The Importance of Trade and Capital Imbalances in the European Debt Crisis
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 a large stock of foreign debt, while flows of foreign capital ceased to finance productive investments that might have contributed to debt repayments. 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.