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The great Scottish philosopher and economist, David Hume, understood all too well how national boundaries and balance-of-payment statistics affect and even determine flows of international trade. In principle, the vaunted “Hume mechanism” should operate within the eurozone. Countries which export less than they import should lose euros to surplus countries, unless offset by private capital inflows. Euro outflow leads to a scarcity of money and credit, less lending for consumption and investment, a slowdown in activity and falling prices. Chronic deficits will imply higher interest rates and declining creditworthiness for both sovereign and private borrowers. But declining domestic absorption and non-traded goods prices ultimately bring wages back into line with productivity and restore competitiveness. Similarly, chronic surplus countries should accumulate euros and domestic bank lending should expand, leading to more demand and inflation there relative to deficit countries.
But the Hume mechanism is slow to work, most of all because prices need time to adjust and are driven by stubborn expectations. Another reason is that flaws in the construction of the eurozone hinder the Hume mechanism. Current-account deficits are not bad per se – especially if they tide over consumption in a temporarily bad year, or finance capital goods imports in response to productive opportunities. Yet since the financial crisis, eurozone countries with chronic current-account deficits have also experienced significant capital outflows and balance-of-payment deficits. In the days of Bretton Woods system before 1971, the IMF would put out such fires with fiscal stabilisation programmes; the UK and Italy are two memorable examples. Chronic payments imbalances were not tolerated because no sovereign country was expected to fund permanently deficits of others.
In the eurozone, there is no authority to regulate imbalances between sovereign nations:
These bookkeeping entries in the balance sheets of national central banks have become the subject of heated discussion in Germany.
By passively monetising intra-eurozone imbalances, the ECB has put Hume on hold, postponing necessary adjustment of relative prices between regions. Dismissed at first by most economists, the elephant in the room is now too big to ignore. Bundesbank surpluses with the ECB have swelled to well over €700 billion, or about 30 per cent of German GDP. Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.
In a world without national boundaries and without national central banks, balance-of-payment deficits cannot occur – current-account deficits are always financed by private capital. As long as the members of the monetary union accept it, changing tides of trans-European ownership of national assets should be perfectly acceptable and left to owners of capital flows. Governments should prevent bad mistakes of private banks and investors from becoming the liability of taxpayers. The ECB should refrain from allocating liquidity directly to any particular market. Yet as long as economic nationalists continue to pay attention to them, national balance-of-payment deficits and surpluses will continue to play a role in the formulation of policy. In the case of a breakup of the eurozone, the book-keeping Target2 entries become explicit national assets and liabilities, opening the way for further recriminations and deterioration of economic and even political relations.
In the end, the euro’s founders committed an egregious error by ignoring this not-so-minor detail that Hume certainly would have caught. By not abolishing national central banks irrevocably, the back door was left ajar for national interests to interfere with the natural workings of the financial system and Hume’s mechanism. This oversight, combined with the failure to establish a European Banking Authority with real teeth, has left a gaping hole in European monetary and financial integration and will come back to haunt us in the months and years to come.