Abstract
The paper assesses the contribution of key drivers of external imbalances in the Eurozone through the estimation of a panel-data Vector Autoregressive model over 1975–2011. Growth fluctuations, initially associated with demand booms triggered by unusually low interest rates, and later with demand contractions resulting from the crisis and policy adjustments, have played an important role in current account balance fluctuations. Changes in real exchange rates or unit labor costs have played a less important role. Demand shocks have contributed more to current account balance dynamics in the Eurozone periphery than in the core, whereas competitiveness has been a less prominent factor in the periphery but relatively more important in the core. Some broad policy implications of the findings for demand management in a currency union are discussed, including for fiscal policy coordination and macroprudential policies when union members face asymmetric shocks. The role of internal devaluation policies as a means of correcting external imbalances is also reassessed.
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Notes
The “Eurozone periphery” in this paper is defined to include the countries of the monetary union most affected by the sovereign debt crisis: Greece, Ireland, Italy, Portugal and Spain. These are the largest net debtor countries in the Eurozone, although in some countries, particularly in Italy, the current account deficits have not always been excessive. The “Eurozone core” countries are defined to include: Austria, Belgium, Denmark (member of the European Exchange Rate Mechanism), Finland, France, Germany, The Netherlands and Slovenia. The choice of countries is further explained in section 3.
The Macroeconomic Imbalance Procedure (MIP) includes an early warning system based on a scoreboard, which consists of a set of eleven indicators covering what is commonly perceived as major sources of macroeconomic imbalances. The MIP also involves recommendations for corrective action to members experiencing persistent imbalances and, in the event, an enforcement mechanism based on sanctions for members that fail to comply with the recommended corrective actions.
The literature has also examined other factors affecting the external balance, such as dependency ratios and trade. For example, using a methodology of bilateral trade regressions, Chen et al (2012) found that the Eurozone periphery suffered from asymmetric trade shocks compared to the core. It benefited less from increased demand from China and oil producing countries, while it was affected more from competition by Eastern and Central European countries.
This partly reflects the collapse of tax revenues linked to pre-crisis booming sectors such as construction but also the support provided to ailing banks in some periphery countries. It also partly reflects the fiscal fragilities of those periphery countries which used reduced interest payments on debt and buoyant tax revenues to expand public spending, thus leaving their budgets vulnerable to a loss of revenue as public expenditure was difficult to cut on short notice (see also IMF 2011b).
This view is well epitomized by Sinn (2011): “The euro brought about a convergence in interest rates, lowering all euro members’ borrowing costs down to German levels. But it proved to be a mixed blessing. The competitiveness of these countries was severely eroded in the process, since their wages and prices rose excessively over the period. To come out of the crisis, the GIPS [Eurozone periphery countries] now need to depreciate in real terms, i.e., reduce wages and prices relative to their trading partners, a painful process that requires harsh austerity programs, straining the social fabric and causing significant political strife.”
The competitiveness of tradable goods sectors can even be affected more directly by rising prices of non-tradables to the extent that non-tradable goods and services are used as inputs in the production of tradable goods.
Actual inflation rate is admittedly a crude measure of expected inflation. An alternative would be to use a backward looking approach to compute expected inflation. For instance, MacDonald and Nagayasu (2000) use a one-sided moving average filter consisting of four quarterly lags of actual inflation. Another alternative would be to use indexed-inflation bonds to calculate expected inflation. However, not all the Eurozone countries issue these type bonds.
Long term government bonds, the consumer price index series, and the REER series are taken from the IFS database of the IMF. REER series is also complemented with BIS data. YGAP and GR series come from the WDI database of the World Bank. Finally, CA is taken from the BPS database of the IMF.
Slovakia adopted the euro in 2009 so consequently we do not include it in the sample. Luxembourg, Cyprus, and Malta are excluded from the panel because of their relatively small economic size and the large size of their financial sector (implying that the dynamics of the current account can be potentially driven by very different factors than for the other members of the Eurozone).
Using the first-differenced OLS presents an additional advantage since it highly increases the likelihood of obtaining a stable VAR system.
All the robustness results are available upon request.
Not always these three criteria results coincide. However, one lag is always selected by the majority of criteria in the different specifications.
The ULC series are taken from the OECD database.
Actually, the standard deviation for the R shocks in the baseline VAR in the full sample [1975-2011] is higher (1.62) than in the more recent sample [1996-2011] (1.35).
Indeed, the standard deviation for the R shocks is 1.81 for 1996-2011, compared to 2.12 for the entire period [1975-2011].
External demand changes perceived as permanent may lead to reassessments of future income that alter savings, thus offsetting part of the direct impact of external demand changes on the current account balance. The direct impact of external demand shocks on the current account would be unlikely, however, to be reversed by the induced response of domestic demand.
In 2006-07, on average, the overall fiscal balance was in surplus, at 1.5 and 2% of GDP respectively in Ireland and Spain. Gross public debt in proportion to GDP was 25% in Ireland and 38% in Spain. During the same period, the average fiscal deficit in the Eurozone was 1% of GDP while public debt was, on average, 67.5% of GDP (IMF, Fiscal Monitor, October 2012).
Macroprudential measures motivated by systemic risk considerations, such as the dynamic loan provisioning implemented in Spain, can contribute to taming the credit cycle, while counter-cyclical macroprudential measures can reduce the probability of systemic risk by preventing suboptimal fluctuations in capital flows (see Cordella et al. 2014).
