MASTER PROJECT

Michel Carlo Nies Master in Economics 2013/2014

Barcelona Graduate School of Economics

EUROPE OUT OF BALANCE An analysis of current accounts in Europe

ABSTRACT

The European sovereign debt crisis should not only be seen as the simple failure to

manage public finances, but also as the consequence of divergent balance of payment

positions. This paper attempts to shed light on this line of argument by analysing

empirically the determinants of current accounts. The principal conclusion is that

divergent developments in labour costs and misallocation of capital are behind the

developments that led to the sovereign debt crisis. Given these results, this paper also

evaluates different policy measures designed to address the issue of diverging current

accounts.

TABLE OF CONTENTS

1. INTRODUCTION ...................................................................................................................... 2

2. THEORY ................................................................................................................................. 4

2.1. Differences in competitiveness ..................................................................................... 4

2.2. Failure of financial markets ........................................................................................... 7

3. EMPIRICAL ANALYSIS ............................................................................................................ 8

3.1. The model ...................................................................................................................... 8

3.2. The dataset .................................................................................................................. 11

3.3. Results ......................................................................................................................... 12

4. POLICY RECOMMENDATIONS ............................................................................................... 15

5. CONCLUSION ....................................................................................................................... 18

REFERENCES ................................................................................................................................ 19

APPENDIX .................................................................................................................................... 20

1

1. INTRODUCTION

Divergent balance of payment positions are one of the principal challenges for

international economic coordination. This development can be observed on the global

level, with China running persistent current account surpluses while the United States

exhibit negative current account balances since 1989, as well as on the regional level. In

Europe, the divergent balance of payment positions are today seen as the underlying

cause for the sovereign debt crisis that started with the de facto default of Greece and

has spread over to Ireland, Portugal, Spain and Cyprus.

Since the current account is by definition mirrored by the financial account, current

account deficits decrease a country’s net foreign asset position. Hence, when a country

runs persistent current account deficits, it accumulates foreign liabilities. The Pitchford

thesis, which states that current account deficits only matter if driven by the public

sector, appears largely violated in Europe. With the exception of Greece, the crisis

countries in Europe displayed rather moderate debt levels prior to the crisis.

Figure 1

Figure 1 shows that, until the outbreak of the crisis, Ireland, Portugal, Spain and Cyprus

maintained sovereign debt to GDP ratios around or even considerably below the level of

Germany, the country that is often praised as a haven of sound public finance

management.

0.020.040.060.080.0

100.0120.0140.0160.0180.0

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Gross government debt

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2

Current account balances on the other hand displayed divergent patterns for more than a

decade.

Figure 2

Figure 2 shows that Greece, Portugal, Spain and Cyprus (and for a few years Ireland)

had been persistently running current account deficits, thereby increasing their level of

foreign debt. Since in Portugal, Spain, Cyprus and Ireland, sovereign debt was not

particularly elevated until the outbreak of the crisis, this leads to the conclusion that

those countries must have accumulated important levels of private debt. According to

the Pitchford thesis, this should not be an issue, but last years’ developments

demonstrated that, at least for Europe, this assumption is not correct.

High levels of private debt have the potential to render the economy vulnerable. A

shock that negatively affects the ability of a sufficient number of private agents to

honour their financial commitments can get even healthy financial institutions into dire

straits and trigger a full blown banking crisis, often followed by a general recession.

Increasing sovereign debt levels might in such a case rather be a consequence than the

underlying reason for the crisis; the government needs to come to the rescue of financial

institutions and mitigate general socioeconomic effects of the recession, while at the

same time, it loses tax income due to shrinking economic activity. This pattern appears

to apply at least to some of the crisis countries in Europe.

-17.0

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3

While persistent current account deficits rather obviously carry a danger, it is worth

mentioning that persistent current account surpluses, although in public discussion often

regarded with a certain pride, are not desirable either. There would be scope for

increasing domestic consumption and/or investment, but the surpluses are instead

invested abroad. In the long run, a balanced current account should thus be targeted.

Given that persistent current account imbalances of both kinds are still present in

Europe, this paper will try to identify their drivers.

