The eurozone needs an economic fire department
The actions we see when a fire erupts in a building are not unlike those observed during the eurozone crisis: panic-stricken residents flee the burning building while fire fighters enter it to extinguish the flames. Similarly, we saw private investors rushing out of the periphery countries, while public capital flew in to prevent a disorderly unwinding of external imbalances. The lesson here is that the eurozone must always have an economic fire department in combination with stronger institutions. Having only one without the other is a clear recipe for a future crisis.
The case for a fire department
When a fire erupts in a building, panic-stricken residents rush for the exit, while brave fire fighters enter it to extinguish the flames. Now imagine that the fire department would decide to take no action until the investigation as for the causes of the fire was complete. Or that it would refuse to extinguish the fire because it would lead to moral hazard risks. Perhaps, it could even refuse to help because of a high risk of casualties amongst the fire fighters. In any case, the decision to stay on the sidelines would increase the risk that the whole neighbourhood goes up in flames. Thankfully, fire departments around the world have no such reasoning. Their universal motto is save as many lives as possible, save properties and protect the environment and, in doing so, never put their own safety knowingly at risk.
Similarly, economies catch a fire every now and then due to an adverse exogenous or endogenous shock. And, regardless of their size, if the fire is not contained adequately, it can have devastating consequences for their economic neighbours, if not the world economy. Basically, when investors rush for the exit in a state of panic, there should be at least one institution that is willing to act as an economic fire department.
The eurozone crisis showed how important it is to have an effective economic fire department. As soon as the debt crisis made landfall in 2010, private sector investors started to abandon the periphery countries (Greece, Ireland, Italy, Portugal and Spain - GIIPS) in droves. The BIS data on cross-border banking claims (figure 1) shows that foreign banks lowered their exposure by USD 1,685bn between 08Q3 and 12Q3.
The sudden stop in private capital inflows combined with outright capital flight should have resulted in an abrupt rebalancing of the current account. This is because the GIIPS did not have access to the currency-depreciation option that emerging markets had when they went through a balance of payments crisis. Although we see a sharp fall in current account deficits of the periphery countries since the inception of the crisis (figure 2), only one country (Ireland) had a current account surplus in 2012. The aggregate current account deficit of the GIIPS has fallen from 6.7% of their combined GDP in 2008 to 1.8% last year. This adjustment, while extremely rapid, would have been even quicker if public capital would not have replaced private capital. The former mainly include the international support provided by the official sector – the loans provided by the IMF, the European governments and the EFSF/ESM bailout funds – and the growing Target2  liabilities of the central banks in GIIPS to the Eurosystem. The latter has been the subject of great debate amongst economists recently (see Buiter and Rahbari, 2012; Cecioni and Ferrero, 2012; Cecchetti et al., 2012; Merler and Pisani-Ferry, 2012; Mody and Bornhorst, 2012; Sinn and Wollmershäuser, 2012).
To see how private capital flows behaved during the euro crisis, we need to find a way to measure it. One method is taking the equation provided by Merler and Pisani-Ferry (2012):
and re-arrange it to get
So if we deduct the accumulation of Target2 liabilities and official sector financing from the accumulated current account deficit, we have a rough estimate for cumulative private capital inflows. The result of this exercise is depicted in figure 3, where we see strongevidence of a sudden stop of capital inflows in the periphery countries since 2010. It is also clear that that the corresponding public capital inflows prevented a sharp unwinding of external imbalances.
The Target2 system provided most of the relief and this is why the external debt of the monetary authorities in the GIIPS increased from 0.7% of combined GDP in end-2007 to 31% in Q3 2012 (figure 4). In the same period, the total external debt of banks and governments in the periphery countries fell by around 30% of their combined GDP.
Another way to appreciate the importance of public capital inflows compensating for private capital outflows is to look at the breakdown of total foreign liabilities of the crisis-hit countries, which comprises of foreign direct investment (FDI), portfolio investment (equity and debt) and other liabilities. The banking sector liabilities are mostly in the portfolio investment liabilities.
Figure 5 shows that total external liabilities of the Southern European countries have not fallen much since reaching the peak in early 2008 . Most important, portfolio investment has fallen sharply, especially debt securities, which dropped by EUR 1,160bn between 08Q2 and 12Q3. This can be a combination of reduced exposure and decline in market values. On the other hand, the ‘other liabilities’, which include the official sector support, have risen since the financial crisis.
Figure 5: Total external liabilities breakdown
 ^ TARGET2 is a payment system owned and operated by the Eurosystem for the settlement in central bank money of central bank operations, interbank transfers and other large-value payments.
