right)}{\alpha +\alpha \ast -1}>\frac{E_{+1}{E}^2}{\left(1+r\ast \right)X\ast \left(X-F\right)}. $$

(13)

Equation (13) is satisfied if:

• X >> F. This represents an economy with a large domestic asset base and self-sufficient in investment and funding. Conversely, stability is at risk if the economy is heavily dependent on foreign debt for funding.

• If E is low and expected to remain low; or X* is large. This is generally a matter of policy stance; as in Germany in the EA, or China.

These stability conditions are not met if

• α + α* < 1;

• X > F is small, even if α + α* > 1. This is likely in Greece, Ireland or Portugal whose assets are widely held by other EA countries. Italy, whose assets are predominantly held at home, may be relatively safe.