A very interesting guest post by Christoph Zwick following up on our discussion on Eurozone rebalancing.
Current account imbalances within the Euro-Zone are frequently regarded as one of the driving factors that contribute to the ongoing economic crisis in the periphery countries. There is, however, some often observed inaccuracy in the debate about the channel through which the imbalances affect economic growth and employment. I first want to give a more detailed view on how the mechanism works before outlining some challenges that current account rebalancing poses on the Euro-Zone.
From basic economic theory, current account imbalances reflect different saving patterns across countries. In an open economy framework, a country with ample savings can lend to foreigners in the present and increase its future spending while a country with tight savings can borrow from abroad to finance higher current consumption or investment. This “intertemporal trade” is commonly regarded as welfare enhancing. Take for example Norway in the 1970s. The country borrowed extensively from abroad to develop its North Sea oil resources after world oil prices shot up. The result was a large current account deficit for four consecutive years that peaked at close to -14% of GDP in 1978, a value which even exceeds the deficits of the Euro-Zone-periphery before 2008. Soon after, the Norwegian current account returned to positive values, all debts were repaid and the development of the North Sea oil resources is still regarded as a success story.
In contrast to these considerations, current account imbalances are thought to have substantially contributed, if not triggered, the crisis in Latin America in the 1980s, the Asian crisis in the late 1990s and nowadays the crisis in the Euro-Zone periphery countries. So what is wrong with imbalances? The answer is that we should not care about the imbalances itself, but about the contraction of current account deficits. More on that below the fold.
Persistent current account deficits lead to a deterioration of the net foreign asset position of a country. At some point in time, investors will no longer be willing to finance large deficits as doubts arise on the ability of a country to serve its debts. This can either lead to a slow adjustment of the current account or to an abrupt contraction of the deficit. Empirical articles show that the higher the deficits and debts are, the higher is the probability of a country to experience a “sudden stop” of capital inflows. A reduction or even reversal of capital inflows induces an immediate external adjustment as the capital account is the counterpart to the current account. Such an external adjustment can be brought about by two mechanisms. “Expenditure switching” is typically caused by a real depreciation which causes a shift away from imports towards domestically produced goods and increases exports to other countries. “Expenditure reduction” lowers imports due to a compression of domestic demand. Both of which improve the current account, but “expenditure reduction” leads to shortfall in domestic demand. This negatively affects output and employment if the reduction in domestic demand is not compensated by an “import” of foreign demand via an appropriate real depreciation. If the exchange rate is flexible this depreciation follows directly from the expenditure reduction induced by the “sudden stop”, implying no significant negative consequences by the current account adjustment. If the exchange rate is fixed or furthermore if the considered country is part of a monetary union, real depreciation relies on bringing relative prices down which is often a long process due to diverse price rigidities. During the process, the country faces a shortfall of demand which caused several severe recessions over the last decades.
Now, let´s go back to the Euro-Zone finally. It is empirically shown that the periphery countries experienced “sudden stops” of capital inflows in the aftermath of the global financial crisis which caused abrupt reversals of their current accounts. In my working paper (pdf), I try to give an estimation of the required real depreciation of the Euro-Zone-periphery to overcome the shortfall in demand that current account rebalancing poses on these economies. Sadly, one of the conclusions of the paper is that many factors can be found that substantially influence the results, which makes a viable prediction very tricky. As a consequence, I decided to include these various factors in my analysis in a way that gives minimum results as far as possible. This strategy allows for some interesting conclusions, but I did not really regard this as a satisfying result given my initial goal to give at least an approximate estimate.
This is the reason why I am very thankful to Max Gödl and the commentators here on this blog, as they reminded me of the value of this minimum estimate. Following the discussion in and on the topic, several possible scenarios related to Euro-Zone rebalancing come to my mind which I believe as worth mentioning. I base most of my arguments on the mentioned 15% internal devaluation between Euro-Zone-core and -periphery, which I regard as the absolute minimum to overcome the shortfall in demand over the next three years.
1) “A Lost Decade”: This is the scenario in which prices further react very slowly, meaning that the 15% devaluation cannot be achieved over the few next years. This implies a very long period of demand shortfall and slow economic growth. (I have to add here that one of the results of my paper is that global current account adjustment puts substantial upward pressure on the Euro, which prevents a nominal depreciation against the rest of the world which could support rebalancing the Euro-Zone-periphery). This painful period of “internal devaluation” will finally end as prices have a long time to adjust and as relative price movements yield higher expenditure switching effects in the long run. In my paper, I estimate the long-run internal devaluation at a minimum of 7%. This scenario corresponds to the experiences during the Latin America crisis in the 1980s, which is the reason why Barry Eichengreen recently called it “The Lost Decade”. From the results of my paper, I cannot say if this period lasts for another 7, 8 or 10 years, but that does not affect my conclusion. This is a totally inacceptable future way for the Euro-Zone, in my opinion.
