Balance of payment concept in the market

Balance of payment, a concept that is defined by Fieleke (1996,p.3) as a record of all the transactions between the residents of a country and other foreign residents over a specified time interval is critical to the monetary stability of any given economy. Euro crisis for instance, is attributed to balance of payments disequilibria that affected the Eurozone (Sinn, 2012, p.3).Sinn and Wollmershäuser (2012) indeed argued that the Euro crisis is basically a balance-of-payments crisis that is analogous to the Bretton Woods crisis (p.1). One of the aims of European Monetary Union (EMU) was that only the global balance of payments of the European Union with the rest of the world be of importance and not those between members. However, it has failed miserably in containing the balance-of-payments crisis affecting the region (Katsimi & Moutos, 2010, p.568).In this paper, we evaluate alternatives and then focus on the optimal policy alternative(s) that the EU can use in addressing the BoP disequilibria with the rest of the world.

EU crisis as a balance of payment (BoP) crisis

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Popularized by Wolf (2012), the treatment of the European crisis as a form of balance of payment (BoP) crisis is rapidly becoming dominant. Therefore, the main cause of the crisis must be found in the much easier access for a large number of peripheral EMU countries to the greater European financial markets at much lower nominal interest rates (Wyplosz, 2012).  Instances of financial liberalization coupled with the removal of the exchange rate risk are noted by Merler and Pisani-Ferry (2012) to have  encouraged massive capital flows from the core regions to the to periphery countries in the region’s  ‘periphery’. Autonomous consumption which was credit-financed effectively determined a growth of both the domestic demand as well as of the nominal wages at a rate which was higher than in core regions. The higher inflation rates in the periphery, effectively determined low real interest rates which was a support to the region’s domestic demand (De Grauwe Paul, 1998). As Dadush et al., (2010) noted, the fiscal mess at the periphery was not the main cause of Euro-zone‘s sovereign debt crisis. The recorded growth of domestic demand was effectively associated to a rising developed housing bubble both in Ireland and Spain, as well as to the growth of public spending in EU nations such as Greece (Reinhart, 2011).

The European Monetary Union as a source of institutional failure in the EU crisis

According to Krugman’s (2011) contribution on the analysis of the origin of EMU crisis, the choices that were made by European politicians are the main reason for the crisis. The politicians’ move of calling for a much closer union immediately after the German reunification instead of considering economic reasons is noted to be what precipitated to the disaster. This is in line with the views of Carlo Panico (2010) that attributed the origins of the economic crisis in institutional failure. According to his premise, EMU institutional failures are what precipitated the EU crisis and he noted that the specific cause was the speculative attacks’ to EU peripheral state that were by the regarded as in-debt countries. This argument is however disputable as noted by Cesaratto (2011a,2011b) due to the fact that its takes undue advantage on a crisis that is much older and having more profound root causes.

Policy alternatives

There exists several policy alternatives that can be used in fixing the BoP mess that EMU has failed to take care of. The work of Panico (2010, p. 5) proposed the establishment of an independent authority that is similar to the ECB to be put in charge of the region’s fiscal policy. This is however noted by Cesaratto (2011a) to be disputable, mainly from a Keynesian point of view, because it certainly elicits a reaction on of a body whose general mandate is limited to fiscal rigor (Keynes,1980). Additionally, an independent fiscal authority would end up increasing the general lack of democratic accountability of the economic decisions made in the European regions. The European Central Bank (ECB) is noted by Richter and Wahl (2011) to be one of the most important players in the sovereign debt crisis that gripped the Euro-zone. Its operations were based strictly, on the monetarist’s idea of central banking that reduced central banks to be mere guardians of citizens against consumer price inflations. In the process, the body totally ignored inflation of financial asset prices. Also ignored were employment, growth and financial stability. This therefore means that faults in the very design of the ECB and to be specific, with the monetarist ideals and obsession with issues of consumer price inflation coupled with the undemocratic, unaccountable and nontransparent nature of the institution.

Expenditure changing and expenditure switching

Expenditure changing and expenditure switching are noted by Caves et al (2002) to be excellent methods for achieving both internal and external balance of payments. In any given open economy scenario, policymakers are tasked with aiming to achieve two main goals that are both necessary for the achievement of a macroeconomic stability. These are internal and external stability (Reinert et al., 2010, p.398). Internal balance, they note, is a state whereby a given economy is at it optimal level of output which is achieved by fully engaging a nation’s resources and maintaining the stability of domestic price levels. External balance on the other hand is achieved when a nation is operating neither at an excessive level of current account deficit nor at a surplus. This means that net exports are either close or equal to 0 (zero). Expenditure changing policy as well as expenditure switching policy are noted by Reinert et al. (2010) to be two rather independent policy mechanisms or tools that can be used in the attainment of internal and external balances.

