Do current account balances matter for competitiveness in the Euro Area?

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1 Preliminary draf, do no quoe wihou he permission of he auhors Do curren accoun balances maer for compeiiveness in he Euro Area? Sefan Collignon* San Anna School of Advanced Sudies Piero Esposio** San Anna School of Advanced Sudies and Cenro Europa Ricerche (CER) Absrac Many economiss have argued ha curren accoun balances are a good indicaor for assessing compeiiveness. The European Commission has aken his idea on board in is design of he The Excessive Imbalance Procedure. Furher, he Real Effecive Exchange Rae and Uni Labour Coss are proposed in order o monior inra area imbalances. The aim of he paper is hreefold: firs, we show heoreical and economic policy argumens supporing he idea ha he curren accoun is no an appropriae measure for inernal compeiiveness; second, we apply a new measure, he CER index of compeiiveness, which incorporaes he effecs of wage bargaining, labour produciviy and he average efficiency of capial. Finally, we will es economerically he relaion beween curren accoun/ne expors and produciviy/compeiiveness. We do so by using he reduced form approach for esimaing curren accoun deerminans firsly used by Debelle and Farquee (1996, 1998) applied o a panel composed by he 12 firs Euro Area. We will furher es he behaviour of he CER compeiiveness index in comparison wih he oher measures proposed by he Commission. Keywords: Curren Accoun Defics; Euro; Moneray Union; Uni Labour coss; Real Effecive Exchange rae; Resrucuring Process; Panel Daa. * ph ; ** ph ; 1

2 1. Inroducion Many economiss have argued ha curren accoun balances are a good indicaor for assessing compeiiveness. The European Commission has aken his idea on board in is design of he The Excessive Imbalance Procedure. Before ha, he same idea has been pu forward for advanced economies in he G20 summi of November In our opinion such a concep in a moneary union may no be appropriae. There are several reasons for a curren accoun surplus (defici) o be bad ( good ) for compeiiveness, depending on he evoluion of several facors such as inernal and exernal demand, he balance beween saving and invesmen and he aging of he populaion. There is a furher difficuly as curren accouns cover ne expors plus facor income plus ne ransfers wih he laer having no necessarily o do wih compeiiveness. This implies ha while he imporance of curren accoun balances beween counries wih differen currencies is beyond dispue as hey add o foreign asses/liabiliies and affec foreign exchange reserves wih possibiliy o cause a crisis as he one experienced in Europe in , wihin a moneary union hey lose heir original meaning. Addiionally, form an economic policy poin of view, he use of curren accoun balances has a furher negaive feaure as i generaes a naionalisic bias prevening boh he design of coheren economic policies and he esablishmen of a democraically conrolled economic governmen for he Euro Area. Ne expors may be a beer indicaor for compeiiveness bu his concep also presens some difficulies, in paricular considering he disincion beween exernal compeiiveness, which is dependen on exchange raes beween he euro and oher currencies, and inernal compeiiveness, which is driven by he relaive coss of labour and capial. If comparaive advanages allocae resources efficienly in a single marke wih a single currency, some regions may specialize in radable and ohers in non-radable goods. They will herefore be affeced asymmerically by exchange rae movemens, which will, however, show up in diverging rade balances. I may herefore be no reasonable o use he aggregaed ne expors as shown in he curren accoun balance and inerpre hem as a significan indicaor for compeiiveness. This is exacly wha happened since he creaion of he EMU, as wih a single currency, ineres raes and he cos of capial have fallen in he souh, converging o he Norhern low levels. This caused an increase in he capial sock relaive o labour in Souh, while in he Norh an opposie process occurred, leading o a profound process of srucural reallocaion of resources across Europe. As resul, Germany and Neherlands are emerging as manufacuring cenres, while Ialy and France are de-indusrialising and specialising ino non-radable, hence, 2

3 curren accoun and ne rade saisics would simply reflec he new resource allocaion in an inegraed marke. Wha maers in order o monior inra Euro Area imbalances is cos compeiiveness. The Commission scoreboard has aken his noion ino accoun and proposed eiher he use of he Real Effecive Exchange Rae and Uni Labour Coss as indicaors. Neverheless, boh indices have some shorcomings as he former is mainly driven by he euro-dollar exchange rae and he laer does no consider he capial efficiency. The aim of he paper is wofold; firs, afer showing heoreical and economic policy argumens ha he curren accoun is no an appropriae measure for inernal compeiiveness, we apply a new measure, he CER index of compeiiveness (see CER 2011, Collignon e. al., 2011), which is given by he difference beween acual and equilibrium ULC. This index defines equilibrium ULC as he level which would guaranee a reurn of he naional economy s capial sock equal o he Euro Area one. The measure incorporaes herefore he effecs of wage bargaining, labour produciviy and he average efficiency of capial. We argue ha his index is a beer measure for inernal compeiiveness and can be a more reliable ool as policy variable. Secondly, we will es economerically he relaion beween curren accoun/ne expors and produciviy/compeiiveness. We do so by using he reduced form approach for esimaing curren accoun deerminans firsly used by Debelle and Farquee (1996, 1998) applied o a panel composed by he 12 firs Euro Area. We will furher es he behaviour of he CER compeiiveness index in comparison wih radiional measures of compeiiveness. The srucure of he paper is as follows. In secion 2 we will give poliical economy argumens agains he use of he curren accoun as measure of compeiiveness in a moneary union. In secion 3 we will shif he focus on he European resrucuring process and on he concep of cos compeiiveness. In secion 4 he CER Compeiiveness Index is derived and compared wih oher indexes of cos compeiiveness. In secion 5 we develop he economeric analysis on he relaion beween curren accoun balances and compeiiveness, while secion 6 concludes. 2. The Curren Accoun as measure of compeiiveness Many observers have argued ha he crisis in Europe s Souh has been caused, in addiion o fiscal indiscipline, by he loss of compeiiveness due o above average inflaion in wages and prices, while some Norhern counries have improved heir cos compeiiveness. These diverging price developmens are hough o have engendered curren accoun deficis in he 3

