The Importance of Trade and Capital Imbalances in the European Debt Crisis

Andrew Hughes Hallett and Juan Carlos Martinez Oliva ()
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Juan Carlos Martinez Oliva: Peterson Institute for International Economics

No WP13-1, Working Paper Series from Peterson Institute for International Economics

Abstract: The current debate on the European crisis has highlighted the role of fiscal imbalances in explaining the turmoil that has dominated Europe in the past few years. This paper adopts a different point of view by suggesting that intra-European payments imbalances are crucial for the survival of the Economic and Monetary Union (EMU). Indeed, payment imbalances between the North and South have contributed to the accumulation of large stock of foreign debt, while flows of foreign capital ceased to finance productive investments that might have contributed to debt repayments--being used instead to finance consumption and real estate. The dynamic interplay between current account imbalances and the accumulation of foreign debt reveals that, once the system is driven into disequilibrium by a real exchange rate misalignment, the longer a payments imbalance persists and the harder the eventual adjustment will be. Capital reversals, by shifting portfolio balances, then lead the system toward instability, sovereign default, and the collapse of the exchange rate regime. Replacing private with public creditors can temporarily help us to stay away from the point where the system breaks down. But this is only a temporary expedient because the underlying imbalances will need continuing and increasing financing until equilibrium is restored by other means. One permanent solution is the European Central Bank's (ECB) official monetary transactions program, if the potential expansions to the central bank's balance sheet can be tolerated.

Keywords: external debt; trade space; real exchange rate adjustments; official financing; OMT (search for similar items in EconPapers)
JEL-codes: F32 F41 G12 H63 (search for similar items in EconPapers)
Date: 2013-01
New Economics Papers: this item is included in nep-eec and nep-opm
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Citations: View citations in EconPapers (2)

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Journal Article: The importance of trade and capital imbalances in the European debt crisis (2015)
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