The Real Problem With the GIIPS: Current Account Deficits, not Budget Deficits

By Avraham Baranes

Modern Monetary Theory (MMT) emphasizes the Sectoral Balances approach. According to the sector balances identity:

Domestic Priv. Sector Balance + Domestic Public Sector Balance + Current Account Balance = 0

It follows that:

Domestic Priv. Sector Surplus = Domestic Public Sector Deficit + Current Account SurplusThe deficit rules for the EU state that each countries budget deficit may not exceed 3% of GDP. This has the unintended consequence of also restricting the maximum sustainable current account deficit to 3%. At any current account deficit greater than 3%, the Domestic Private Sector Balance (DPSB) will be negative, a truly unsustainable situation as Wynne Godley famously predicted. Since 1999, the big winner in the EU has been Germany. Simply looking at current account balances, Germany moved from running small current account deficits in 1996 to amassing large surpluses after 2001. In the meantime, Italy, Ireland, and France saw their current account balances move from surplus (in the case of Italy and Ireland, quite substantial ones, more than 3% of GDP) to deficit.

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What these graphs show is that the austerity programs proposed to fix the situation with the GIIPS cannot work. The current account deficits for Portugal, Greece, and Spain make it so that it is impossible to follow the deficit rules and maintain positive DPSB. Furthermore, these charts show why Germany is able to have smaller budget deficits and lower unemployment. By running large current account surpluses, Germany is able to run lower budget deficits or even budget surpluses while maintaining positive DPSB. This is why Germany has lower unemployment compared to GIIPS (Greece, Italy, Ireland, Portugal, and Spain).

Donald Luskin and Lorcan Roche Kelly have an interesting, yet woefully incorrect explanation as to why Germany has been doing so well. They claim that the structural reform “Agenda 2010” transformed “Germany into an economy where business has an incentive to invest, and where labor has an incentive – and an opportunity – to work.” These reforms weakened the power of labor unions and gave more power to businesses. The claim here is that this boosted the German economy (leading to a current account surplus) and that the rest of the EU, particularly the GIIPS, should adopt similar programs. There are two major problems with this conclusion. First, the timing makes no sense. “Agenda 2010” was not fully implemented until 2003; Germany was running current account surpluses (albeit very small ones) as early as 2001. By the time the reforms were in place, Germany was already running a current account surplus and positive DPSB, putting them in a good position to implement these reforms. This is not true for the GIIPS. Second, the notion that labor market reforms in the GIIPS will solve the problem is flawed. According to the Variant Perception’s Primer on the Euro Breakup, there are two ways to obtain current account surpluses. Option one includes labor reforms such as reducing wages for deficit countries while boosting imports for surplus countries. Option two involves currency adjustments. Historically, option two is the only thing that works in practice, even though option one is the choice currently being proposed by the mainstream.

So what does this all mean? Largely, it means that the budget problems of the GIIPS are not the real issue; the issue is the current account deficits these countries are running. It has nothing to do with the notion that workers in the GIIPS are simply lazy, but more that they are being asked to implement policies that have no chance in working. A better option would be for these countries to leave the euro and return to a sovereign currency. From here, these countries would be able to devalue and move from current account deficits to surpluses. The fact that Germany is doing well has less to do with their lower budget deficit (which is still larger than 3% of GDP, by the way), but more with the fact that they are running large current account surpluses, ones that started before the labor reforms were put into place. Unless all countries in the EU can run current account surpluses, it is unlikely that the same reforms would work for the GIIPS. Now, if these countries were to leave the EU and move to their own currency, they would then have the option of unrestrained (to a degree) fiscal stimulus as described elsewhere on NEP and devaluing their currency, making their goods more competitive and lowering their current account deficits.

The notion that “Agenda 2010” worked in Germany and should therefore be implemented throughout the EU does not hold any water and is a simple fallacy of composition[1]. Germany began running current account surpluses before implementing these programs, giving them an advantage over the GIIPS and France. Furthermore, it would be next to, if not completely, impossible for each country in the EU to run current account surpluses. Demand, not supply, policies are needed for the troubled countries, and it is unlikely that these will happen while still on the Euro.

[1] A fallacy of composition is the idea that the whole is true because a part is true; in this example, the idea that the German reforms will lead to current account surpluses for all of the EU because they led to current account surpluses for Germany.