The paper is structured as follows: section 2 explains the theory behind potential current

account determinants. Section 3 tests some of them empirically. Section 4 analyses

potential policies to address the issue and section 5 concludes.

2. THEORY

The current account can be defined in two different, but equivalent ways. The first way

to define the current account is as the sum of the balance of trade (goods and services),

net income from abroad and net current transfers. The second way is as the difference

between savings and investment. When trying to identify potential determinants of the

current account balance, it is helpful to use both definitions, i.e. to ask what the drivers

of the trade balance, net income from abroad, net current transfers, savings and

investment are.

The literature on balance of payments in Europe generally identifies two drivers of

imbalances: divergent developments in competitiveness and failure of financial markets.

2.1. Differences in competitiveness

A common view in politics as well as in academia is that the huge current account

imbalances in Europe are rooted in competitiveness differences across the continent.

Many different factors are likely to influence a country’s competitiveness. Zemanek,

Belke and Schnabl (2010) for example argue that divergent developments in inflation

rates, unit labour costs and industry specialisation were increasing the differences in

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competitiveness in Europe in the years preceding the sovereign debt crisis. They claim

that in the crisis countries, a lack of labour market flexibility, coupled with lower levels

of productivity, deteriorated competitiveness compared to the Northern part of Europe.

Diverging unit labour costs are also identified by De Grauwe (2008) as the main

determinant of competitiveness differences. Unlike Zemanek, Belke and Schnabl (2010)

though, he does not consider them to stem from a lack of labour market flexibility but

rather sees them as evidence for “beggar-thy-neighbour” policies by countries like

Germany. Stockhammer (2011) and Brancaccio (2012) share De Grauwe’s (2008)

opinion, claiming that Germany‘s “neomercantilist policies” are the primary source of

imbalances in Europe.

Increasing unit labour costs (ULC), i.e. increases in employee compensation (wage plus

fringe benefits1) that are not compensated by increases in labour productivity, have

indeed considerable potential to negatively influence the current account balance. By

making a country’s goods and services more expensive, demand for them will decrease.

Foreign and domestic consumers will probably look for cheaper substitutes, which

reduces a country’s exports and increases its imports. The effect on the current account

is hence through the trade balance (which is usually the most important component of

the current account). If the increase in ULC is of sufficient magnitude, it might even

lead to eradication of certain tradable industries in the country, which again is likely to

decrease exports and boost imports, since all consumption of goods produced by these

industries now has to be imported.

Moreover, if the increase in ULC stems from increasing wages (as opposed to falling

productivity) overall demand in the country will rise, thereby again increasing imports.

An important question to address is though: how can ULC persistently deviate from

equilibrium levels? Should increasing unemployment not create enough pressure to

bring ULC back to equilibrium levels? There are several possibilities why market forces

do not work efficiently.

The domestic economy might react to increasing ULC with structural changes, i.e.

specialising in industries where it has a comparative advantage over foreign economies,

1 Compensation includes employer’s contribution to social security and unfunded employee social benefits paid by employers.

5

despite higher ULC. Sources of such advantages might be a favourable regulatory

framework, high quality infrastructure, a highly specialised workforce, etc. An example

of such an economy is Luxembourg, which, despite very high wages, manages to run

persistent current account surpluses by specialising in financial services and the IT

industry. According to standard international trade theory, there is nothing wrong with

such a specialisation pattern; it might actually be an efficient strategy in order to

maintain high wages. It is crucial though, that the specialisation is to a sufficient degree

in tradable industries in order to generate exports and reduce dependence on imports.

Furthermore, it is important that specialisation is not the consequence of a bubble in a

certain industry. The temporarily high returns during a bubble can generate upward

pressure on wages, thereby masking competitiveness problems in other sectors (Sinn,

Buchen and Wollmershäuser, 2011). When the bubble finally bursts, the country is left

with uncompetitive wages, an over-specialised workforce, an unfavourable industry

structure and high unemployment. This appears to have happened in Ireland and Spain,

countries which experienced a bubble in a non-tradable industry: construction.