4 Souh and surpluses in he Norh. Hence, so is he argumen, srucural reforms are needed o resore compeiiveness in he Souh, wihou making he Norh less compeiive. In order o provide a srucured framework o preven and correc macroeconomic imbalances, he Commission proposed an Excessive Imbalances Procedure (EIS). 1 One of he core pars of his proposal is he regular assessmens of he risk of macroeconomic imbalances by using an aler mechanism, which would rigger more in-deph analysis of macroeconomic imbalances before concree policy measures are adoped. The aler mechanism will use a scoreboard based on a small se of indicaors for which a series of hresholds will be defined. Differen hresholds apply for Euro Area and non-euro Area Member Saes. The scoreboards will focus on curren accouns, exernal deb and cos compeiiveness. The Commission calls for monioring inernal and exernal imbalances, wih he laer meaning in pracice he curren accoun balances and ne foreign financial asse posiions of Member Saes. Ye, in our opinion alking of exernal balances wihin he Euro Area does no make economic sense. There is nohing exernal abou imbalances wihin he same currency area and real effecive exchange raes confuse inra- and exra-eu rade. While i may be useful o assess how naional policies and economic developmens pursued in Member Saes may affec he Euro Area as a whole, applying he noion of exernal balances o members of moneary union confuses economic, poliical and juridical conceps and creaes a chauvinisic bias for policy making in he Euro Area, wih chauvinism meaning a bias in favour of he familiar. This bias in favour of he familiar resuls from aking for graned he naion sae framework for policy making, even if he economy is inegraed in a single marke wih a single currency and would require a coheren European framework for cenralised European macroeconomic policies. 2 The use of curren accoun balances o assess inernal imbalances in he Euro Area is an example for such confusion, because radiional naional sae saisics are no longer expressing useful funcional economic relaionships and herefore preven correc policies. The concep of curren accouns is an iem in he balance of paymen, which measures inflows and ouflows, i.e. paymens, in foreign currencies. Clearly, when one uses he same currency in Moneary Union, paymens beween differen member saes are no longer in foreign currency. Hence, he role of balance of paymens mus have changed significanly and curren accoun saisics no longer play he funcional role, which hey radiionally have fulfilled when hey represened he ransacion beween differen currency areas. 1 See European Commission (2010). 2 The claim he macroeconomic sabilizaion policies need o be cenralized has been esablishes a long ime ago by Musgrave R. and P. Musgrave, (1973). 4

5 Many economiss argue ha even in Moneary Union naional curren accoun saisics are meaningful. They derive ha meaning from sandard ex book economics, whereby he curren accoun posiion eiher closely reflecs he balance of expors and impors and herefore implicily of compeiiveness, or alernaively measures he imbalance beween savings and invesmen. Boh hese argumens have los heir relevance in moneary union. Firs of all, curren accoun balances are ofen wrongly idenified wih ne expors and herefore do no necessarily reflec a counry s he expor capaciy. Curren accoun saisics are defined no only by ne expors of goods and services, bu also by facor incomes and remiances and by ransfers beween counries. Table 1 shows ha for some counries, such as Germany, curren accouns do indeed mainly reflec ne expors; bu for ohers, like Luxembourg and Ireland, huge discrepancies beween curren accouns and ne expors occur. A closer look reveals ha in Germany he primary facor income (essenially profis from foreign invesmen) of +33.5bn is large (more han a quarer of ne expors), bu i is closely balanced by ne ransfers of -32.4bn o he res of he world, so ha he ne balance of facor income plus ransfers is close o zero. In Ireland and Luxemburg, by conras, wo counries which have araced significan foreign invesmen in he pas, ne primary income is srongly negaive (firms are repariaing profis), while ransfer paymens are irrelevan. Hence, he curren accoun posiion does reflec no only expor compeiiveness, bu also he ownership srucure of capial and invesmen. In a fully inegraed economic and moneary union, one should expec ha capial and labour are allocaed efficienly according o comparaive advanages and capial should flow freely across Member Sae borders. In addiion, wih aging socieies cross-border ransfers will also increase if pensioners move from he Norh o warmer climaes in he Souh. As a consequence, divergences beween curren accoun saisics and ne expors are likely o increase wihin he European Union and curren accouns are an inappropriae measure for expor compeiiveness. The second argumen for using curren accouns when measuring macroeconomic imbalances derives from he ex book ideniy whereby curren accouns reflec he difference beween he naional savings and invesmen. While his is, of course, always correc, he ideniy has no more significance wihin a single Moneary Union han he savings-invesmen balance of regions wihin any naion sae. Invesmen is condiioned on possessing and conrolling money in he hand of invesors. Wihou money, here is no invesmen. In a domesic economy, he banking sysem collecs deposis and savings and allocaes his money o invesmen, 3 bu he sysem as a whole obains money, i.e. liquidiy, from he cenral bank. By conras, in foreign economies making paymens and invesmen requires access o foreign currency. For example, if 3 In fac, banks also creae (broad) money by graning credi. 5

