Why should we worry about regional imbalances within the Eurozone?
Global imbalances consume media attention about international economic relations—the Eurozone is becoming a large contributor, having built up a surplus in the last five years. Yet surpluses can reflect weak consumption, and drag economy growth. This matters regionally as it may pose long-term problems for the Eurozone, especially in a context of growing worry of renewed European recession (Pisani, 2016).
A Slow Rebalancing Within Europe
Even though the Eurozone has a surplus vis-à-vis the rest of the world (3.2% of GDP in 2015 (IMF), the heterogeneity within the group is striking and evolving over time (European Commission Macroeconomic Imbalances Report; Sanchez & Varoudakis, 2014) . Despite the narrowing of global current account imbalances, some countries maintain large current account surpluses: Germany’s represents 8.5 % of its GDP. On the other hand, Cyprus is facing a deficit of 4.5% of its GDP (Darvas, 2015; IMF). Countries like France or Italy have experienced a drastic change from supporting surpluses to dealing with deficits. Germany has experienced the converse track. The dispersion peaked around 2007 and reversed after as a consequence of global financial crisis. Regional imbalances remain a source of vulnerabilities. For Mouhamadou Sy (2015), the gap’s narrowing is due to internal devaluation by periphery countries, but this does not change underlying concerns. According to Villeroy de Galhau (2016), governor of the Banque de France, a surplus of more than 3% of GDP in an economic area with a -2,3 % output gap is suboptimal.
The perception of current account deficits in the Eurozone evolved substantially since the EMU. Initially, large current account deficits (in the EU periphery) were seen as signs of future competitiveness improvements in these countries. Blanchard & Giavazzi (2002) provide evidence from early years of Eurozone confirming a view that current account deficits could be one of the benefits of monetary union. Merler, extending Blanchard & Giavazzi’s time horizon since the Maastricht Treaty, argues however that the analysis of current account assumed that the accumulation of foreign liabilities is matched by future surpluses and ignored that most macroeconomic imbalances were the product of capital flows internal to the monetary union (Merler, Bruegel, 2016).
Source: AMECO
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Recent adjustments have been asymmetric, driven by deficit countries since 2011 while surpluses increased in Germany and the Netherlands. Moreover, in deficit countries, improvements resulted from lower wages and unemployment, rather than an increase in productivity, which raises questions on the durability of such improvements. (Bluedorn and Wang, 2014) The case of the German surplus calls for specific attention. The European Commission considers trade surpluses that are repeatedly over 6% of economic output as dangerous for stability and has urged Germany to undertake more investment to stimulate imports (Reuters). Forecasts show that it will be at a record high this year with the fall of oil prices. Germany’s trade surplus exceeds China’s as a share of its economy. Some have argued however that focusing on the German surplus ignores the real problems experienced by the EZ, by concentrating reform efforts solely on public finances (The Economist, 2013).
Careful monitoring is therefore important (Baldwin and Giavazzi, 2015). Both deficits and surpluses create vulnerabilities. While deficits are obvious risks, surpluses bring several problems to the Eurozone framework. According to Hobza & Zeugner (2013), surpluses may reflect misallocations of resources, if they are the product of improper financial supervision, or market distortions (even if some are justified in ageing countries). Their reduction would be “welfare-enhancing,” since “they are driven by structural weaknesses affecting demand.”
Structural deficiencies at the heart of imbalances
Imbalances grew since the adoption of the EMU—attributed to competitiveness gaps via diverging unit labor costs, effects of financial integration through the creation of optimistic expectations, and real interest rate differentials.
Financial integration: the standard explanation via the convergence trend. “Good imbalances” can result from different investment needs and convergence trends (Lund and Roxburgh, 2009)—as suggested more generally by O. Blanchard and G.M. Milesi-Ferretti (2010) who differentiate “good” and “bad” imbalances. With the implementation of the Euro, sovereign and private spreads declined and converged, and contributed to a dramatic increase in capital flows, increased peripheral Europe’s deficits, and expanded asset price booms, while surplus countries grew their surpluses, all of this beyond convergence prospects and over optimism.