Another explanation for the downward rigidity of ULC is government action; too

favourable unemployment benefits can take pressure of the labour market. Furthermore,

the government itself might change the economy’s industrial structure by creating

employment in the public sector (especially if the public sector pays above average

wages). In both cases, the sovereign debt is likely to increase while the country’s

competitiveness suffers. Especially in Greece, this seems to have played an important

role in the build-up of the sovereign debt crisis.

Finally, labour market reforms can, even in crisis times, be prevented by too powerful

unions, especially if the unionised sector is not severely affected by the crisis.

According to Mulas-Granados (2011), this phenomenon can at the moment be observed

in almost any of the Mediterranean countries.

Although the literature focuses mainly on labour costs, it should be mentioned that

many other factors are likely to influence a country’s competitiveness, e.g. political

stability, corruption, quality of institutions, infrastructure, etc. High levels of corruption

and slow administration could for example lead to companies choosing to not invest in a

country, despite low labour costs.

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Given that current account surplus countries like the Netherlands, Germany,

Luxembourg, etc. enjoy rather high wages, factors other than labour costs might

actually be crucial in determining a country’s competitiveness.

2.2. Failure of financial markets

Besides divergent evolution of competitiveness, the literature assigns an important role

in deterring balance of payment positions to the failure of financial markets. Indeed,

financial markets appear to not have assessed the situation correctly in the build-up of

the crisis, which led to over-borrowing and misallocation of capital. Jaumotte and

Sodsriwiboon (2010) argue that Eurozone creation led to a decrease in savings and an

increase in investment, thereby reducing current accounts by definition. This is not in

itself problematic; easier access to capital and subsequent higher investment was one of

the outcomes of creating a common currency many governments were hoping for.

Temporary current account deficits might actually be desirable if a country is in the

process of catching up to more developed economies. The current account would in this

case decrease because of high investment in a growing economy. The crucial point is

what capital inflows are used for. Giavazzi and Spaventa (2010) develop a model

showing that a minimum amount of investment has to take place in tradable industries.

In their two periods model, countries are not allowed two have debt outstanding after

the end of the second period. Hence, if countries run a current account deficit in the first

period, they need to run a current account surplus in the second one in order to pay back

the foreign debt taken up in the first period. This is only possible if enough investment

takes place in industries that are able to generate exports. Although in reality, the

intertemporal budget constraint is not as strictly binding as in the model, the intuition

remains valid; capital inflows from abroad should be sufficiently allocated to industries

able to generate exports and/or to replace imports in order not to run current account

deficits and accumulate foreign debt indefinitely. Giavazzi and Spaventa (2010) come to

the conclusion that those European countries that are now in trouble did not manage

capital inflows properly; in Spain and Ireland, they were mainly allocated to the

construction industry, whereas in Portugal and Greece, they were to a large extent used

for consumption. This view is shared by Sinn et al. (2011), who claim that Eurozone

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creation, by decreasing interest rates, led to increases in borrowing and to capital

inflows into temporary high return, but non-tradable industries such as construction.

Well functioning financial markets are supposed to increase macroeconomic stability by

monitoring the behaviour of debtors and enforcing efficient usage of funds. In the case

of Europe, it appears fair to say that they did not fulfil this task at all. By providing

more and more liquidity to bubbles doomed to burst at some point, by helping to mask

competitiveness problems and by allowing governments to accumulate more and more

debt, they had an important contribution in the creation of unsustainable economic

developments. Furthermore, financial institutions became a macroeconomic danger

themselves when they had to be bailed-out by governments, tearing enormous holes in

countries’ budgets.

3. EMPIRICAL ANALYSIS

3.1. The model

Over the years, a standard econometric model for analysing drivers of current accounts

has emerged in the literature. Prime examples of such a model are Chinn and Prasad

(2003), Gruber and Kamin (2007) and Jaumotte and Sodsriwiboon (2010). The standard

method is to use panel data regression with time fixed effects, but excluding entity fixed

effects. Chinn and Prasad (2003) claim that using an entity fixed effects model “would

abstract from much of the cross-country variation in current accounts”. I found though,

that using entity fixed effects for my dataset does not render the coefficients on other

regressors insignificant. There are indeed many factors that will not be directly included

in the regression, but that are likely to have some effect on the current account, e.g.

degree of labour mobility, efficiency of administration, quality of the legal system,

societal structure, etc. I therefore believe that using entity fixed effects has the potential

to increase the robustness of the results significantly, which is why I decided to deviate

from the literature and include entity fixed effects as well as year fixed effects in my

regressions.