6 a European firm wans o inves in he USA, i needs US dollars. Hence, for he domesic economy, he ulimae budge consrain is he supply of cenral bank liabiliies (i.e., base money), bu wih respec o a foreign economy he budge consrain is he supply of foreign exchange. Because changes in he balance of paymens are causing changes in he sock of foreign exchange reserves, he balance of paymens and a foreriori he curren accoun balance are of crucial significance for ransacions beween differen currency areas, bu no wihin he same moneary area. Table 1 Curren accoun and main componens as % of GDP in 2010 Curren accoun Ne expors Facor income and ransfers Luxembourg Neherlands Germany Esonia Ausria Belgium Finland Euro area Euro area Slovenia Ireland Slovakia Ialy France Mala Spain Cyprus Greece Porugal Source: AMECO In a single financial marke wih a single currency here are no exernal savings. 4 Therefore, savings originaing in one Member Sae are ransferred o anoher Member Sae hrough he European banking sysem; hey are neiher foreign, nor do hey reflec ne foreign financial asse posiion in any meaningful sense, because all savers and invesors are subjeced o he same budge consrain, which is he money supplied by he cenral bank. 5 In same currency areas, here is no currency risk, because base money is supplied by he cenral bank. Banks borrow from he cenral bank and lend o he real economy, i.e. o firms and governmens. 4 Of course i is always possible o keep savings in foreign currency, bu his means he disincion is precisely he currency and no he jurisdicion. 5 This would of course be differen if deb in one counry were denominaed in foreign currency, for example in USD, alhough he rusworhiness of he debor who has issued deb in ha currency would be suppored by he foreign exchange reserves of he Euro Area as a whole. 6

7 In European Moneary Union, he European Cenral Bank (ECB) is he lender of las resor o all banks, and all banks can herefore always coun on obaining he necessary liquidiy from he ECB, provided hey accep he prevailing erms and ineres raes. I makes no difference wheher he lender is a domesic or foreign bank in he Euro Area. This open and unlimied access o liquidiy for banks defines a Moneary Union as a domesic economy. In oher words, European Moneary Union is no a fixed exchange rae area; i is effecively an economic counry. Member Saes are economic provinces of Euroland. In order o clarify he differen roles of curren accoun balances beween and wihin currency areas we can use wo equaions. We will call he firs he exernal, he second he inernal balance of paymens. Exernal balance of paymens (1) (Expors-Impors) +(Ne Transfers in -) +(Ne Capial flows in ) =Δ Ne foreign reserves The sum of ne expors plus ne inflows from ransfers equal he curren accouns of he currency area; ogeher wih ne capial inflows hey deermine he change in he foreign reserves in he Cenral bank s balance shee. By conras, he inernal balance of paymens for an individual Member Sae in moneary union is defined as: (2) (Expors-Impors) i +(Ne Transfers in -) i +(Ne Capial flows in ) i =Δ M i Where Δ M i is he money sock held in Member Sae and M M is he money supply of he Euro Area. Thus, he sum of ne paymens deermines he amoun of money held in individual Member Saes. A so-called curren accoun defici in a Member Sae may be financed by capial inflows provided by he banking sysem, or i will lead o a reducion in he locally held money sock. Such moneary ouflow may cause lower prices and depress local demand. In any case, i is equivalen o a general reducion in local wealh; bu i does no imply ha he siuaion is unsusainable. I only means ha i is uncomforable. The inflow of ne capial ino a Euro-Member Sae can preven he depressive effec of moneary ouflows, alhough i reduces local wealh. In he exernal balance of paymens, curren accoun deficis increase he indebedness in foreign currency. Wihin moneary union, capial inflows also creae liabiliies for local debors, bu in local currency. They are exemp of currency risks and herefore do no reflec a counry risk. Neverheless, hese liabiliies lead o a reducion of ne wealh for local debors and an increase of ne wealh for foreign crediors. In 7 n i= 1 i =

8 oher words, German expor surpluses and Souhern deficis make German lenders richer because hey build wealh claims agains Souherners. Macroeconomic imbalances are herefore increasing wealh inequaliy. Neverheless, if he so-called curren accoun posiions of Member Saes are financed by he European banking sysem, hey are always susainable as long as banks are solven. This saemen does no imply ha borrowing is limiless in moneary union. Deb mus be serviced and repaid. Even if here is no exchange or counry risk, here are sill significan risks wih respec o individual debors. If individual debors canno repay heir obligaions, lenders incur losses. If banks loan porfolios are well diversified, he defaul of a single debor can be absorbed by he banking sysem wihou causing major insabiliies. However, public deb issued by naional governmens is ofen concenraed in he porfolios of banks in hose member saes and a defaul of a sovereign debor is herefore likely o creae sysemic risks wih poenial conagion for he whole currency area. This is why sovereign debors have a paricular role in moneary union. Public deb maers and, herefore, fiscal policy maers for he sabiliy of he banking sysem. This fac may jusify monioring public finances in he common ineres, bu his is an argumen differen from monioring curren accouns and compeiiveness. If he banking sysem allocaes savings o invesmen, i is he responsibiliy of banks and invesors o assess he risk of defaul and o charge prices ha would compensae losses if hey occurred. Bu as long as individual debors are able o mee heir obligaions, here is no harm if some borrowers are clusered in some regions of moneary union. In his case, regional curren accoun deficis are susainable and no governmen ransfers are needed o susain defici counries. This fac is ofen misundersood when macroeconomic imbalances are discussed in he Euro Area. However, rouble comes when a region is hi by an asymmeric shock or suffers a gradual loss of compeiiveness, because ha could increase he insolvency risk of local governmens. Prevening his risk from occurring is he proper reason for monioring cos compeiiveness. 3. The European resrucuring process and cos compeiiveness Over he las wo decades, compeiive advanages have shifed significanly wihin he EU. The creaion of he European Single Marke in 1992 and European Moneary Union in 1999 had a clear purpose: o improve Europe s producive capaciy and compeiiveness in he global economy. 8