The expenditure changing approach is a special macroeconomic adjustment technique that has an emphasis that the level of aggregate demand contraction (using the appropriate monetary and fiscal policies) can help in reducing the level of a nations total expenditure with an inclusion of imports and thereby helping by improving external balance of payment. The problem with this approach is that it could lead to a general reduction of both import and exports in cases where exports have particularly large import levels. This approach is not suitable for the entire EU region due to the fact that the nations have different fiscal policies on which it is dependent.

The expenditure switching approach on the other hand is a macroeconomic adjustment technique that has an emphasis on currency devaluation and thereby making imports to be less attractive in term of price and hence forcing the domestic consumers to replace the imports with the locally available substitutes. The main problem with this approach however, is that it is very sensitive of both domestic and foreign consumers in regards to the price changes. For example, whenever the domestic demand for certain imports become inelastic to price changes or to foreign exchange rate, price devaluation would in this case be ineffective in regard to external deficit reduction. If fiscal expansion is successfully implemented, then money demands as well as interest rate would subsequently increase and thereby discouraging private investment. This only occurs if some degree of price stickiness is inherently assumed. It can also lead to worsening of net exports.

Among the above mentioned, expenditure switching policies, the most suitable policy for solving the Euro crisis is devaluation since it would affect the current account balances as well as the output equilibrium levels of the EU economy. Devaluation would increase the domestic price of import while at the same time decrease the export’s foreign price. The degree to which devaluation would improve the current balances is however dependent on the level of elasticities of demand for both the imports and exports.  In accordance to the Marshall-Lerner condition,  if the total sum of  a nation’s or region’s elasticities of demand for imports and exports is larger than one, then the depreciation of the nation’s or region’s domestic currency would lead to the improvement of the current account. The Marshall–Lerner condition is noted by Davidson (2009) to be a technical reason for devaluation of a nation’s or region’s currency needs to be gradual and not immediate in an effort of improving the balance of trade. According to Bahmani-Oskoee and Ratha (2004), trade in goods is normally inelastic within the short term period as a result of the time taken in changing consuming patterns as well as trade contracts. If Marshall–Lerner condition is never met, then devaluation is mot likely to worsen the trade imbalance at the initial stages. However, in the long run, the consumers would adjust to the set prices and the level of trade balance would improve. (Bahmani-Oskooee,2011)

Control of money supply

The control of money supply can only be affected by ECB.However, this is a far less favorable approach due to the weaknesses facing ECB.As pointed out earlier, and European Central Bank (ECB) is noted by Richter and Wahl (2011) to be one of the most important players in the sovereign debt crisis that gripped the Euro-zone. Its operations were based strictly, on the monetarist’s idea of central banking that reduced central banks to be mere guardians of citizens against consumer price inflations. In the process, the body totally ignored inflation of financial asset prices. Also ignored were employment, growth and financial stability. This therefore means that faults in the very design of the ECB and to be specific, with the monetarist ideals and obsession with issues of consumer price inflation coupled with the undemocratic, unaccountable and nontransparent nature of the institution (Milbradt,2012).

The optimality of the policy alternatives

The most efficient policy in resolving BoP disequilibria with minimal negative externalities is devaluation. This can be achieved by means of expenditure switching policies which as earlier postulated, is the most suitable policy for solving the Euro crisis is  devaluation since it would affect the current account balances as well as the output equilibrium levels of the EU economy. Devaluation would increase the domestic price of import while at the same time decrease the export’s foreign price. The degree to which devaluation would improve the current balances is however dependent on the level of elasticities of demand for both the imports and export. The only condition is that the Marshall–Lerner condition must be met otherwise the condition would worsen.


The Euro-crisis is a crisis that can only be tackled with a series of policies which can only be implemented over a longer period of time. There needs to be patience and cooperation among major players in the EU economy. The ECB must play its role in stabilizing the macro and micro economic variables of the EU economy. The entire EU banking landscape needs to be reformed (Leppänen,2012).At this point, it would wise for policy makers to focus more on a Keynesian principles in a bid to solve the Euro-crisis and expenditure switching is such a policy that is based on Keynesian ideals.






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