8

I follow the literature by using the government balance, real GDP growth and the

dependency ratio as independent variables. Based on the explanations in section 2, the

government balance is expected to be positively correlated with the current account,

since higher government spending is likely to increase overall demand (of which a share

will probably fall on imports) and investment.

GDP growth is meant to capture the general situation of the economy. It is of particular

interest when analysing the current account situation of economies that are in the

process of catching up. In my sample, these would mainly apply to the economies of

Eastern Europe, and to a lesser extent also to the economies of Southern Europe. A

generally accepted view is that countries in the process of catching up run persistent

current account deficits because of investment flows into a growing economy. The

coefficient on GDP growth will hopefully give more information about whether this

theory applies to Europe.

The dependency ratio is defined as the ratio of the population age 0-14 and 65+ to the

population age 15-64. It is supposed to control for naturally higher savings in countries

with a higher share of dependent population. The coefficient on this variable is hence

expected to be positive.

Additionally to these variables used in the literature, I include other regressors that I

believe have the potential to shed light on the balance of payment problems in Europe.

The first new variable I introduce is the adjusted wage share. The adjusted wage share is

supposed to capture the effect of differences in unit labour costs on the current account.2

It is hence a measure of competitiveness of the country. In accordance with the theory

presented in section 2, the coefficient on this variable is expected to be negative.

In order to test Giavazzi and Spaventa’s (2010) theory of investment in tradable/non-

tradable industries, I include the share of investment that takes place in tradable

industries3 as a regressor. More precisely, I include four lagged values of this variable

2 The adjusted wage share is defined as: 𝑇𝑜𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛

𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠�𝐺𝐷𝑃

𝑇𝑜𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡�. The

adjustment compared to the simple wage share is made in order to account for self-employment. 3 Following Crossan and Attewell (2013), an industry is defined as tradable if 10% or more of that industry’s output is exported or if 20% or more of supply to that industry is imported. Tradable/non-tradable industries can then be constructed using input-output tables. The share of investment in tradable industries is simply the sum of investment in tradable industries divided by total investment in the economy.

9

as independent variables, but not the contemporaneous value. The motivation is that

investment only translates into production after a certain period of time. If Giavazzi and

Spaventa’s (2010) model is correct, then we can expect the coefficients on (some of)

these lagged values of the share of investment in tradable industries to be positive.

Another new variable that I introduce is Transparency International’s Corruption

Perception Index (CPI). It is expressed on a scale from zero to ten, ten being an almost

corruption free country, zero being a completely corrupt country. The motivation for

including this indicator as an independent variable is that corruption is likely to have an

effect on the current account by influencing investment and borrowing decisions.

Companies might refrain, despite low labour costs, to invest in certain countries if high

levels of corruption translate into additional costs and unpredictable risk (regarding

licences, expropriation etc.). In this spirit, the CPI is thus another indicator of

competitiveness. Furthermore, there is anecdotal evidence of corruption leading to

public funds being channelled towards superfluous investment in certain projects (e.g.

certain construction projects) or deviated for private purposes. Corruption hence leads to

misallocation of capital, which, according to Giavazzi and Spaventa (2010) is also

likely to have an effect on the current account balance. In this sense, the CPI can also be

seen as an indicator for the efficiency of financial markets.

Besides all the regressors described above, the regression includes dummy variables for

EU and Eurozone membership, since not all countries in the dataset belong to the EU or

the Eurozone for every year in the sample (e.g. Norway never belongs to either one).

Finally, in order to get a clearer picture of which one of the current account’s

components actually drives the results, the same regression is run again, but this time

replacing the current account with the trade balance as the dependent variable. The

motivation is that traditionally, the trade balance is the largest component of the current

account. Moreover, many of the theoretical concepts presented in section 2 actually

explain the effect on the trade balance when they refer to the effect on the current

account.