9 However, he gains from greaer marke inegraion are no equally disribued. European unificaion has creaed winners and losers. The radable goods secor in manufacuring has generally benefied from economies of scale, bu oher secors, which depend on low skilled labour or produce non-radable goods, have suffered. These shifs in he disribuion of welfare gains are ypical for efficien marke economies. Kaldor (1939) has shown ha in a welfare maximising economy, winners should compensae losers. Inspired by he German model, he European Union has paid lip service o his idea by declaring ha i is a Social Marke Economy, bu a he same ime i has resised he idea of Transfer Union. This economic and poliical chauvinism now risks undoing all he economic benefis ha European Inegraion has produced. In a single marke wih moneary sabiliy, facors of producion are allocaed according o comparaive advanages. Invesors seek o combine capial and labour in such a way ha coss are minimised in he EU. Relaive facor prices of labour and capial (which includes all kinds of oher coss such as energy, land, ec.) are increasingly deermining he allocaion of facors of producion and his requires shifs away from radiional producion models. Economic heory eaches ha higher wages and/or lower ineres raes should encourage he subsiuion of labour by capial. This means ha, for he same level of oupu, he accumulaion of capial will accelerae and employmen growh will slow down, while labour produciviy will increase and capial produciviy will fall. We may illusrae his by a simple ex book model. Figure 2 shows he logic of he subsiuion of facors of producion in accordance wih relaive facor prices. The verical axis gives he amoun of capial, he horizonal axis he amoun of labour and he iso-cos curve indicaes he possible combinaions of capial and labour ha are required o produce a given amoun of oupu. Toal facor produciviy increases when we move from he higher iso-cos curve o he lower curve a he lef, because less capial and less labour are now required o produce he same amoun of oupu. In heory, any poin on he iso-curve is efficien. The quesion is hen: where will an economy find iself on his curve? The answer depends on relaive facor coss. Profi maximising firms will chose a combinaion of capial and labour, a which he oal coss are minimized, and his depends on he relaive price of hese wo facors of producion. The relaive price raio of labour o capial is indicaed by he angen line ha ouches he iso-curve a poin A. If relaive facor prices change because capial becomes cheaper and labour more expensive, he economy moves from Poin A o Poin B, provided oal facor produciviy does no change. As a consequence, more capial and less labour will be used o produce he same oupu, which means ha capial produciviy has fallen and labour produciviy has increased. 9

10 However, he accumulaion of capial may improve producion echnologies so ha oal facor produciviy improves and he economy moves from a higher o a lower iso-cos curve. These shifs may lead o varied adjusmen pahs in response o shifs in he cos of capial and labour. For example a movemen from poin A o Poin D increases boh capial and labour produciviy, alhough capial produciviy has improved less. The opposie effec akes place when capial (labour) becomes relaively more expensive (cheaper). In realiy, an economy may move simulaneously on he iso-curve, and see he curves hemselves being shifed. Since he beginning of European Moneary Union, relaive facor prices have shifed significanly for some Member Saes in he Euro Area. Wih he single currency, ineres raes and he cos of capial have converged in he Souh o low levels. As a consequence, he cos of capial has fallen and he average capial efficiency (ACE) has slowed down, while labour produciviy has ofen improved. In he Norh, on he oher hand, he cos of capial has sayed fairly consan, while wages have fallen relaive o he Euro Area. Thus, he shif in relaive facor prices has moved he equilibrium poin on he iso-curve in he Norh in he opposie direcion of he Souh and he average capial efficiency has risen. Figure 3 gives a long run overview of he average efficiency of he capial sock of major Member Sae of he Euro Area since We observe ha for he Euro Area as a whole (las panel), here was a drop in ACE afer he collapse of he Inernaional Moneary Sysem of Breon Woods in 1973 ha lased unil he early 1980s. Wih he ani-inflaionary policies of he 80s ineres raes were high and capial efficiency has improved. Afer he inroducion of he Euro in 1999, ACE has moderaely fallen unil oupu was hi by he Lehman crisis in Neverheless, for individual economies in he Euro Area he picure is differen. In Finland, Belgium, Germany and he Neherlands, ACE has coninued o increase over he las 20 years. To a lesser degree his was also for rue in Greece. However, in he Souh, in paricular in Ialy, Spain, Porugal, Ireland and France, he average efficiency of capial has fallen since he Euro was inroduced in This is in accordance wih our heoreical model, whereby an increase of he cos of labour relaive o capial will lead o a fall in capial produciviy, and inversely a reducion in labour coss relaive o capial will raise he average efficiency of capial. 6 ACE is calculaed as he raio of GDP o he value of he capial sock. I herefore represens capial produciviy muliplied by he raio of he GDP deflaor o he capial goods indicaor. In he long run, his laer raio should be one, so ha ACE is a good proxy for capial produciviy. 10

11 Figure 1 Mechanism of change in labour and capial produciviy Hence, he shif in relaive facor coss induced by European Moneary Union has ransformed he compeiive advanages of Member Saes and caused a profound process of srucural reallocaion of resources across Europe. Germany and he Neherlands are emerging as he cenres for manufacuring, while Ialy and France are gradually de-indusrialising. Member saes, which have less poenial for economies of scale, may reallocae resources o non-radable secors. The broad picure is hen ha curren accoun balances reflec he new resource allocaion in a fully inegraed European marke. Some regions, like Germany, will become permanen surplus areas no only wihin he Euro Area, bu also in he inernaional economy, while ohers are srucurally moving ino a posiion of permanen deficis. Insofar as his is an expression of efficiency gains in he European economy, his is desirable, and he surpluses ouside he Euro Area will provide he foreign exchange reserves which back he converibiliy of he Euro, while he banking sysem will finance he curren accoun deficis in oher regions wihin he Area. Hence, i is no rue ha every region need o have he same producion mix, nor i is necessary ha curren accoun imbalances wihin he Euro Area mus always be eliminaed. In fac, he heerogeneiy wihin he Euro Area is a sign of economic efficiency. The persisence of curren accoun imbalances signals ha European Moneary Union and European inegraion work and operae as economic heories have prediced. 11