In the case of Italy, Portugal, and Spain these extra capital buffers would have absorbed most of the banking system losses resulting from the global financial crisis, although in Ireland and Greece these buffers would have not been enough.
Strictly speaking, a change in the relative price of the two goods would violate the assumption of fixed consumer income in each period, measured in terms of tradable or non-tradable goods. However, this is inconsequential for the point made here. A constant returns technology would be consistent with the assumption of fixed income but this would preclude changes in the relative price of the two goods as a result of changes in current consumption.
This adjustment can, however, be brutal if it is triggered by a sovereign debt crisis, as in the Eurozone in 2009-10, when markets doubt that the accumulated debt is sustainable. This would lead to sharply higher interest rates, a fall in domestic demand, and real exchange rate depreciation that may prove contractionary if resources cannot be easily shifted in the short run from non-tradable to tradable goods sectors.
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Acknowledgment
Views expressed in this paper are of the authors’ and should not be attributed to the World Bank or its Executive Directors. Helpful comments from Tito Cordella, Hinh Dinh, Poonam Gupta, Sam Ouliaris, and participants in seminars at the World Bank and the IMF Institute are gratefully acknowledged.
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Appendices
ANNEX 1: Impact of income convergence and lower borrowing costs in a simple intertemporal model of an open economy
Consider a rudimentary two-period, small open economy with no investment, where representative consumers are endowed with predetermined income (Y1, Y2) in each period and can borrow from or lend abroad at an exogenous interest rate (r). Consumers have no initial assets or debts so that we can neglect interest payments when looking at the economy’s external current account. They decide present and future consumption by maximizing utility over two periods subject to an inter-temporal budget constraint, with future consumption discounted by a certain rate of time preference (β). Assume that the income endowments, the interest rate, the discount rate, and the inter-temporal rate of substitution of present and future consumption are such that the economy is initially in autarky, with consumption (C1, C2) equal to income in each period and hence a balanced external current account (Fig. 12a, point A).
Consider a metaphor meant to illustrate the change in the environment faced by the Eurozone periphery after the introduction of the common currency. Assume that, as a result of international financial integration, the cost of borrowing is reduced to r’‹ r while the expectation of faster convergence raises future income to Y2’›Y2 with present income remaining unchanged. It is straightforward to establish that, at the new equilibrium (point B), the rudimentary economy will run a current account deficit (Y1-C1’) in the first period as the representative agents will attempt to smooth consumption over time by increasing both future and present consumption. A future current account surplus (Y2’-C2’) will have to match today’s deficit so as to repay the debt incurred to increase present consumption.
A rudimentary inter-temporal model of a small open economy (a) Impact of an increase in future income and a decrease in the interest rate on the current account balance (b) impact of the production of tradables and non-tradables on the real exchange rate
Assume next, for simplicity, that tradable and non-tradable goods are consumed in each period according to a fixed proportion, as illustrated by the radiant in Fig. 12b, regardless of their relative price—this can be derived, for example, from a Cobb-Douglas type utility function for the two goods. We also assume diminishing returns in the production of the two goods so that point A in Fig. 12b illustrates the production of tradable goods (YT) and non-tradable goods (YN) in the present period, before the increase in expected future income and the decline in the interest rate. As the economy is in autarky consumption of both types of goods equals production. The relative price of tradable goods in terms of non-tradables (PT/PN) is measured by the slope of the production possibility frontier at equilibrium and can be interpreted as the equivalent of the real exchange rate. A decline in the relative price of tradable goods (an increase in the relative price of non-tradables) denotes an appreciation of the real exchange rate.Footnote 22
Consider now how the increase in current consumption, induced by the expected growth in future income and the decline in the interest rate, which is reflected in the current account deficit run in the present period, affects the production of tradable and non-tradable goods. The new consumption equilibrium is illustrated by point B (Fig. 12b), indicating higher consumption of both tradables and non-tradables (CT’› CT and CN’› CN). The higher consumption of non-tradables has to be met through a shift of domestic production from the tradable goods sector to non-tradables, such as illustrated by the new production equilibrium at point C. The economy now produces YN’ = CN’› YN and YT’‹ YT. Consumption of tradable goods exceeds their domestic production by an amount (CT’-YT’›0) equal to the economy’s current account deficit measured in terms of tradable goods.
Note that in the new production equilibrium (point C) the relative price of tradable goods in terms of non-tradables must decline in order to induce the required shift of resources to the non-tradable goods sector. This is equivalent to an appreciation of the real exchange rate which underlies the current account deficit in the current period. In the future period, when the economy must turn the deficit into a current account surplus to repay its debt, production will have to shift from non-tradable goods to tradables, with a parallel increase in the price of tradable goods—tantamount to a depreciation of the real exchange rate. Footnote 23
ANNEX 2: Robustness exercise: Italy included in the Eurozone core subsample
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Diaz-Sanchez, J.L., Varoudakis, A. Tracking the causes of eurozone external imbalances: new evidence and some policy implications. Int Econ Econ Policy 13, 641–668 (2016). https://doi.org/10.1007/s10368-015-0316-0
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DOI: https://doi.org/10.1007/s10368-015-0316-0