Europe’s role in global imbalances

The whole world is a closed economy, while Europe is not. In a closed world the current account deficit of a country is, by definition, the surplus of another country. The EU used to have a close to balance external current account position, but recent moves suggest that this stance may change.

The euro is depreciating against the dollar, yet from highly overvalued levels, and more and more European countries start to announce fiscal consolidation plans. Fiscal consolidation and euro depreciation may easily push Europe to an external current account surplus position. But who will accommodate more current account deficit?

Disputes about fiscal consolidation are expected at the upcoming Toronto summit. Few days before the summit, President Obama warned about the risks of too early withdrawal of fiscal stimulus: premature consolidation may hinder economic recovery. In response, Chancellor Merkel emphasized that their approach to consolidation is cautious and it is a large budget deficit that poses serious risks. President Barroso added that there will be no confidence without consolidation, and no growth without confidence.But is Europe’s overall fiscal situation really worrying? Considering the euro area as a whole, budget deficit is expected to be about 6.5 percent of GDP in 2010. In the US, deficit is at 10 percent of GDP. Government debt is 85 percent of GDP in the euro area, while it is 116 percent in the US. (For the US, this number is the sum of federal, state and local government debt – the concept better corresponds to EU’s debt statistics. US Federal debt, which is more frequently reported, is around 94 percent of GDP.)

Therefore, the overall fiscal situation and outlook is considerably better in the euro area than in the US.The euro area indeed suffers from a confidence crisis and many outsiders have even questioned the viability of the European Monetary Union. But the reason for the confidence crisis is not the overall fiscal situation of the euro area. Consequently, it is not the euro area overall fiscal stance that needs an urgent repair in order to restore confidence.The core reasons for the euro area confidence crisis are Greek solvency problems, fear that contagion will spread to some other euro-area countries and to the fragile euro-area banking industry, ambiguous policy response and governance deficiencies. Consolidating public finances in Germany and France is not an answer to these issues.Premature fiscal consolidation at the euro-area level will likely have several side effects.

First, the private sector is still in the midst of the so called deleveraging process, that is, banks, corporations and households wish to decrease their indebtedness. History tells us that such a process used to last for several years. When the public sector consolidates under such circumstances, it is unlikely that the private sector can fully substitute reduced public demand and therefore overall economic activity will suffer.

Second, an overall euro-area consolidation will make the job much harder for those Mediterranean countries that indeed have no choice but to consolidate, i.e. Greece (due to a severe solvency problem), and Portugal and Spain (due to the fear of contagion). But if solid euro-area countries consolidate and thereby jeopardize economic recovery in the whole euro area, it will impact growth in the South as well. Slower growth in the South will make fiscal situation worse there and will require even harsher fiscal consolidation, again impacting growth downward.

Third, fiscal consolidation in current account surplus countries, such as Germany, will make it much harder to reduce intra-euro area current account imbalances. It has been well recognised that intra-euro-area current account imbalances, when they are not the result of equilibrium developments, jeopardise financial stability. But when current account surplus countries reduce their demand, they make pressure on others, both inside and outside the euro area, to accommodate higher current account deficits.Yet a short detour is worthwhile to take here: I do not share the frequently cited blame that the gain in competitiveness by Germany during the past fifteen years is the main culprit of intra-euro-area imbalances. In the euro-area current account deficit countries there was a strong domestic component, partly related to labour market inefficiencies; Austria, Finland and Ireland also improved their manufacturing compositeness, while France, Belgium and the Netherlands have broadly kept their manufacturing unit labour costs stable. And in any case the euro area as a whole should be more productive and gain competitiveness compared to other regions of the world if it intends to slow down the fall of its share in world output. But Germany and her fellows have a strong responsibility in managing the overall demand in the euro area. Instead of worsening intra-euro-area imbalances, they should take measures to improve the situation.

And fourth, premature fiscal consolidation at the euro-area level will likely worsen global imbalances as well. In an ideal world catching up emerging countries should have current account deficits and advanced economies should have current account surpluses. With the exception of Central and Eastern Europe (where current account deficits were excessive in some cases), other emerging country regions had either balanced current accounts or surpluses in the aftermath of the severe Asian and Latin American crises of the late 1990s and early 2000s. Part of this development was motivated by self-insurance. There are many proposals on the table how to improve the international monetary system in order to decrease the self-insurance motivated current account surpluses, but it is unlikely that a major breakthrough could be achieved. 

Also, in the biggest surplus country, China, where the major motive is not self-insurance, much more should be done domestically. But at least in the short and medium run a European move toward a current account surplus would likely be accommodated by a higher US current account deficit.The question is indeed whether fiscal consolidation is premature at the euro-area level. In fact, the fiscal stance is still expansionary in Germany and also at the aggregate euro-area level in 2010 and the announced plans for consolidation from 2011 and beyond are not extremely ambitious. Also, Germany’s fiscal consolidation may not have the deflationary effects that many fear, and the private sector in Germany may indeed substitute the falling public sector demand. And in the long run Europe indeed should manage its serious aging problem, which will require substantial reforms to the public sector.

But in the short run the announcement of German consolidation plans may start a wave of consolidation elsewhere: other euro-area countries will have no other choice as they will be assessed against Germany by the markets. And expectations about future consolidation may have an immediate effect especially when there are a lot of question marks about the recovery.My answer is, therefore, to wait with fiscal consolidation in fiscally sound euro-area countries till recovery will indeed prove to be sound. This would not at all jeopardise credibility of the euro area, and would even help the adjustment of intra-euro-area current account balances, and also the necessary fiscal adjustment of Mediterranean countries. It would also be in line with the G20 framework for strong, sustainable and balanced growth. Instead of premature fiscal consolidation, fixing the core problems that have led to the euro-area crisis would be much more important.