 ^ Note that FDI has stayed constant due to two reasons. First, firms have difficulty immediately pulling out in the aftermath of a crisis. Second, the marked-to-market valuation of FDI is difficult in practice. In other words, the loss of value of a direct investment may not be correctly captured by the data.
Faster adjustment would be desirable?
To be sure, some would have preferred a far faster pace of current account adjustment (Sinn and Wollmershäuser, 2012). In other words, not everyone is convinced that we need an economic fire department for the hard-hit periphery countries. But figure 6 makes it clear that the rebalancing process until now, even with public sector help, has been extremely painful economically. This is because most of the adjustment has taken place through domestic demand contraction. The side effect has been surging jobless rates. To have expected a better outcome given the competitiveness challenges of these countries would have been nothing more than wishful thinking. Against this backdrop, we can safely assume that the GIIPS would have experienced even greater economic turmoil had they been forced to adjust at an even faster rate in the absence of external support. Not only would fiscal sustainability be jeopardised, in our view, but also the drive for structural reforms would become impossible amid enormous social strains.
Figure 6: Economic hardship amid adjustment
Source: IMF, World Bank, Rabobank
Can economic pain be reduced more?
The analysis shows that the support by the public sector was necessary to avoid even greater economic hardship in the periphery during the adjustment phase. But this does not mean that the situation is desirable. At some point in time, confidence must be restored so that private sector investors send their capital back to the GIIPS. The steps taken by the European policymakers, the ECB in particular, have helped somewhat in this regard. The total Target2 liabilities of GIIPS is falling (figure 7), suggesting that private sector capital is cautiously re-entering the periphery countries.
Figure 7: Target2 liabilities falling
Source: Osnabrück University, Rabobank
The official sector could further fast-track this process by writing-off some of the loans they have provided. The advantage of this is that no corresponding adjustment would need to be made to any of the other flows. So far, this topic has remained a taboo. Only time will tell whether they will go down this road. Either way, the official sector might have to accept that assuming losses is the natural task of an economic fire department. Any fire fighter would admit that occasional casualties, no matter how tragic, are part of the job description. Believing otherwise is being naive.
Lessons for the long run
The speed of crisis took the European policymakers completely off-guard. The European institutions were never built to respond quickly to crises. This was obviously a big mistake as it left policymakers unprepared to take resolute steps to boost confidence in the euro. It finally took more than a dozen European Summits in combination with numerous ECB actions until some sense of calm was restored. Therefore, the important lessons of this crisis for the eurozone as a whole should be:
- Strengthening of European institutions to reduce the risk of fire.
- Creating an economic fire department in case fire breaks out.
Thus far, many steps have been taken for addressing the first point. Notable measures include agreeing to a stronger framework for economic governance ('Six-Pack' and ‘Fiscal Compact’) and the creation of a Single Supervisory Mechanism (SSM) for the banking sector. As regards the second step, the creation of a future permanent bailout facility (ESM) was very welcome. But to act as an effective protection against economic wildfires in Europe and to make sure that the ECB does not have to act as a fire fighting department in every crisis, the facility must be made more flexible and credible. This means increasing the amount of funds in the ESM (currently capped at EUR 500bn) whenever necessary and allowing it to operate more freely (e.g. by directly bailing out weak banks in order to break the vicious sovereign-bank nexus). What’s more, the Target2 system, which has proven to be an essential bloodline to the periphery countries, must remain functional in future crises complemented by liquidity provision by the ECB. Restricting Target2 imbalances would only inflict unnecessary economic damage to a crisis-hit country that is going through a painful adjustment phase.
By taking both steps simultaneously, the European policymakers not only ensure that the eurozone becomes more resilient to shocks, but they also show their resolve in maintaining the euro by helping one another in desperate times. An economic fire department is indispensable for the survival of the EMU.
Buiter, W. en Rahbari, E. (2012). TARGET2 redux: The simple accountancy and slightly more complex economics of Bundesbank loss exposure through the Eurosystem. CEPR Discussion Paper No. 9211.
Cecchetti, S., McCauley, R. and McGuire, P. (2012). Interpreting TARGET2 balances, Bank for International Settlements, Working Paper 393
Cecioni, M. and Ferrero, G. (2012). Determinants of TARGET2 imbalances. Banca d’Italia Questioni de Economia e Finanza, No. 136.
Merler, S. and Pisani-Ferry, J. (2012). Sudden stops in the euro area. Bruegel Policy Contribution. Issue 2012/06.
Mody, A. and Bornhorst, F. (2012). TARGET imbalances: Financing the capital-account reversal in Europe. VoxEU, 7 March.
Sinn, H.W. en Wollmershäuser, T. (2012). TARGET loans, current account balances and capital flows: The ECB’s rescue facility. NBER Working Paper No. 17626.