Real Interest Rates and Regional Imbalances. Sy (2015, 2016) explains the current account deficits in peripheral countries by a mismatch in the real interest rates, and excessive credit to the non-tradable sector, with an increasing differential in real exchange rates between core and peripheral Europe (Bénassy-Quéré, 2015). Sapir (2016) advocates that deviation of real exchange rates should be “closely monitored and corrected before they become protracted and painful to adjust”
Labor Markets and Imbalances. Different of labor market legislations between core and peripheral European countries have had an impact on imbalances, according to Bertola and Lo Prete. Empirically, they find that labor market deregulation was on average positively related to current account surpluses in OECD countries, due to households’ access to credit and improved productivity. J.L. Diaz Sanchez, A.Varoudakis argue that imbalances in the Eurozone periphery were mainly driven by a domestic demand boom, triggered by greater financial integration, with changes in the periphery’s competitiveness playing only a minor role. In core European countries, “unit labor costs have played a role in the emergence of current-account surpluses” enabling countries to benefit from the demand growth in emerging-market economies.
Real exchange rate misalignment. For Ben Bernanke, large surpluses in some euro zone countries result from real exchange rate under appreciation, a benefit especially for Germany. If Germany were still using the deutschemark, its higher value would reduce the cost advantage of German exports substantially. Second, this is compounded by deflationary policies (tight fiscal policies, for example) that suppress the country’s domestic spending, including spending on imports.
For Schoder, Praono and Semmler (2011), the adjustment through productivity growth and labor mobility is insufficient to keep trade accounts balanced and imbalances sustainable. Peripheral countries theoretically strongly rely on nominal exchange rate adjustment. Therefore, the introduction of the euro harmed these countries’ current account balances, taking away the only reliable adjustment tool they had.
What solutions against regional imbalances in a fragile Eurozone?
Internal Devaluation—Achieving the necessary reduction in relative costs would probably require sustained deflation in nominal wages outside Germany - likely a long and painful process, supported by Sinn and Valentinyi, 2013 and described by Bernanke (2015). Evidence, from countries like Greece or Italy, is weak (Posen, 2013) and this option faces economic and political hurdles. Schoder, Praono and Semmler (2011) argue that a decrease in peripheral countries’ wages will not be sufficient, and give arguments for higher wages in core European countries. They also argue that low-interest credits for productivity enhancing infrastructure would substantially reduce the uneven productivity distribution.
Reduction of the German trade surplus—According to Pritchard, Germany’s current account surplus is out of control, and Germany's record trade surplus is a bigger threat to euro than Greece. Germany has several policy tools at its disposal to reduce the surplus. (1) It may invest in public infrastructure. (2) It can raise wages of German workers (also advocated by Derviş, 2013). (3) Germany could increase domestic spending through targeted reforms, including for example increased tax incentives for private domestic investment; the removal of barriers to new housing construction; reforms in the retail and services sectors; and a review of financial regulations that may bias German banks to invest abroad rather than at home (IMF; Brookings, 2015; Darvas, 2013; Legrain, 2015; Bernanke, 2015; Cohen-Setton, 2013; Kollman et al., 2014). Wood (2014) also talks about “internal appreciation” in core European countries, mainly through an increase in wages. So far, data indicate that in the six years between 2007 and 2013, Germany has not given a small contribution to the correction of imbalances within the Eurozone (Daveri, 2014).
Structural Reforms for GIIPS countries—A long-run goal for many countries that will help deficit countries enhance their competitiveness and increase their fiscal base (European Commission, 2014; Dodig et al., 2015).
Macroeconomic Imbalance Procedure (MIP) — Established in 2011, the MIP contains 14 indicators covering different areas concerned with imbalances and adjustment issues (European Commission, 2016). There is no consensus among academics concerning the implementation of this procedure. Sapir (2016) argues that the MIP, thanks to the sanctions, will be able to harmonize wage-setting systems, when members countries have no incentives on it on their own. The MIP could also be the “foundation for significant synergies between the MIP and macro-prudential policy” (Merler, 2015). However, Villeroy de Galhau (2016) states that it might be weak because of its non-mandatory aspect. Finally, Saint Paul (2014) believes that such a procedure might go against natural market adjustment forces, and that national governments could collude against the EC in order to avoid sanctions.