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3.2. The dataset

The panel constructed for this paper contains data for 28 countries from 1995 to 2012.

The countries analysed are Norway plus all current EU members except Croatia.

Unfortunately, due to a lack of data, it was not possible to include Croatia. The input-

output tables was obtained from the OECD; these data are not directly included in the

dataset and do hence not (directly) influence the results. Their only purpose was to

divide the industries according to tradability. The data on adjusted wage shares and on

government balances are extracted from the AMECO database of the European

Commission. The dummy variables for EU/Eurozone membership are created manually.

All remaining data are extracted from Eurostat.

The advantage of this dataset is that all data used for the final estimation stem from

European Institutions (the European Commission and Eurostat); measurement

techniques are hence harmonised.

All shares and ratios are expressed in percent.

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3.3. Results

VARIABLES 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡

𝐺𝐷𝑃

𝐸𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑚𝑝𝑜𝑟𝑡𝑠𝐺𝐷𝑃

Wage share -0.2165*** -0.2878*** 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

𝐺𝐷𝑃

0.2261*** 0.1169*

Invest. in tradable, lag 1 0.0516 0.1014** Invest. in tradable, lag 2 -0.0104 0.0084 Invest. in tradable, lag 3 0.0481 0.0185 Invest. in tradable, lag 4 -0.0722 -0.0395 CPI 0.8756* 0.4525 Dependency ratio 0.4525*** 0.3577*** Real GDP growth -0.5590*** -0.5299*** EU dummy 0.3079 1.6752** Eurozone dummy -0.2678 -0.3043 Country fixed effects Year fixed effects

Yes Yes

Yes Yes

R-squared 0.8168 0.9132 Number of nations 28 28 Time period Adj. R-squared

1995-2012 0.7878

1995-2012 0.8994

*** p<0.01, ** p<0.05, * p<0.1

The first result of the estimation is that the adjusted wage share has, as expected, a

negative impact on the current account balance. The coefficient in the regression with

the current account balance as the dependent variable is -0.22 and it is significant at the

1 percent level; an increase by 1 percentage point in the adjusted wage share yields a

predicted decrease in the current account of 0.22 percentage points. Given that cross-

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country differences in the adjusted wage share of over 20 percentage points are not

exceptional in this sample, about sometimes up to 5 percentage points of cross-country

differences in the current account balance could be explained by differences in the

adjusted wage share. When the current account in the regression is replaced with the

trade balance, the coefficient on the adjusted wage share becomes 0.29 and gains in

significance. The effect of the adjusted wage share on the current account is hence via

the trade balance; up to 6 percentage points of cross-country differences in the trade

balance can be explained by differences in the adjusted wage share. This finding

strongly supports the hypothesis that differences in competitiveness, in particular

differences in labour costs, played a crucial role in the build-up of current account

imbalances in Europe.

As predicted by the theory, the government balance positively influences the current

account; the coefficient on this regressor is 0.23 and highly significant if the dependent

variable is the current account and 0.12 and significant at the 10 percent level if the

current account balance is replaced with the trade balance. The first conclusion is

therefore that government spending behaviour has indeed important consequences for

the balance of payment position of a country; since in this sample, differences in

government balances of over 15 percentage points are rather frequent, cross-country

differences in the current account balance of up to 4 percentages points can be explained

by differences in the government balance.

Second, it can be observed that the effect on the trade balance is less severe and also

less significant. The effect of government spending on the current account is hence not

only through the trade balance, but also through net income from abroad and through

net current transfers. This could be seen as evidence for misallocation of capital such as

deviation of public funds for private purposes. Nevertheless, the effect on the trade

balance is still of considerable magnitude; differences in government balances can

explain differences in trade balances across countries of up to 2 percentage points.

