Tie w12 Sinn

European
End Game
The striking similarity between
todays eurozone situation
and the end of Bretton Woods.
BY HANS-WERNER SINN
THE MAGAZINE OF
INTERNATIONAL ECONOMIC POLICY
888 16th Street, N.W.
Suite 740
Washington, D.C. 20006
Phone: 202-861-0791
Fax: 202-861-0790
www.international-economy.com
editor@international-economy.com
10
THE INTERNATIONAL ECONOMY
WINTER 2012
he financial community claims nearly unanimously and somewhat vociferously that the eurozone is suffering from a confidence crisis that can
only be solved by wielding a big bazooka. If the
rescue fund is large enough, goes the argument,
markets will be assuaged, interest spreads will
shrink, and the distressed countries will manage to
refinance their public debt. But as popular as this
view may be, it is far too optimistic.
Of course markets are jittery, and the risk of self-reinforcing runaway processes is real. However, markets have every reason to be nervous. There is not just the self-inflicted instability of mutually infecting
speculators, but a fundamental distortion of prices for goods, labor, and
capital that would need a currency realignment that is impossible within
a currency union. Whoever offers his guarantee for the funds powering
the big bazooka should know that such a guarantee will be drawn eventually, given that the debtor countries lack the competitiveness to be
able to redeem their debt.
The distortion of prices stems from the bubbles that built up in the
eurozones periphery in the years before the crisis. The rapid interest
convergence that took place from 1995 to 1997 in anticipation of the
Hans Werner Sinn is President of the Ifo Institute and Professor of

Economics and Public Finance at the University of Munich.
SINN
euro induced governments and private agents to overborrow and overspend, making their respective
economies overheat. In Greece and Portugal, the borrowed funds went largely into the wages of government
employees, and in Ireland and Spain largely into the
wages of construction workers. As construction workers
paid more taxes, and government employees bought
more homes, they pulled each other along into the bubble. At the end of the day, whoever borrowed the cheap
funds from abroad made little difference. From 1995 to
the crisis year 2008, the GIIPS countries (Greece,
Ireland, Italy, Portugal, and Spain) appreciated against
their eurozone trading partners by 30 percent. By contrast, Germany depreciated against its eurozone trading
These problems of the eurozone

are similar to, but much more
extreme than, those of the Bretton
Woods system, the fixed exchange rate
system that lasted until 1973.
partners by 22 percent, which translated, for instance,
into Italy appreciating by 50 percent against Germany.
Increasing wages, prices, and nominal incomes in the
GIIPS undermined their export competitiveness and
boosted imports, driving all countries into current
account deficits: 2.2 percent of GDP in Italy, 3.5 percent
in Ireland, 7.7 percent in Spain, 10.9 percent in Portugal,
and 12.5 percent in Greece over the past five years.
The most recent estimates for 2011 show that the
combined current account deficits of the GIIPS will be
on the order of 127 billion, and their net foreign debt
position will have risen to 1,620 billion. Italys net foreign debt amounts to only 26 percent of GDP, but that of
the rest to a staggering 95 percent (95 percent for
Greece, 86 percent for Ireland, 105 percent for Portugal,
and 95 percent for Spain). No less than 52 percent of the
total net foreign debt of the GIIPS, or about 1,021 billion in absolute terms, lies in Spain, with 417 billion or
21 percent in Italy, and the rest shared among the other
GIIPS countries. (Surprisingly, even France had a net

foreign debt position of about 215 billion in 2010, the
eurozones third-largest in absolute terms. In relative
terms, however, that amounts only to 11 percent of
French GDP.)
A net foreign debt position on the order of 100 percent of GDP is extreme by any standards. Greece,
Ireland, Portugal, and Spain will therefore have a hard
time repaying their foreign debt, to put it mildly. There is
every reason for the current holders of the respective
government bonds to be frightened.
The only chance to repay the debt is to become
competitive enough to earn a current account surplus.
That, however, requires becoming cheaper. The terms of
trade must deteriorate in order to stimulate exports and
redirect import demand towards the purchase of domestic goods. That is easy if a country exits from the euro,
but difficult if it stays in.
Nevertheless, the available data show that the extraordinary nature of the Irish crisis provoked a depreciation that brought about an improvement of the Irish
current account balance. The Irish price level declined
by 15 percent relative to its trading partners from the
peak in the second quarter of 2007 to the second quarter
of 2011. In 2010 and 2011, Ireland even clocked in a
small current account surplus, the first in a decade.
By contrast, in the other crisis countries, net-of-VAT
prices have hardly reacted to the crisis. These countries
inflated as much as their eurozone competitors did, or
even more. Portugal and Spain have depreciated by just
1 percent relative to their euro trading partners, and Italy
even appreciated by 2 percent. Thus, except for Ireland,
based on the hard statistical facts available, there is no
sign whatsoever as yet that the euro countries are undergoing the necessary internal realignment to improve
their competitiveness.
The question is why such realignments have not yet
taken place. After all, the European interbank market
broke down as early as August 2007, and it has been
increasingly difficult for some of the crisis countries to
rustle up the necessary funding to cover their deficits.
Their financial difficulties should have resulted in sufficiently deep cuts in aggregate demand to exert the necessary downward pressure on wages and prices.
The answer is that the afflicted countries all had
easy access to the money-printing press. Backed by the
ECB Councils decisions to substantially lower the collateral requirements for refinancing credits, Greece and
Portugal in the years 2008 to 2010 were able to cover
more than 90 percent of their current account deficits by
resorting to the printing press. Spain financed a quarter
Continued on page 78
WINTER 2012
11
SINN
Continued from page 11