12 Figure 2 Average capial efficiency AUSTRIA BELGIUM FINLAND Breon Woods EMS ERM EURO crisis FRANCE GERMANY GREECE IRELAND ITALY NETHERLANDS PORTUGAL SPAIN EURO AREA (12 counries) Source: AMECO 4. Measuring cos compeiiveness: he CER Compeiiveness Index The mos commonly used measures for compeiiveness are indexes of relaive prices or relaive inflaion raes, which are usually based on some indices saring a an arbirary base year, ofen he year Among hese indices, paricular imporance is given o he uni labour coss, which are supposed o signal differences in labour cos developmens per oupu. Beween Germany and Ialy a cos gap of he order of 22% has developed from 2000 on and his is ofen 12

13 inerpreed as a sign for Ialy losing compeiiveness. Similar argumens apply o oher Souhern Saes, which accumulaed a subsanial gap in ULCs oo. Anoher imporan index of compeiiveness is he real effecive exchange raes, i.e. he relaive prices of a rade weighed baske of 35 counries. An increase in his index reflecs a loss in compeiiveness. There are problems wih his index oo as i amalgamaes expors ino he Euro Area wih hose of non-euro Area sae, which are subjec o exchange rae changes. In figure A1 in he appendix we plo he REER relaive o he euro average and he euro dollar exchange rae. I is eviden ha, especially from he beginning of he moneary union, he wo variables move in he same direcion. Thus he nominal effecive exchange rae of Euro Area Member Saes is largely driven by he euro-dollar exchange rae, and his can hardly be an indicaor for compeiiveness wihin he Euro Area. The Commission s scoreboard would herefore base is early warning sysem on a disored se of indicaors. Furhermore, cos compeiiveness derives from relaive cos levels and heir discrepancies canno be measured by hese indicaors. We herefore need a differen approach. Wha maers for he compeiiveness is he level in relaive coss. Neverheless, focusing on labour cos alone is no appropriae. Labour coss are only one elemen in he oal cos srucure of an economy s supply and producion srucure. The oher imporan facor, as we have seen in he previous secion, is he cos of capial. Thus, one needs o esablish a sandard of measuremen where he compeiiveness of firms in a given economy reflecs he relaive advanage of labour and capial. The proper way of measuring equilibrium in efficien markes is assuming ha he raes of reurn on capial are equalized relaive o some benchmark economy. This does no mean ha marke dynamics will necessarily and always equalize he reurns on capial, bu his is he sandard of measuremen agains which deviaions from efficiency can be clearly described. Wha follows is a heoreical derivaion of he compeiiveness index based on he above evidence. The rae of reurn is he operaing surplus (ne profi) per uni of capial. If we absrac from capial depreciaion and axes, i is (3) R = Py-wL PK k The ACE (k) is he nominal oupu produced by one uni of capial a curren prices: 13

14 Py k = (4) PK k we ge he rae of reurn as he produc of he profi share and ACE (5) Py wl Py w 1 ULC R = kσk = k(1 σw) = = 1 k = 1 k Py P K P λ P k share σ w where λ= y/l is labour produciviy and he profi share σ k is he complemen of he wage (6) σ k Py wl = = 1 σ w Py Because of (5), he reurn on capial R improves when he average efficiency of capial and/or he profi share improve. The average efficiency of capial rises wih he echnological produciviy of capial (y/k) or when prices for capial goods are less han he GDP deflaor (P/P K <1). The profi share rises when he wage share falls, which implies ha real wages rise less han labour produciviy. Assuming efficien markes, R should converge in differen counries. Thus, for counry A and B we have (7) or: R R ULC k ULC k σ * * * * A B A = B 1 A = 1 B PA PB = σ k * * B KA KB ka Hence, in equilibrium he differences in wage shares mus reflec he relaive produciviies of capial and he equilibrium pah for ULC is (8) ULC k = P ULC k 1 P * B A * B A B A ka PB ka We will use he Euro Area average of equilibrium ULCs as he benchmark for assessing European compeiiveness. If acual uni labour coss are higher or lower han his heoreical equilibrium level, we will say ha a counry is over or undervalued relaive o he defined 14