Giavazzi and Spaventa (2010) showed in a theoretical framework, that a minimum share

of investment has to take place in tradable industries if the country is not to violate its

intertemporal budget constraint. The outcomes of the regression using the current

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account as the dependent variable though cannot confirm this prediction; the

coefficients on the lagged variables of the investment share in tradable industries are of

little magnitude, differ in sign and are of very low significance. But when the current

account balance is replaced with the trade balance, the coefficient on the first lag of

investment share in tradable industries becomes positive, of considerable magnitude and

significant at the 5 percent level. This is not surprising as Giavazzi and Spaventa’s

(2010) model is strongly simplified and does not take into account net income from

abroad and net current transfers. As investment shares in tradable industries vary

considerably across country (the range being 65 percentage points and differences of

over 30 percentage points can be frequently observed), in several cases, differences

between trade balances around 4 percentage points can be traced back to differences in

investment in tradable industries. The empirical outcomes in this paper thus find support

for Giavazzi and Spaventa’s (2010) theory regarding the trade balance, but

unfortunately not regarding the current account balance.

When using the current account as dependent variable, the coefficient on Transparency

International’s Corruption Perception Index (CPI) turns out to be of surprising

magnitude (0.88) and only barely misses the threshold for significance at the 5% level

(t-stat: 1.92). On the other hand, when the trade balance serves as dependent variable,

the coefficient on the CPI loses in magnitude (0.45) and becomes insignificant at any

conventional significance level. The dispersion is thus too high to interpret any effect of

corruption on the trade balance, but the still rather high coefficient indicates that at least

in some countries, it does decrease competitiveness. Overall, it appears though that

corruption is more likely to influence the current account through misallocation of

capital. This is also in line with the findings on the government balance. Differences in

the CPI are of considerable magnitude, with the range being 7.4 index points and cross-

country differences of 5 index points being a frequent observation. In a number of cases,

corruption could hence explain cross-country differences in current accounts of 4 to 5

percentage points.

In both regressions, GDP growth is attributed a very similar, highly significant

coefficient: 0.56 when the current account balance is the dependent variable, 0.53 when

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the trade balance fulfils this role. I interpret this as evidence that for Europe, the theory

that countries in the process of catching up are running current account deficits, applies.

Finally, the control variables, especially the dependency ratio, appear to have fulfilled

their purpose; the coefficient is in both regressions positive, of important magnitude and

significant. It seems to capture the effect that populations with higher dependency ratios

have naturally higher saving rates and therefore higher current account balances.

4. POLICY RECOMMENDATIONS

Since the literature recognises diverging evolution of competitiveness and failure of

financial markets as the principal drivers of current account imbalances, it is not

surprising that policy recommendations in the literature also aim at restoring

competitiveness and increasing the efficiency of financial markets.

Many authors identify differences in labour costs as the main determinant of

competitiveness divergences. The empirical outcomes in this paper suggest as well that

getting labour costs to converge is crucial when trying to reduce imbalances across

Europe. Zemanek, Belke and Schnabl (2010) therefore recommend labour market

reforms, suggesting that more liberalised labour markets will lead to internationally

competitive wage levels. Jaumotte and Sodsriwiboon’s (2010) recommendation of

“internal devaluation” is in the same spirit. So far, this is more or less the route taken by

European policy makers.

The main drawback of such a policy is that it carries the danger of provoking a

deflationary spiral; cutting wages and laying off workers could lead to a fall in overall

demand, thereby creating even more unemployment which will lead to even more wage

reduction and decreases in demand, etc. Countries with uncompetitive wages could

hence be driven into a deflationary trap, where consumption and investment are

postponed in expectation of a further decrease in prices. Indeed, this scenario seems to

realise in Europe at the moment, with Spain and Greece having insupportably high

levels of unemployment and falling price levels.

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Krugman (2012) therefore suggests increasing inflation in countries with a current

account surplus, thereby allowing crisis countries to catch up without having to go

through the painful and politically very difficult process of nominal wage cutting. A

potential disadvantage of such a policy is that while it would allow closing the

competitiveness gap within Europe, it could reduce Europe’s overall competitiveness on

the world market.

Since many labour market reforms have already been realised over the last couple of

years and as inflation has consistently been below the target of 2 percent, it might

though be recommendable to consider Krugman’s (2012) suggestion, especially since

the European Central Bank (ECB) is looking to increase inflation rates anyway. Given

the recent results in European elections, it appears indeed politically unfeasible to

further rely on internal devaluation.

