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Addressing macroeconomic imbalances within the euro area: still a long road ahead

The shock caused by the 2007-08 financial collapse, followed by the European sovereign debt crisis, has raised new doubts about the ability of the single currency to work well in a region with huge economic and political diversity. It has also given a new dimension to this debate by highlighting the building-up of unsustainable macroeconomic imbalances within the European Monetary Union (EMU).
Par Virginie Coudert, Cécile Couharde, Carl Grekou, Valérie Mignon
 Billet du 15 avril 2019

The architects of the euro area counted on the monetary union to facilitate balance-of-payments adjustments by encouraging imbalances mainly driven by productivity differentials and catching-up developments. In short, there were widespread expectations that the removal of exchange-rate risks and the increased financial integration would play an important role in the adjustment process.

Although the Eurozone, a monetary union based on a single currency, is supposed to be immune from unstainable disequilibria characteristic to fixed-exchange rate regimes, it is now well established that macroeconomic imbalances initially considered as “good imbalances” turned out to be “bad imbalances”.

In a recent working paper, we illustrate these unresolved adjustment problems by examining between-country disparities in terms of equilibrium exchange rates among the Eurozone’s founding members before and after the launch of the single currency.

Assessing imbalances’ adjustments

Looking at the evolution of internal and external imbalances over time gives an idea about the existence of a rebalancing process among countries. However, this does not tell us the full story as this does not shed light on how adjustments take place. Indeed, suppose that improvements in debtor economies are accompanied by declining domestic demand and rising unemployment — as it has happened in the euro area — the adjustment process is not necessarily appropriate as the improvement in current positions occurs at the cost of increased internal disequilibria.

A more comprehensive analysis of imbalances’ adjustments needs then to establish whether they are appropriate. Equilibrium exchange rate approaches allow for such assessments by giving a rough measure of real exchange rates that are consistent with the achievement of internal (reducing output gap and unemployment) and external (a more sustainable current account) balances. If a rebalancing process is observed among countries while real exchange rates still exhibit departures from their equilibrium values, hence the process may not be sustainable as it is likely to be achieved in an asymmetric way.

Adopting this approach, we explain how adjustment patterns have taken place among euro area countries before and after the launch of the single currency. We first calculate departures of real exchange rates from their equilibrium levels over time, in order to obtain an estimate of the evolution of currency realignments that would have been necessary to accompany an appropriate rebalancing process among EMU countries. We then implement a cluster analysis, which allows us to form groups of euro-members that correspond to different adequate adjustment patterns of exchange rates among Eurozone countries. Once the groups have been established, we validate them by identifying the common features shared by euro area countries belonging to the same group.

A partition of the EMU in three groups of countries

Our findings show that in the decades leading up to the euro, the euro area was partitioned into two groups of countries that exhibited each relatively homogenous adjustment patterns, while a third set of economies with lower initial GDP per capita, such as Portugal and Greece, displayed a diverging pattern.
Contrary to expectations, heterogeneity within the euro area failed to decrease. Monetary union did not succeed in reducing dissimilarities between these clusters of countries and even further increased the diverging pattern of Greece.

The two charts displayed in Figure 1 help to understand between-country disparities in terms of adjustment patterns and how they have evolved before and after the launch of the euro. As can be seen, the cluster analysis gives a partition of the euro area into three distinct sets of countries over the two periods, shown by the three colors: blue, orange and red. Differences among these clusters have increased from the first to the second period, as illustrated by larger color contrasts on the right-side map.

Figure 1 — The Euro area clusters

Note: Distinct clusters are color-coded on the basis of their distance to Greece in terms of exchange rate adjustment: blue for countries with higher distance to Greece, orange for those with lower distance. In each cluster, a deeper color represents countries with higher distance to Greece.

Identifying the drivers of rising between-countries disparities

Let us inspect more closely the heterogeneity of these adjustment patterns during each period, looking in particular at the main drivers of the formation of the three clusters of countries within the euro area. During the pre-EMU period, our results show that stronger financial position (measured by current account positions and debt-to-GDP ratios) and internal balances (measured by growth and unemployment rates) were the main drivers of heterogeneous adjustment patterns in the euro area. The bottom performers such as Portugal and Greece were characterized by structural weaknesses compared to the other founding members. In particular, both countries exhibited high inflation, high debt-to-GDP ratios, and strong current account deficits, hence implying high realignments of their nominal exchange rates in order to rebalance their internal and external positions. On the contrary, Belgium, France, Germany and the Netherlands displayed low inflation rates and debt-to-GDP ratios, which resulted in lower current imbalances and/or current surpluses. The other countries (Austria, Finland, Italy and Spain), generally performed well on one factor but at the expense of the other.

During the EMU period, we find evidence of more marked differences in terms of adjustment patterns, highlighting that the bottom performers in the previous period were unable to start a convergence process. Instead, the situation of Greece and, to a lesser extent, of Portugal deteriorated, with the accumulation of large imbalances in the first decade of the EMU. Greece and Portugal hence further diverge, as reflected by their poor performances in terms of both internal and external balances (persistent current account deficits, high unemployment rates and zero-growth rates on average). Only Spain moved from its initial group to the set of top performers thanks to the improvement in its fiscal position, while being quite distant given the still remaining macroeconomic imbalances at play. In contrast, Belgium, France, Germany, and the Netherlands appear closer to each other thanks to their performances —especially Germany and the Netherlands.

The need for structural reforms to raise productivity

Overall, our findings suggest that the configuration of the Eurozone has become more fragmented since the launch of the single currency as dissimilarities across and within groups of countries have augmented. They also point to a truism: in a monetary union, appropriate adjustment requires structural reforms to raise productivity as the nominal parity can no longer be adjusted and compensated by higher financial integration. Without such reforms, the adjustment is essentially borne by debtor economies through declining relative prices. The adjustment following the sovereign debt crisis in the euro area could thus only be achieved by a painful correction through domestic deflation policies in debtor countries, threatening the long-term sustainability of the Eurozone. Since then, many steps have been taken in order to correct macroeconomic imbalances, and notably the macroeconomic imbalance procedure (MIP) that the European Commission introduced in 2011. However, to make the adjustment process more robust, policymakers should also focus on raising productivity growth in order to make output gaps and current account positions more consistent among euro area countries.

This blog post reflects the opinions of the authors and does not necessarily express the views of the institutions to which they belong.
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