Intra-EMU Divergence Is A Feature Not A Bug

Yves here. I’m leery of reinforcing the “competitiveness” meme, since it’s based on the false premise that all countries can be exporters. But this article nevertheless makes important observations about Eurozone structural flaws.

By Paolo Pasimeni, Economist, European Commission. Originally published at the Institute of New Economic Thinking website

Germany’s wage restraint policy is likely to amplify divergences in competitiveness.

Germany ran the largest current account surplus in the EA, and its banking sector developed an increasing exposure toward the rest of the currency union. A first, stylized fact is the similar trend of the gross exposure of the German banks and the country’s CA balance with the rest of the Euro Area.

Figure 2: Gross exposure of German banks and German Current Account balance vis-à-vis the rest of the EA (1999-2014, quarterly)

Source: own elaboration on data from the Bank of International Settlements and the Deutsche Bundesbank.

First, the similarity applies not only to the overall position of the country towards the rest of the world, but also holds true for its relation with the Euro Area. Second, and most importantly, the same similarity applies to the bilateral relations between Germany and each other euro area partner.
Changes in relative competitiveness and in domestic demand in Germany and in each other partner can both determine the bilateral current account balances. In a recent paper (Pasimeni, 2015) I try to better understand the impact of the various factors. The results (see also the annex) show an important and significant effect of the banks’ exposure and of the difference in investments, while real effective exchange rates and interest rates are significant, but with very low coefficients. The exposure of the German banking sector towards each EA country has actually been significantly associated with the German bilateral current account balance (positive and significant coefficients). At the same time, the comparatively lower level of investments made in Germany was the other relevant and significant determinant of the bilateral current account surpluses (negative and significant coefficients). Time-fixed effects suggest that these relations are independent of any specific policy change that might have occurred.

These results confirm the hypothesis that intra-EMU trade imbalances were caused not so much by changes in relative cost competitiveness, but rather by demand shocks and investment in particular. Similar result comes from a study by Danninger and Joutz (2007) on the determinants of Germany’s export performance, which appears to be mainly linked to trade relations with fast growing countries, rather than on improved relative cost competitiveness, which actually “played a comparatively smaller role in explaining the brisk export growth” (less than 2% of German export growth).

Moreover, the significant effect of the banking sector’s exposure on current account balance provides an illustration of the role played by the “private insurance channel.” The larger the capital outflow from Germany to each trading partner, the higher the bilateral surplus, and vice versa. The funds flowing from the German banking sector to other EMU countries, in a context of growing financial integration, boosted aggregated demand in the other countries, and therefore their imports from Germany, in a kind of vendor-financing operation.

Policy Implications

If this diagnosis is correct, then, the EMU has a structural tendency towards developing internal imbalances in the current accounts of its members. Absent the exchange-rate, the only way to deal with those is through periodic internal adjustments of income. But pressure to adjust a CA surplus is never as strong as the one to adjust a CA deficit. In fact, the adjustment in recent years has been driven by an important fall in aggregate demand in deficit countries, with large output and employment gaps.

So, if the pressure to adjust is asymmetric, if there are no common instruments for demand management; if the response can only be provided at national level, and if deficit countries can only adjust through deflationary policies, then the whole area has an inherent deflationary bias, which determines subdued growth rates in good times and longer stagnations and recessions in the worst cases.

The EMU faces a cruel trade-off: growth with imbalances, or balance without growth. Either it has to rely on the pre-crisis growth model, when financial integration was substituting a common fiscal capacity, channelling credit and capital flows from surplus to deficit countries, and fuelling unprecedented imbalances. Or, it has to impose restrictive policies, trying to consolidate public finances and achieve balanced external positions, at the cost of a drag on growth. In the worst case scenario, if deflationary policies are prolonged, it may also face the even more unpleasant situation of imbalances without growth. The system lacks an instrument capable of defusing this dangerous mechanism.

The two structural problems of the EMU — the tendency to develop imbalances and the deflationary bias — connect via the balance of payment constraint. Without such constraint, only common fiscal policy can prevent the building up of imbalances, acting as a buffer and providing the adequate fiscal stance over time. Such a fiscal capacity should be linked to the relative, intra-EMU, external balances of the participating countries: The higher the net surplus in intra-EMU trade (that is, the direct benefit from other members’ income), the higher the contribution to a common fiscal capacity.

It is important to stress that the relevant variable is the relative, intra-EMU, current account position and not the absolute one: This way, the composition of the budget can be independent from the overall external position of the euro area, allowing for a form of built-in automatic rebalancing mechanism that guarantees intra-EMU equilibrium, symmetry, and stability.

This idea is not new; it was at the core of John Maynard Keynes’ reflection on a more stable international monetary system (Keynes, 1940). Keynes’ plan for an international clearing union was conceived precisely on the basis of this underlying analysis, in view of the Bretton Woods monetary arrangements. Keynes was concerned with the asymmetric consequences of a mercantilist strategy in a fixed-exchange rate system on effective demand and employment.

The build-up of disequilibria in the balance of payments increases the risk of having to apply deflationary measures in deficit countries to adjust and restore competitiveness. This in turn creates periodic falls in aggregate demand and prevents the system from achieving full-employment.

He proposed an international closed system of payments that, within a system of fixed (but periodically adjustable) exchange rates, ensured symmetric rebalancing between deficit and surplus countries, [2] a kind of “financial disarmament” as he called it (Keynes, 1940). If this plan was too ambitious to be applied at a global level, its relevance is manifest for a smaller but tighter international monetary system such as the EMU.

Some decades later, the 1977 “MacDougall Report” revived the issue, precisely with an eye to the European monetary unification process. It studied how central or federal public finance could reduce inter-regional income differences in eight case studies (Germany, UK, France, Italy, USA, Australia, Canada and Switzerland).

The report measured the public finance outflow/inflow at the regional level in parallel with the relative current account position of each region. It showed that the redistributive function of the national budget at regional level reflected corresponding positions of the regions in their balance of payments on current account. Inflows to relatively poor regions were on average equal to 70% of their current account deficits, while outflows from relatively richer regions were on average equal to 95% of their current account surplus. This achieved an overall stabilisation effect at national level through reducing per capita income differences by 40%.

Had such a scheme been in place in the EMU, it would have automatically reduced the imbalances, periodically and symmetrically correcting them. It would have ensured that surpluses did not remain idle and that absorption of deficits did not pose a drag on aggregate demand. It would have eliminated incentives to “beggar-thy-neighbour” through competitive internal devaluations. It would have been much less pro-cyclical than the system of transfers operated by capital flows in financial markets, which stopped once the financial crisis erupted. It would have also reduced the need for the system to exclusively rely on the efficiency and stability of financial markets, thus reducing systemic risks. It would have provided an instrument for stabilization against common shocks, and it would have substituted the inherent deflationary bias of the system with an adequate demand management, propaedeutic to full employment.

Would such an instrument have avoided the long period of recessions and divergences? This is hard to say, since a proper counterfactual does not exist. What seems clear, however, is that its absence has undermined the stability and prosperity of the monetary union.