In the long run, it seems attractive to follow Paul de Grauwe’s (2008) suggestion of

harmonising the conditions under which wage setting takes place across Europe. This

would prevent differences in labour costs from becoming an issue in the future again.

Given the empirical outcomes above, it is furthermore crucial to improve the efficiency

of financial markets. Although in this paper, the empirical evidence on Giavazzi and

Spaventa’s (2010) theory is somewhat mixed, they make a strong, reasonable argument

in favour of more capital allocation to tradable industries. More efficient financial

markets should foster such an allocation instead of fueling bubbles in non-tradable

industries. Moreover they would discipline governments earlier, instead of providing

cheap liquidity until a sudden stop. Increasing investors’ liability is therefore a frequent

suggestion in the literature. Especially Sinn et al. (2011) propose a catalogue of

measures formulated in this spirit. In order to increase shareholders’ interest in more

adequate risk pricing, they suggest more demanding equity rules. As systemically

relevant banks will always need to be rescued in order to prevent major impacts on the

economy, Sinn et al. (2011) also recommend that the government will only come to

their rescue in exchange for equity. The idea behind these measures is that if more of

the shareholders’ money is at stake, they will force banks to monitor debtors’ projects

and activities more closely. Although certain steps in that direction have already been

16

taken with the creation of the Basel III agreement, equity rules are still not demanding

enough according to Sinn et al. (2011).

Giavazzi and Spaventa (2010) claim that attempting to change investors’ behaviour is

not sufficient and might actually have harmful effects. They argue that even the much

praised rules for the Spanish banking sector regarding dynamic provisioning did not

prevent a banking crisis when the construction bubble burst. Furthermore, a regulatory

framework that is too tough could hamper the flow of necessary capital to the economy.

Giavazzi and Spaventa (2010) therefore advocate lending restrictions for specific

purposes such as construction and consumption. This is supposed to prevent the creation

of bubbles and free capital for more productive purposes.

Moreover, this paper found that corruption has a (surprisingly) strong impact on current

accounts. As explained above, corruption can have consequences for competitiveness

and for capital allocation. One can thus add the balance of payment position to the many

other valid reasons to fight corruption.

Finally, it should be taken into account that there are a lot of other potential

determinants of current accounts, which, in the regression, were absorbed by the

country fixed effects. In order to improve the balance of payment position for a specific

country, it is hence necessary to conduct a country specific analysis.

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5. CONCLUSION

The literature suggests that the current account imbalances in Europe stem from

differences in competitiveness, in particular differences in labour costs, and failures of

financial markets leading to misallocation of capital.

The empirical findings in this paper give support to the idea that differences in labour

costs led to diverging balance of payment positions. Policy makers should therefore

attempt to stimulate a converging development of labour costs and install mechanisms

that prevent a diverging development in the future. With respect to the economic and

political situation in Europe, governments should share this burden across European

countries and not place it solely on the crisis countries. One way to do this would be to

stimulate moderately higher inflation in countries running a current account surplus.

The view that failures in financial markets played an important role in the build up of

current account imbalances can also be supported by the empirical outcomes in this

paper. Efficient financial markets should not have allowed countries to persistently run

current account deficits and then discontinuously stop capital flows. Furthermore, they

should not have provided liquidity for over-investment in non-tradable industries such

as construction.

Finally, this paper also investigated the effect of corruption on the current account, an

aspect that, to my knowledge, has not been treated in the literature yet. The empirical

results suggest that corruption has a negative impact on the current account through

misallocation of capital and possibly also by decreasing countries’ competitiveness. For

this reason (and obviously many others), governments should make the fight on

corruption a priority.

