Euro Area: An Unbalanced Rebalancing?

IMF Blog, July 22, 2014

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Since the financial crisis, the euro area current account has moved from rough balance into a clear surplus.
Rebalancing across economies within the euro area has been highly asymmetric:
- Debtors such as Greece, Ireland, and Spain have seen large current account improvements (sometimes into surplus).
- Creditors such as Germany and the Netherlands have basically maintained their surpluses.

Many debtor economies have seen unit labor costs decline, improving competitiveness and boosting current accounts.
Recent competitiveness gains in euro area debtor economies are largely driven by declining unit labor costs (Tressel and others, 2014; Tressel and Wang, 2014).
Composition of labor-cost declines in specific debtors:
- Greece and Ireland: labor cost declines due to a roughly equal mix of declining wages and employment.
- Spain: labor cost declines due to declining employment.
These competitiveness improvements have been accompanied by declining domestic demand and rising unemployment.
Key question raised: when domestic demand recovers in these economies, will current account deficits re-emerge?

Many creditor economies have had large and persistent surpluses, driven by both higher saving and lower investment.
Germany:
- Both private (corporate and household) and public saving rose over the past decade, contributing to an overall saving rise of 4 percent of GDP.
Overall euro area investment declined by about 3 percent of GDP, from 20 percent of GDP in 2001 to about 17 percent in 2012.
Netherlands:
- Declines in both overall saving and investment, but the investment decline was larger (from about 21 percent of GDP in 2001 to about 17 percent in 2012).
- The Netherlands’ larger surplus is entirely due to the corporate sector.
Conclusion: Restrained domestic demand (high saving and low investment) is part of the story behind persistent surpluses in creditor economies.

Large and persistent surpluses in creditor economies contribute to a stronger euro, which:
- Makes it tougher for euro area debtor economies to adjust.
- Exacerbates the external competitiveness gap facing debtor economies.
- Contributes to weak euro area inflation (the “lowflation” environment).
The observed rebalancing appears “unbalanced,” relying heavily on:
- Anemic domestic demand in debtor economies.
- Restrained domestic demand in creditor economies.
Appropriate adjustment requires policies that achieve both:
- Internal balance (reducing output gap and unemployment).
- External balance (a more sustainable current account).

Boost investment in creditor economies.
Implement structural reforms to raise productivity in all euro area economies through:
- Further liberalization of product and service markets.
- Reforms to make labor markets more flexible.
These policies would:
- Raise potential growth across the board.
- Help output gaps close faster.
Breaking out of the current “lowflation” environment would ease adjustment by opening up space for faster relative price changes within the euro area.

John Bluedorn and Shengzu Wang, July 22, 2014.

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