15 compeiiveness sandard. The CER compeiive index (CCI) is hen defined as he difference beween acual and equilibrium uni labour coss: * (9) CCI A =ULC A -ULC EA In figure 4 we repor he evoluion of he CER compeiiveness index for he firs Euro Area Members and in aggregae. The posiion of he index above he horizonal zero line indicaes an overvalued posiion, below his line is an undervalued indicaion. An increase in he index is equivalen o a loss of compeiiveness. We noiced ha relaive o he Euro Area mos counries, wih he excepion of Germany, Greece and iniially Ireland, have los compeiiveness since he sar of European Moneary Union. The loss is paricularly dramaic for Ialy, Spain, France and Ireland afer Some counries like Ausria have experienced a srucural overvaluaion for several decades while oher counries like Porugal and Spain used o be srucurally undervalued unil hey joined he Euro. Germany wen hrough a serious period of overvaluaion afer Unificaion, bu hen has improved is compeiiveness from 2000 onwards. In order o show he addiional feaures of he CCI in comparison wih oher radiional measures of compeiiveness we show in figure 4 he evoluion of he German CCI ogeher wih labour produciviy, TFP, ACE, ULC and he Real Effecive Exchange Rae (REER), all expressed in erms of he Euro Area average. The laer, for he way i is buil, maches almos exacly he relaive ULC, so ha he same conclusions apply o he wo indicaors. According o he CCI (panel 2), beween 1980 and 2000 Germany loss compeiiveness, alhough alernaing seady losses wih periods of srong increases. In paricular, he srong loss beween 1983 and 1988 was due o he srong reducion in boh produciviy indicaors while ACE (panel 1) experienced only a minor reducion. In he following hree years he gain was due o he recovery of TFP (panel 4) and ACE. Relaive ULC (panel 5) moves in line wih he CCI in his second par while in he previous period he mach is only parial. In he period despie decreasing ULCs, he loss in TFP caused a loss in compeiiveness, due also o he sagnan relaive produciviy of boh labour and capial. The excepional compeiiveness increase from 2000 on is due boh o he srong rise in ACE and o he conracion of he ULC. I can be noed ha he reducion in CCI is seeper han ha of ULC, poining o he addiional role of ACE s growh in explaining compeiiveness. Tradiional indicaors flucuaed unil 2005, while afer ha hey sared o rise again, increasing he speed of compeiiveness gains. This paern can be an explanaion for he German exraordinary increase in rade surplus from 2000 on. The above evidence suggess ha he CCI, by including he effec of capial efficiency, is able o capure an aspec of compeiiveness 15

16 which is absen in he radiional indicaors and can shed furher ligh on he deerminans of he evoluion of European economies. Figure 3 The CER Compeiiveness index for he Euro Area (12 counries). AUSTRIA BELGIUM FINLAND FRANCE GERMANY GREECE IRELAND ITALY LUXEMBOURG NETHERLANDS PORTUGAL SPAIN Source: CER elaboraions on AMECO daa 16

17 Figure 4. Comparison beween he CCI and oher compeiiveness indicaors Relaive ACE Cer Compeiiveness index Relaive labour produciviy Relaive TFP Relaive ULC 1.10 Real Effecive Exchange rae (EU15) Source: auhors elaboraions on AMECO daa 5. Tesing he performance of he CER Compeiiveness Index In his secion we es he performance of he CCI in comparison wih oher measures of compeiiveness. This is done by esimaing he deerminans of he curren accoun balances and is main componens for he original 11 Euro Area Members. 7 In his way we can reach wo resuls: firs o give evidence for oher forces a work which may shape he evoluion of he curren accoun, especially wihin a moneary union, independenly of any compeiiveness gain or loss; second, we can see wheher he CCI improves he explanaory power of he model wih respec o he oher measures. 7 Belgium and Luxemburg are considered as a single counry. 17

18 5.1 Economeric sraegy The deerminans of he curren accoun are invesigaed by following he lieraure on Srucural Curren Accoun (SCA), which applies sandard panel economeric echniques in order o analyse he long run relaionship beween he curren accoun and sandard macroeconomic deerminans. This lieraure is mosly derived from he heory of ineremporal approach o he curren accoun (see Buier, 1981, Sachs, 1981, Obsfeld and Rogoff, 1995) and has been firs applied by Debelle and Farquee (1996, 1998), while several analyses applied his mehod in recen years (Cà Zorzi e. al, 2009, Chinn and Prasad, 2003, Gruber and Kamin, 2007) For he Euro Area, Blanchard and Giavazzi (2002) applied his mehod o give an explanaion for he relaion beween saving and invesmens in a counry when invesors are free o move capials around he world and hence, solving he Feldsein-Horioka (1980) puzzle. A recen paper (Brissimis e. Al., 2010) used his approach o invesigae he susainabiliy of he Greek curren accoun in a period of srucural change. We mainly follow his conribuion for he choice of he macroeconomic deerminans of he curren accoun. The saring poin of his approach is he ideniy beween curren accoun and he difference beween saving and invesmens. Privae savings depend upon invesmen decisions and oher macroeconomic variables such as he GDP per capia relaive o a reference counry, he governmen budge balance, he relaive ineres rae and he real effecive exchange rae (REER). The relaive GDP per capia reflecs he higher exernal borrowing requiremens of caching up counries, while he budge balance reflecs he Keynesian win defici assumpion. REER reflecs he purchasing power effec, so ha an appreciaion leads o boh an increase in consumpion and a higher demand for impors, affecing negaively he curren accoun. This effec is closely relaed o compeiiveness as a real appreciaion indicaes ha domesic producs increase heir cos of producion, leading o deerioraion in cos compeiiveness. Brimissis e. al. (2010) consider in addiion he dependency raio, given by he raio of populaion below 15 years and above 65 years on he populaion beween 15 and 65 years. This variable should capure he higher consumpion share of non working populaion bu may also reflec addiional saving due o bequess or o he uncerainy of he afer reiremen life. In order o es he relaion beween curren accoun and compeiiveness on he one hand, and he performance of he CCI agains oher sandard measures on he oher, we add alernaively he CCI and he ULC boh in absolue erms and relaive o he Euro Area. As already poined ou, he Commission proposed he use of he REER based upon ULCs for he 35 major rade parners as measure of compeiiveness, bu unforunaely his measure has been calculaed only from he second half of he nineies. The measures available for a longer ime 18

