Unbalanced Europe

In this piece, Benedicta Marzinotto talks about currency wars and Europe's imbalances. The G-20 governments have declared that competitive devaluations (or currency wars) must be avoided and that excessive external imbalances should be monitored and handled in a coordinated way. The EU's internal imbalances, however, are being treated as a single region. The immediate problem is to correct today’s imbalances, but given the political considerations driving the EU’s approach to the issue, the adjustment process could be long and challenging.

The G-20 governments have declared that competitive devaluations (or currency wars) must be avoided. Excessive external imbalances, they also argue, should be monitored and perhaps fought in a coordinated way.
Those resolutions sound mild. But there is no good reason to tackle these problems differently. After all, there are no instruments to enforce strict rules at the global level, and the unwinding of today’s global imbalances – led by some revaluation of the renminbi and China’s shift to a growth model based on stronger domestic demand – might be only a matter of time.
Europe’s internal imbalances, however, are a much knottier problem. The G-20 decided not to deal with the issue and agreed to treat the 27-member European Union as a single region. Defined that way, the problem disappears, because the current-account deficit of the EU as a whole is only about 0.35% of its GDP, even though individual member countries have very different external positions.
This bit of statistical legerdemain reflects the political sensitivity of Europe’s current-account imbalances, which stems from eurozone members’ inability to rely on the exchange rate to restore equilibrium. If an internal EU imbalance is to be corrected, deficit countries must accept real output losses, while surplus countries can maintain or even boost their growth rates.
Both the EU Commission and the European Central Bank argue that macroeconomic imbalances in Europe are largely the result of widening competitiveness disparities. Thus, deficit countries have to control price and wage growth to improve competitiveness, while surplus countries may have to accept some inflation.
But the situation is not so simple. First, there is no close relationship between external positions and competitiveness trends – not with some of the price and cost competitiveness that the EU Commission and the ECB examine, and not with output-based competitiveness (export growth and change in export market shares). For example, Spain’s exports have grown without producing tangible positive effects on the country’s trade balance.
The relationship becomes tight when considering the evolution of each country’s real effective exchange rate based on the GDP deflator. That indicator is often used by the EU Commission and the ECB as a proxy for the divergence in competitiveness trends within the eurozone but in fact it does
not measure price and cost competitiveness as such; instead, it captures the price effects of changes in aggregate demand. The EU Commission’s insistence on the need to target “competitiveness” means that it is proposing a supply-side solution for a demand-side problem.
And, of course, the political sensitivity of Europe’s imbalances consists precisely in telling deficit countries that they must accept enduring hard times while surplus countries are required merely to save a little less. Here, there is also a technical aspect that must be taken into account: it is much easier to constrain consumption through wage contraction or lower credit expansion than it is to stimulate it, especially if the high propensity to save in some surplus countries reflects cultural and institutional factors.
Moreover, it should not be taken for granted that higher prices and wages in Germany will reduce the country’s trade surplus. To the extent that German products compete on quality rather than price, the surplus might persist even if domestic prices in Germany rise.
Finally, internal price and cost developments would have no impact on trade with non-eurozone members. Germany is by far the largest EU exporter to China, whose trade significance, though nowhere close to that of Germany’s eurozone partners, is growing fast. German exports to China accounted for only 0.3% of the country’s GDP in 2005, but stood at 1.4% of GDP in 2008. If anything, EU institutions should be looking at intra-eurozone accounts.
But, even if EU members’ current-account positions are mainly driven by domestic-demand factors, international competitiveness does matter. It is not necessarily the cause of Europe’s internal imbalances, but it may be the cure.
In principle, deficit countries may not have to go through further recession to promote external adjustment if they can generate sufficient income from exports to service their external debts. In that case, policymakers should focus on improving productivity, rather than on price reductions alone.
Obviously, it is easier in the short run to change prices and wages than it is to boost productivity. Still, if competitiveness underpins the sustainability of trade deficits, there is in principle no good economic reason to impose short-run measures – price and cost adjustments – for the purpose of achieving a long-term objective, unless the purpose of price and cost adjustment is indeed to dampen demand.
The problem is that some countries have no other adjustment strategy than slower growth. This is the case where external debt was used to finance low-productivity non-tradable sectors (say, housing in Spain and Ireland).
In most deficit countries, strong credit expansion over the last decade fueled unsustainable pre-crisis booms. In this respect, the recent Basel III preliminary agreement and the establishment of new European financial supervisory structures might be more important for correcting and preventing external imbalances than recent plans by the EU to extend economic surveillance of member countries – and even to impose sanctions to enforce non-fiscal macroeconomic targets.
The immediate problem, of course, is to correct today’s imbalances. And, given the political considerations driving the EU’s approach to the issue, the adjustment process will be anything but rapid and smooth.
Benedicta Marzinotto is a research fellow at Bruegel and Lecturer in Political Economy at the University of Udine.