of its current account deficit this way. Had the moneyprinting presses been less easily available, the downward pressure on prices and wages would surely have
been much stronger.
Ireland not only covered its current account
deficit with money printing, but in addition and primarily a huge capital flight. From the summer of 2011
onwards, Italy too accommodated a brisk bout of capital flight with the printing press, about 80 billion in
August and September alone. The Bank of Ireland and
The only chance to repay

the debt is to become competitive
enough to earn a current
account surplus. That requires
becoming cheapereasy if a
country exits from the euro,
but difficult if it stays in.
the Banca dItalia lent fresh money to their commercial banks, which in turn bought government bonds
and other assets from their clients, and the clients then
went on a shopping spree, buying foreign assets to
safeguard their wealth.
The money printed in the periphery flowed to the
core countries, Germany in particular, and the resulting abundance of liquidity crowded out the normal
provision of money via refinancing credit or induced
banks to lend the surplus money back to their national
central banks. This eventually brought the
Bundesbank into a net debtor position with regard to
the German commercial banking system. In exchange
for the now inexistent claims against the banking system, the Bundesbank received so-called Target claims
against the European Central Bank, by now about
500 billion, accounting for about 50 percent of
78
WINTER 2012
Germanys net foreign wealth. In the years 200810,

Germany was unable to acquire marketable assets in
exchange for its current account surplus, as the case
should normally be. Fully 96 percent of its current
account surplus with the rest of the eurozone was
compensated just with Target claims.
As my colleague Wilhelm Kohler has pointed out,
these problems of the eurozone are similar to, but
much more extreme than, those of the Bretton Woods
system, the fixed exchange rate system that lasted until
1973. At the time, the U.S. Federal Reserve System
had printed many more dollars than were needed for
internal U.S. circulation. These dollars were used, for
example, to buy cheap goods and assets in Europe,
including German and French firms that had attracted
the interest of American investors. By virtue of the
fixed exchange rate regime, the dollars arriving in
Europe had to be converted into national currencies by
the Bundesbank and the Bank of France, and the converted dollar-deutschmarks and dollar-francs then
crowded out the refinancing deutschmarks and francs
that usually constituted the respective currency stocks.
The dollars (or U.S. Treasury Bills to which they were
converted) accumulating with the European national
banks were the analogue of todays Target claims, and
in both cases there were sizable public credit flows
through the central bank systems. It was said that
Europe financed the Vietnam war that way.
General De Gaulle did not like this public credit
flow. In 1968, he asked the United States to convert the
dollars that had piled up with the Banque de France
into gold, and he sent a warship to protect the gold
transport back home. This was the beginning of the
end of the Bretton Woods system, as the United States
was forced to end the gold convertibility of the dollar.
Today, the Bundesbank cannot call due its claims
in a similar fashion. No warship and not even a public
letter will be sent to the GIIPS countries or the
European Central Bank. German politicians try to
sweep the issue under the carpet rather than making a
federal case out of it. After all, there are already too
many fires that need to be put out. This should give
the eurosystem a better survival chance than the
Bretton Woods system.
Nevertheless, even Germanys tolerance cannot
be stretched indefinitely. As two of its representatives
in the ECB Council, Axel Weber and Jrgen Stark,
resigned this year because of the ECBs government
bond purchases, and as German President Christian
Wulff has already accused the ECB of circumventing
the Maastricht Treaty, the ice on which the euro skitters along has become very thin indeed.

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European

THE INTERNATIONAL ECONOMY

Hans Werner Sinn is President of the Ifo Institute and Professor of

These problems of the eurozone

GIIPS countries. (Surprisingly, even France had a net

THE INTERNATIONAL ECONOMY

Continued from page 11

The only chance to repay

THE INTERNATIONAL ECONOMY

Germanys net foreign wealth. In the years 200810,

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