Martin Wolf in today's Financial Times is completely correct when he describes the current Eurozone crisis as, at root, a balance of payments problem not a government deficit, sovereign debt problem.
Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today's crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years. After the crisis, the picture changed, with huge (and unexpected) deteriorations in the fiscal positions of Ireland, Portugal and Spain (though not Italy). In all, however, fiscal deficits were useless as indicators of looming crises.
Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable. Again, after the crisis, the picture transformed swiftly. Ireland's story is amazing: in just five years it will suffer a 93 percentage point jump in the ratio of its net public debt to GDP.
Now consider average current account deficits over 1999-2007. On this measure, the most vulnerable countries were Estonia, Portugal, Greece, Spain, Ireland and Italy. So we have a useful indicator, at last. This, then, is a balance of payments crisis.
So, the proposals currently being crafted on deficit and debt limits by Merkel and Sarkozy are not relevant and will not deal with the problem.
The problems of the Eurozone are largely 'systemic' although the behaviour of some governments and private sector agents in individual countries such as Greece has not helped. Kash Mansori demonstrates that the creation of the Eurozone made it more attractive for investors in the rest of Europe to buy assets in the peripheral countries, where there were, on the face of it, significant investment opportunities. Governments in the periphery were able to borrow at near German rates because the financial markets believed, and were implicitly led to believe by the ECB and Germany and France, that peripheral country sovereign bonds had the backing of the Eurozone authorities. This led to significant borrowing largely by the private sector but also sovereign borrowing resulting in major flows of capital from the centre - especially German and French banks - to the periphery. A crisis was precipitated when these flows suddenly stopped, due in part to the wider consequences of the credit crunch and many of the investments went bad e.g. commercial property and housing investments in Spain and Ireland. This led to a rapid rise in public debt as some of the periphery countries bailed out their banks, and spent more and taxed less in the recession mainly through indirect 'automatic stabiliser' effects - e.g. increased unemployment benefit payments .The analogue of these flows in the national accounts was current account deficits in the periphery and a massive rise in Germany's current account surplus. See chart:
Source: Paul Krugman, 5 December 2011
These capitals flows worsened an already weak and worsening current account trading position in the periphery because of the high exchange value of the Euro driven by continuing improvements in German competitiveness. Several of the periphery countries such as Greece, Portugal and Spain had, and still have, real efficiency and competitiveness problems, which make it difficult for them in a monetary union led by Germany that has high levels of productivity growth. One saving grace might have been if these investment flows had facilitated an economic adjustment in the periphery sufficient to raise their productivity and competitiveness towards German levels. But they did not, even though the evidence shows (Mansori again) that the capital flows were associated with investment spending rising in the periphery countries (with the exception of Portugal) relative to consumption. However, the capital flows in addition tended to fuel rising domestic prices in the periphery, hence a rising real exchange rate and deteriorating competitiveness, which improved little relative to Germany.
So, the Eurozone must first deal with its current sovereign debt financing problem and then deal with the root problem, which is a required adjustment in the relative competiveness - real exchange rates of the periphery relative to Germany.
On financing, the only real solution is for the ECB to take on the true role of a central bank, which is not simply aiming for price stability but also acting as lender of last resort. If ECB acted as a lender of last resort it would start to buy individual sovereign bonds where there was a market shortfall. This is what the Bank of England would do in the UK or the Fed in the US. However, to fulfil this function would require the ECB to print Euros and hence increase the money stock. Given German sensitivities over inflation this is unlikely to happen and so the Eurozone financing crisis will continue. But there is some hope from hints by the ECB that a more solid commitment to fiscal union would result in the ECB playing a more active role in the Eurozone sovereign debt market and therefore move some way towards a lender of last resort position. But this piecemeal approach is unlikely to satisfy the financial markets other than in the very short term.
On the issue of adjustment, the overriding goal of the ECB and the core countries of the Eurozone, especially Germany, is that the burden of adjustment must be borne by the current account deficit countries in the periphery. But to secure adjustment in the absence of individual national currencies requires internal devaluation: price and wage reductions relative to the core. This is almost impossible to secure. Countries such as Ireland and Latvia which might be described as the poster boys of internal devaluation have hardly achieved any real internal reduction in wages and prices. It can be said with some certainty that Germany and the ECB need to accept that current account surplus countries within the Eurozone are part of the problem. They must adjust too. They can adjust by allowing an expansion of domestic demand sufficient to promote a rise in domestic inflation to 3% to 4%. If that happens then it will be easier for the periphery to adjust through a much less stringent internal devaluation, but if that doesn't occur there is little hope for the survival of the Eurozone as presently constituted.