19 period are hose based on he ULC for he EU15 and for he nine mos indusrialised counries as well as he CPI based indexes buil by he BIS. In he presen analysis we will hen use as compeiiveness measures boh he ULC based REER relaive o he EU15 (REER1) and he CPI based REER relaive o he Euro Area (REER2rel). In his way he performance of he CCI will be direcly confroned wih he wo indexes proposed by he commission, he ULC and he REER. Furher, we will esimaes he effec of hese variables on he wo main componens of he curren accoun, i.e. ne rade and ne income ransfers. This is done in order o prove ha curren accouns dynamics are influenced by differen componens no necessarily having o do wih compeiiveness. The final specificaion is as follow: (10a) ΔCA + β ΔINTrel 5 = α + β ΔGDPPCrel 1 + β ΔCOMP 6 + β ΔGB + U 2 i + η + ε + β INVP 3 + β ΔDEP 4 + (10b) ΔTRbal + β ΔINTrel 5 = α + β ΔGDPPCrel 1 + β ΔCOMP 6 + U + β ΔGB i 2 + η + ε + β INVP 3 + β ΔDEP 4 + (10c) ΔNeInc + β ΔINTrel 5 = α + β ΔGDPPCrel 1 + β ΔCOMP 6 + U + β ΔGB i 2 + η + ε + β INVP 3 + β ΔDEP 4 + where CA represens he curren accoun balance, TRbal he rade balance and NeInc he ne income ransfer, all expressed as share of GDP. GDPPCrel is he difference beween a counry s GDP and he US one, GB is he governmen balance in erms of GDP, INVP is he share of privae invesmen, DEP is he dependency raio and INTrel is he raion beween a counry s long erm ineres rae and he US one. COMP represen a compeiiveness measure, which in our case is alernaively given by he wo REER, he ULC (boh absolue and relaive o he Euro Area average) and he CCI. Subscrip i indicaes one of he 11 original Euro Area counries 8 while represen he ime period. Finally, U i is a counry specific effec, which can be reaed as fixed or random depending on he esimaor used, η are ime specific dummies conrolling for common shock and ε is he error erm. Equaions (10a)-(10c) are esimaed in firs difference over he period and over he EMU period ( ). The use of firs differences is dicaed by wo reasons: firs, mos of he regressors are non saionary; second, he presence of Cross Secional Dependency 8 Luxembourg and Belgium are considered as a single counry. 19

20 (CSD). Table A1 in he appendix shows he Pesaran (2004) es for CSD as well as he uni roo es developed by Pesaran (2007), which is robus o he presence of CSD. The resuls indicae ha CSD is presen in all ime series excep for TRbal and NeInc while he uni roo es finds saionariy for INVP, DEP, INTrel, ULC and ULCrel. In his conex a suiable ool for esimaing he long run coinegraion relaion would be he Common Correlaed Coefficiens (CCE) esimaor developed by Pesaran (2006) and improved by Eberhard and eal (2010). This esimaor builds upon he Pooled Mean Group esimaor proposed by Pesaran e. al. (1999), which reurns consisen esimaes of he coinegraion vecor even in presence of saionary and endogenous regressors. This is done by using an Auoregressive Disribued Lags model and by adding cross secional averages of he variables. The improvemen comes from he addiion of cross secional averages of all variables in order o conrol for CSD. The problem wih his esimaor is ha i requires a ime span long enough o allow he separae esimaion of he model for each counry. Given he number of our variables, his procedure would barely work over he whole sample (38 ime poins) bu surely no on he subsample from For his reason we have o esimae he equaion in differences and use sandard saionary panel echniques. The chosen esimaor is he Random Effec model as i is always preferred o he Fixed Effec esimaor by he Hausman es 9 because of he relaive long ime span which brings he correlaion beween he fixed effecs and he error erm close o zero. The CCI as well as he relaive ULC have been buil using daa for nominal wages, labour produciviy and average capial efficiency colleced from he AMECO Annual Macroeconomic Daabase published by he European Commission. This daabase is also he source for mos of he daa used hroughou he paper (curren accoun, ne curren ransfers, ne rade, long erm ineres rae, privae invesmen, governmen balance, real GDP a consan prices, boh in levels and per capia). Populaion daa for he consrucion of he dependency raio are from Eurosa while daa for Real Effecive Exchange rae CPI based are from he Bank of Inernaional Seings. 5.2 Esimaion resuls Esimaion resuls for equaions (10a) o (10c) are shown in Tables 2 o 4, wih he firs four columns of each able reporing he esimaes on he whole sample, while columns 5 o 8 repor he resuls on he subsample The dependency raio has been dropped from he regression because never significan. In order o obain a direc comparison of he effec of he 9 Resuls available upon reques. 20

21 CCI wih he oher indicaors, sandardised coefficiens are repored, hence each coefficien represen he effec of a sandard deviaion increase in each regressor on he sandard deviaion of he dependen variable. Saring wih he deerminans of he curren accoun, we can see ha over he whole period he link beween compeiiveness indicaors and he curren accoun balance is exremely weak. Only he CCI is significan, alhough a 10% level only, and is coefficien indicaes ha a sandard deviaion reducion in he CCI change increases he sandard deviaion of he curren accoun change by 8.6%. Among he oher regressors, a srongly significan impac is given INVP for which he coefficien ranges from o -0.28, while GB has a posiive impac around 0.1 bu significan a 10% level only. INTrel is significan in all cases, excep when COMP is included, wih a coefficien around This resul suggess ha while he CCI performs beer han he oher compeiiveness indexes as deerminan of he curren accoun, here are oher forces which can bring he currenly accoun balance down. In paricular, according o he resuls, an invesmen led growh sraegy would foser a reducion in he curren accoun and he same is rue for a resricive moneary policy. The picure changes wih he esimae on he EMU subsample. Among he macroeconomic deerminans of he curren accoun only INVP keeps (barely) significan, alhough no in all cases, leading o a reducion of he overall fi of he regression. The insignificance of INTrel is probably due o he cenralisaion of he moneary policy and o he convergence of Souhern counries long erm ineres raes o he levels achieved in he Norh. On he conrary, he imporance of compeiiveness indicaors increases and boh REER1 and relaive ULC become significan ogeher wih he CCI. Neverheless, he impac CCI is wice ha of he oher wo indicaors, suggesing once again ha he CCI beer capures he compeiiveness elemen of he curren accoun balance. Turning o ne expors (Table 3) he picure is markedly differen, wih an increased imporance of he sandard macroeconomic deerminans over he whole sample. More specifically, a sandard deviaion increase in he change of privae invesmen o GDP will reduce ne rade variaion by almos 50%. A he same ime, he effec of he relaive ineres rae almos doubled compared o Table 2, wih is impac beween and A sensible increase has been recorded also by he effec of he governmen balance, around As o he compeiiveness measures, none of hem is significan. Quie surprisingly, when considering only he EMU period, all compeiiveness indicaors urn significan wih he excepion of he CCI. A parial jusificaion of he bad performance of he CCI is ha wih fixed exchange raes wihin he Euro Area, mos of he adjusmen akes place via erms of rade of which he REER is a proxy. In addiion, REER is poenially 21