2) Deflation in the Periphery: As greatly discussed by Max, keeping the 2% inflation goal would result in a noteworthy deflation in the periphery if prices start to react as economists want them to, i.e. the required internal devaluation will indeed be achieved over the next few years. What I really like about the post is that it shows that even in the optimistic case that we observe the required price movements, the periphery countries face deflation as an additional problem. Another undesirable scenario.
3) Inflation in the Core: Again referring to Max, the opposite case to the previously discussed is that the ECB raises its inflation target such that the internal devaluation can happen without deflationary pressure on the periphery. As he illustrates, this requires an inflation of up to 5% in the core countries. This already very high number does not take into account the heterogeneity across countries in the periphery and in the core. Avoiding deflation in all of the periphery countries might result in an inflation that even exceeds the mentioned 5% in some of the core countries. My argument against this scenario is less an economic than a political one. How likely will some core countries, especially the inflation-averse Germany accept such high rates over several years?
4) Restore capital inflows
From the presented rebalancing argument, the downward pressure on economic growth in the periphery is a consequence of the stop of capital inflows. Restoring these capital inflows would at least require substantial debt-cuts to reduce the unsustainable foreign liabilities in the periphery. Additional, costly activities might also be necessary. This would allow for further current account deficits and decreases the pressure on economic growth. On the contrary, the burden of these debts cuts will lie on the banking sectors of the core countries as they hold most of the liabilities of the periphery. Further, expensive banking “bail outs” might result from this way. Additionally, it does not really solve the problem as it leads to further current account deficits and deteriorations in the net foreign assets positions. Another economically questionable and politically doubtable scenario.
One thing that I have to add here is that these scenarios abstract from possible productivity developments in the periphery countries. Substantial increases in productivity would mitigate the size of the required depreciation. I do not go into further detail on this topic here and leave the discussion to the experts in this field. The question is can we achieve such substantial increases over the next few years – maybe experts find a way, but I doubt it. If they do not, then I fear I have to agree to Ron´s comment on Max´ topic where he questions the meaningfulness of some countries to remain in the Euro-Zone. An exit would allow for the heavily required adjustment by a nominal depreciation. While I am absolutely aware of the hardly predictable consequences of this way, lessons from the Latin- and Asian crisis show that countries with a flexible exchange rate recover relatively fast from a “sudden stop”, while countries with fixed exchange rate regimes suffer from a long and painful shortfall in demand.
So will this be the end of the common currency? I do not think it needs to, when considering the heterogeneity in the periphery countries. While the discussed 15% depreciation refers to the region as a whole, one can find substantial differences between these countries. Ireland has already made significant progress in terms of external adjustment. Its economy is already recovering so I would not regard it as useful that Ireland leaves the Euro. Italy is also different to the other three (Spain, Portugal and Greece) as its net foreign liabilities-to-GDP – ratio is only about ¼ of the other. Therefore Italy´s need for external adjustment is much lower, if even existing.
What about the remaining three? Portugal and Greece are, in my opinion, hopeless cases. Their need for external adjustment is far beyond the average of the whole periphery – increasing the discussed problems from above. So if Greece and Portugal want to avoid a “Lost Decade” they will have to consider leaving the Euro-Zone and face the challenges which this way imposes on them.
So finally Spain is the remaining patient, facing a need for external adjustment which lies in between Italy and Ireland on the one side and Portugal and Greece on the other. Spain shows significant signs of higher price flexibilities compared to the others which might allow for a meaningful disposition in the Euro-Zone. The problem of inflation differential would be mitigated if Greece and Portugal are no longer to remain in the common currency. Combined with other options in terms of capital flows, I would suggest a considerable chance that Spain stays within the Euro-Zone.
All of the discussed scenarios reflect, of course, only my personal thoughts on the situation and concentrate on the “rebalancing-side” of the Euro-crisis, abstracting from others, like the Banking-crisis and the sovereign debt crisis. I end up with my (long, I know ;)) discussion by thanking again for the interesting inputs that I received from reading the earlier topic here on this blog and would appreciate if I induced a further constructive debate on this important topic.