Don't panic, mister Sinn, as panic is the problem! (2 graphs)

from Merijn Knibbe

Hans Werner Sinn is a leading German economists. He has rightly opened out eyes to the importance of the Target2 balances which at this moment provide the liquidity which keeps the Eurozone afloat. But ccording to Sinn, in a recent article in which he laments the past and regrets the future, interest rates in the Eurozone periphery countries should have been higher, private investments should have been lower and government expenditure should have been slashed even more. This would have caused a faster improvement of the large current account deficits of these countries and possibly smaller Target2 imbalances today. Nothing about more spending in Germany…

On a psychological level, he sounds like somebody who to his abhorrence has discovered that, well, the world did not work the way he supposed it to work, feels betrayed, loathes his own stupidity and now, panicking, tries to cover his losses not by doing the right thing (spend the money!) but by doing the wrong thing (restrickting spending and a flight into safety, i.e. changing Target2 debts into something more tangible ‘non-fiat money’). But is Sinn right on an economic level? First things first: even the economic costs alone of years and possibly decades of 25 to 35% unemployment in the periphery countries are a multiple of the costs Sinn is afraid of. Also, Sinn is by now clearly aware that German banks are of the hook. The ‘Target2′ claims effectively bailed out these, i.e. the current account debts were transferred from private southern and northern European companies and banks to the central banks. And when you read Sinn carefully he also seems to understand that transferring debt is not net-money creation on the Eurozone scale, despite his use of the term ‘printing press’ when it comes to the financing of still existing current account deficits. But he’s still panicking: “what if the Eurozone breaks up?”. Well, unemployment might go down surprisingly fast, in Spain and Portugal and Greece. But that’s not the question here. The question is if Sinn is right about the fact that ‘frontloading’ austerity like the Baltic countries did would have caused current account deficits to decrease faster, which would have caused Target2 imbalances to be slightly smaller today.

Let’s take a look at these deficits (graph 1).

The elephant in the room: Sinn is fighting the wrong battle. In 2005-2007 things went wrong. That was the time to restrict spending! A 2 or 3% deficit of the current account is nothing to worry about. But deficits increased from already high levels to unsustainable levels (and not just in these countries: inflows of to a large extent German capital caused comparable developments in all European low wage countries). We can lament this – but it happened. And now is the time to stimulate spending…

Which in my view means that Sinn is too late, with his laments and regrets. We have to live with it and take time to solve it. Which in the meanwhile might mean even larger Target2 imbalances… But is Sinn right that ‘frontloading’ would have caused smaller Target 2 ‘problems’ today? Hmmm. Maybe not, when we look at graph 1. “Frontloaders” like the Baltics or Ireland did not do really better, taking the initial level of the current account and recent developments into account. The real Target2 ‘problem’ is caused by the extra-ordinary size of the deficits in 2005-2007, Sinn should have taken this into account. Italy did not have a large deficit to begin with and the other countries show, by and large, about the same development of the current account: fast post 2007 improvements, mainly caused by lower spending and higher unemployment at home. More ‘frontloading’ in Greece and Spain and Portugal would only have led to even more misery, unemployment and disintegration. What the Eurozone needs is more spending, not more cuts. Adding Euro countries Slovenia and Slovakia to the sample does not change the conclusion: the main problem is the size of the deficits around 2005-2007, not the way they these were slashed, countries like Romania, Poland and the like do not have the euro or a real euro-peg and have therewith not been added to the sample.

Bonus: Graph 2 shows the graphs for the current account and the ‘goods and services account’ for Ireland and the Baltics, the difference being the income account (profits, wages and the like). Clearly, the ‘bump’ in the Baltics current account was caused by a large decline of outflowing income, probably mainly profits. By now, the outflow of ‘income’ has increased with 5% again. The unusually large difference between the two accounts in Ireland is to quite some extent caused by the ‘Microsoft’ effect. I buy my Microsoft programmes via a so-called ‘surf’ licence in Ireland, which causes Ireland to export ‘services’. As many of the real costs of these programmes are made in the USA almost all of the money I pay is ‘profits’, which is transferred to the USA. This happens on a large scale, in Ireland.

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