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

34 Pages Posted: 22 Jan 2013

See all articles by Andrew J. Hughes Hallett

Andrew J. Hughes Hallett

George Mason University - School of Policy, Government, and International Affairs

Juan Carlos Martinez Oliva

Bank of Italy; International Monetary Institute

Date Written: January 22, 2013

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

JEL Classification: F32, F41, G12, H63

Suggested Citation

Hughes Hallett, Andrew and Martinez Oliva, Juan Carlos, The Importance of Trade and Capital Imbalances in the European Debt Crisis (January 22, 2013). Peterson Institute for International Economics Working Paper No. 13-01, Available at SSRN: https://ssrn.com/abstract=2205269 or http://dx.doi.org/10.2139/ssrn.2205269

Andrew Hughes Hallett (Contact Author)

George Mason University - School of Policy, Government, and International Affairs ( email )

Founders Hall
3351 Fairfax Dr.
Arlington, VA 22201
United States

Juan Carlos Martinez Oliva

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

International Monetary Institute ( email )

No. 59, Zhongguancun Street
Beijing, Beijing 100080
China

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