22 capuring he effec of he euro-dollar exchange rae (see Table A1) so ha is significance as inernal compeiiveness indicaor can be overesimaed. As o he oher deerminans, boh GB and INVP increase heir significance, while INTrel becomes again insignifican and he relaive GDP change urns significan wih a posiive coefficien. Finally, he esimaes on ne income ransfers (Table 4) indicae ha almos none of he usual deerminans of he curren accoun are significan. Only INVP is significan in boh sub samples, while among he compeiiveness measures only REER2rel exers a significan posiive impac, which by compensaing wih he effec on he balance of expors over impors, explains why his measure is no significan for he curren accoun as a whole. While we would expec a negaive impac of REER because of he reduced value of foreign income due o nominal appreciaion, wih a sronger currency a counry could increase is endency o inves abroad in order o exploi cos differences, increasing by consequence he share of repariaed income. Table 2: esimaion resuls of equaion (10a) using he Random Effec model Dependen variable: ΔCA ΔGDPPCrel [0.188] [0.287] [-0.464] [0.234] [0.230] [-0.522] [-0.330] [-1.206] [-0.457] [-0.440] ΔGB 0.098* 0.102* 0.101* 0.099* 0.100* [1.696] [1.733] [1.761] [1.693] [1.717] [1.325] [1.215] [1.128] [1.331] [1.369] ΔINVP *** *** *** *** *** * * * [-5.069] [-5.141] [-3.902] [-5.102] [-5.097] [-1.680] [-1.820] [-0.365] [-1.699] [-1.649] ΔINTrel ** * ** ** [-2.008] [-1.897] [-1.281] [-1.995] [-1.984] [-0.665] [-0.549] [0.353] [-0.675] [-0.707] ΔREER ** [-1.138] [-1.982] ΔREER2rel [0.281] [-0.226] ΔCOMP * ** [-1.849] [-2.013] ΔULC [-1.122] [-1.338] ΔULCrel * [-0.888] [-1.661] N R Sandardized coefficiens; saisics in brackes; * significan a 10% level; ** significan a 5% level; *** significan a 1% level 22

23 Table 3: esimaion resuls of equaion (10b) using he Random Effec model Dependen variable: ΔTRbal ΔGDPPCrel * 0.258** * 0.216** [1.322] [1.357] [0.748] [1.327] [1.339] [1.926] [2.675] [0.865] [1.973] [2.015] ΔGB 0.155** 0.156** 0.157** 0.154** 0.156** 0.246** 0.237** 0.242** 0.254** 0.256** [2.928] [2.943] [2.993] [2.943] [2.960] [2.991] [3.026] [2.782] [3.001] [3.040] ΔINVP *** *** *** *** *** *** *** *** *** *** [-7.251] [-7.314] [-6.686] [-7.273] [-7.287] [-5.248] [-5.599] [-3.946] [-5.278] [-5.220] ΔINTrel *** *** ** *** *** [-3.823] [-3.778] [-3.244] [-3.877] [-3.827] [-0.936] [-0.722] [-0.358] [-0.963] [-0.981] ΔREER ** [-0.556] [-2.681] ΔREER2rel ** [-0.571] [-3.089] ΔCOMP [-1.045] [-1.083] ΔULC ** [-0.979] [-2.081] ΔULCrel ** [-0.481] [-2.214] N R Sandardized coefficiens; saisics in brackes; * significan a 10% level; ** significan a 5% level; *** significan a 1% level Table 4: esimaion resuls of equaion (10c) using he Random Effec model Dependen variable: ΔNeInc ΔGDPPCrel * * [-0.834] [-0.775] [-0.938] [-0.802] [-0.812] [-1.653] [-1.751] [-1.525] [-1.662] [-1.654] ΔGB [-0.446] [-0.380] [-0.431] [-0.421] [-0.430] [-0.921] [-0.798] [-1.136] [-0.933] [-0.935] ΔINVP 0.110** 0.107** 0.124** 0.109** 0.109** 0.187* 0.180* 0.266* 0.184* 0.187* [2.124] [2.042] [2.069] [2.135] [2.114] [1.746] [1.732] [1.663] [1.809] [1.798] ΔINTrel * [1.543] [1.601] [1.707] [1.570] [1.550] [0.214] [0.086] [0.552] [0.226] [0.217] ΔREER [-0.539] [0.296] ΔREER2rel ** [0.841] [2.109] ΔCOMP [-0.854] [-1.050] ΔULC [-0.078] [0.285] ΔULCrel [-0.334] [0.191] N R Sandardized coefficiens; saisics in brackes; * significan a 10% level; ** significan a 5% level; *** significan a 1% level 23

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