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REFERENCES

BRANCACCIO E. 2012. Current Account Imbalances, the Eurozone Crisis, and a Proposal for a “European Wage Standard”. International Journal of Political Economy, vol. 41, no. 1, Spring 2012, pp. 47–65

CHINN M. & PRASAD E. 2003. Medium-term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration. Journal of International Economics, Vol. 59, pp. 47-76

CROSSAN S. & ATTEWELL J. 2013. The tradable sector and its relevance to New Zealand’s GDP. Paper presented at the New Zealand Association of Economists Conference, Wellington, New Zealand

DE GRAUWE P. 2008. The Euro at ten: achievements and challenges. Springer Science + Business Media

GIAVAZZI F. & SPAVENTA L. 2010. Why the current account matters in a monetary union - Lessons from the financial crisis in the Euro area. Banca d’Italia

GRUBER J. & KAMIN S. 2007. Explaining the Global Pattern of Current Account Imbalances. Journal of International Money and Finance, No 26, 500‒522

JAUMOTTE F. & SODSRIWIBOON P. 2010. Current Account Imbalances in the Southern Euro Area. IMF Working Paper

KRUGMAN P. 2012. Revenge of the Optimum Currency Area. NBER Macroeconomics Annual 2012, Volume 27

MULAS-GRANADOS C. 2011. Trade Unions and Social Democracy in Spain. Social Europe Journal

SINN H.-W., BUCHEN T. & WOLLMERSHAUSER T. 2011. Trade imbalances – causes and consequences and policy measures: Ifo’s statement for the Camdessus Commission

STOCKHAMMER E. 2011. Peripheral Europe’s debt and German wages: the role of wage policy in the Euro area. Int. J. Public Policy, Vol. 7, Nos. 1/2/3, pp.83–96

ZEMANEK H., BELKE A. & SCHNABL G. 2010. Current account balances and structural adjustment in the euro area. Ruhr economic papers, No. 176

19

APPENDIX In order to check the robustness of the results, the dependency ratio is replaced by the

ratio of population age 60+ to total population and by the old dependency ratio (the

population age 65+ divided by the population age 15-64). Both variables should capture

the same intuition as the dependency ratio. Since both indicators though vary quite

substantially in values from the dependency ratio, they are ideal to test the robustness of

the results; if overall the coefficients on the important variables remain roughly the

same, they are not sensitive to a specific indicator, which increases the quality of the

results.

VARIABLES 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡

𝐺𝐷𝑃

𝐸𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑚𝑝𝑜𝑟𝑡𝑠𝐺𝐷𝑃

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡

𝐺𝐷𝑃

𝐸𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑚𝑝𝑜𝑟𝑡𝑠𝐺𝐷𝑃

Wage share -0.2024** -0.2556*** -0.1735** -0.2632*** 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

𝐺𝐷𝑃

0.1846** 0.1335** 0.2084*** 0.1087*

Invest. in tradable, lag 1 0.0503 0.1067** 0.0600 0.1043** Invest. in tradable, lag 2 -0.0182 0.0038 -0.0170 0.0029 Invest. in tradable, lag 3 0.0554 0.0244 0.0492 0.0237 Invest. in tradable, lag 4 -0.0387 -0.0462 -0.0661 -0.0309 CPI 0.7656* 0.2487 0.7941* 0.3274 Above 60 ratio 0.7242** -0.5687* Old dependency ratio 0.6154*** 0.0840 EU -0.8829 1.2907* -0.7081 0.9928 Eurozone Country fixed effects Year fixed effects

-0.9313

Yes Yes

-0.6167

Yes Yes

-0.7720

Yes Yes

-0.7414

Yes Yes

R-squared 0.8128 0.9118 0.8175 0.9110 Number of countries Time period

28 1995-2012

28 1995-2012

28 1995-2012

28 1995-2012

Adj. R-squared 0.7831 0.8978 0.7865 0.8968

20

None of the coefficients on any of the interpreted variables changes significantly,

neither in sign, nor in magnitude. The results are thus not sensitive to a specific

indicator; they hold if the indicator is replaced with another one giving the same

intuition.

The Corruption Perception Index (CPI)

In order to account for the effect of corruption, I used the Corruption Perception Index

(CPI) created by Transparency International. One issue with this index though is that for

the earlier years of my sample, data is not available for every country. I therefore had to

estimate those missing observations. In order to do so, I calculated yearly growth rates

of the index for neighbouring countries with similar characteristics and for which

observations for that period were available. I then applied these growth rates to the first

observation of the country in question in order to estimate missing observations from

previous years.

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