In Europe, peripheral countries whose investment opportunities are significantly limited by the reduced level of the domestic saving rate would have, as conventional theory would predict, much to gain with a monetary union which allowed for reduced premiums to foreign finance. Even with the worldwide liberalization of capital movements, the volatility of nominal exchange rates restricts investors’ willingness to allocate their savings in foreign economies as the returns of such investments depend considerably on the exchange rate fluctuation, in turn prone to a great deal of uncertainty.
Therefore, the fixed exchange rate regime entailed by the EMU membership, by ruling out the risk of exchange rates depreciations, would give such countries access to northern European finance at an almost premium-free interest rate and allowed then to invest more than what their consumption pattern made possible. This capital inflow indeed occurred in the southern European countries such as Greece, Ireland, Portugal and Spain (GIPS). With the wisdom of hindsight, it is clear that the accumulation of external liabilities thus induced was not sustainable. The question is whether it could have been.
The logic of sustainably enduring large current account deficits is that foreign investors who channel funds into a given economy do it because their capital would face diminishing returns in richer countries, where the capital stock is higher. Those being allocated in high productivity sectors of the less capital abundant economies, these would then be able to produce the resources needed to cope with their external liabilities.
The surge of capital inflows verified in the southern European countries due to intra-Euro zone lending and borrowing lasted, and at an increasing pace, from 1999 to 2009, that is, during the Euro first decade. It could eventually be argued that the accumulation of capital does not happen overnight and therefore that the financial unrest generated by the fall of the Lehman Brothers and which ended up dictating the sudden stop of lending from the EZ “core” – such as Germany, Netherlands, France, Belgium and Austria – to the GIPS, undermined the sustainability of running such current account deficits. However, even disregarding what can be done in a decade, not only there were no signs suggesting that a reversal of the trade imbalances within the Euro area were to come, has there were several suggesting a further deepening of those. During the same decade, while consumption generally increased across sectors in the southern economies, there was a reallocation of resources towards the non-traded sectors at the expense of traded goods sectors. Rather intuitively, it would not have been through an increase in the production of non-traded goods that the net investment position of those economies relative to their northern counterparts would be reversed. Hence, it is of interest to address the question of whether this “misallocation” was due to GIPS economies’ inherent characteristics that lead them to underperform or whether it is the result of structural fundamentals.
With international competition, the price of similar tradable goods in different countries tend to converge over time. The existence of gaps between such prices implies that it would be profitable to buy the good where it is quoted at a lower price and sell it where its price is higher. Being these arbitrage opportunities fully exploited, the price gaps will be eliminated. Although there are several factors that make postponing the materialization of such arbitrage movements – as the need of establishing contact networks in retail sectors – and others which imply permanent gaps even with the fully materialization of these movements – such as the existence of tariffs or transporting costs –, in the liberalized and highly integrated Euro zone market these are not so relevant or even nonexistent. Thus, the increase in total absorption induced by enhanced credit availability from abroad does not affect the price of traded goods in borrowing economies whose dimension is not enough to influence the price fixed in the international market. In contrast, since a higher domestic demand can only be met by domestic production in some specific sectors, that same increase in aggregate demand will lead to a higher price of nontraded goods.
As a result, capital inflows will entail an increase in the relative price of nontraded goods that, in turn, by inducing entrepreneurs to move away from the traded good sector to the nontraded sector where the price increase provides relatively higher returns, creates pressure for nominal wages to increase which then deteriorate the competitiveness of the resident exporters, as the real exchange rate appreciates.
Therefore, even with a friction-less labour market where workers can move across industries without any cost, the surge of capital inflows will lead to a reallocation of resources across sectors not conformable with the sustainability of current account deficits. Employment and output in sectors such as services and building and construction would increase while reducing in manufactures, which indeed was verified in countries like Portugal.
The possible escapes to such an effect, only distinguishable from the Dutch disease case in its source, are significantly restricted in the context of a monetary union. Without the possibility of resorting to a nominal exchange rate depreciation to mitigate the process of deindustrialization the only avenue to avoid a real exchange rate appreciation would be to have an increase in productivity in the traded goods sector relatively to what is experienced in the EZ partners. This productivity boost would make firms in the traded sector to demand more labour at higher wage rates thus avoiding the reallocation of labour away from this sector even with the increase in the relative price of nontraded goods.
However, given that in most sectors productivity increases are mainly driven by learning by doing and other factors that fall outside of the range of tools economic authorities have at their disposal, the traded-and-nontraded goods framework suggests that significant and increasing external imbalances within a monetary union constituted by economies which differ in productivity levels across the traded sectors are unavoidable. Hence, the sustainability of such current account deficits relies crucially on the capability of preserving the capital flows between creditor and debtor economies.
 The exchange rate referred to is defined as eP*/P , where P* and P are the consumer price index of abroad and of the home economy, respectively, and where e is the nominal exchange rate defined in a way that an increase means a depreciation.
Baldwin, R., & Giavazzi, F. (2015). Rebooting the Eurozone: Step I – agreeing a crisis narrative. CEPR Policy Insights.
Benigno, G., & Fornaro, L. (2013). The financial resource curse. London School of Economics.
Reis, R. (2013, August). The Portuguese Slump and Crash and the Euro Crisis. NBER Working Paper.
Francisco Rodrigues nº 31154