Current Account Imbalances in the Euro Area Alan Ahearne, Birgit Schmitz, and Jürgen von Hagen North American Summer Meeting of the Econometric Society in Pittsburgh 19-22 June 2008 Birgit Schmitz IIW Institute for International Economics University of Bonn birgit.schmitz@uni-bonn.de

Motivation stylized facts Test Motivation stylized facts Euro area had small current account deficits in the past 20 years But individual countries have seen rising imbalances especially since the start of EMU These imbalances were accompanied by strong and persistent changes in real exchange rates

Motivation stylized facts European current account balances in % of GDP

Motivation stylized facts Surplus countries Deficit countries Current Account Balances -12 -10 -8 -6 -4 -2 2 4 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Ireland Greece Spain Portugal per cent of GDP

Motivation stylized facts Countries with large real appreciations Countries with large real depreciations

Motivation research question Can these imbalances be explained by fundamental economic factors? Line of argument: Current account imbalances are the mirror image of capital flows In an efficient capital market, capital should flow from relatively rich to relatively poor countries We should observe that current account imbalances can be explained by differences in per capita incomes With complete international capital market integration, a country‘s rate of investment should be uncorrelated with its rate of savings We should find that the savings retention coefficient is not statistically different from zero

Motivation preview of results Capital tends to flow from high-income to low-income euro area economies These flows have increased since the start of EMU for insiders but not for outsiders Feldstein-Horioka regressions show that investment has been decoupled from domestic savings in the euro-area countries but not in non-EMU countries Our results provide new evidence for the view that EMU has increased capital market integration within the region, but not for outsiders.

Literature Review current accounts Empirical determinants in general Short and medium term determinants: Chinn and Prasad (2003), Chinn and Ito (2005), Gruber and Kamin (2005), Chinn and Lee (2006) Important variables are: government balance, initial stocks of net foreign assets, financial deepening, trade openness, demographic profiles, real effective exchange rates For the EU, Euro Area, new member countries Bussiere, Fratzscher and Müller (2006), Abiad, Leigh and Mody (2007), Arghyrou and Chortareas (2006) , De Santis and Lührmann (2006), Lane and Milesi-Ferretti (2006)

Literature Review financial integration of EU Quantity based measures European Commission (2006), ECB (2007), Abiad, Leigh and Mody (2007), Feldstein and Horioka (1980), Blanchard and Giavazzi (2002) Price based measures, portfolio weights Baele et al.(2004), ECB (2005), De Santis and Gérard (2006), Martin (2007)

Estimation Strategy I data and variables Sources: Ameco database (EU Commission), Direction of Trade Statistics (IMF), IFS (IMF) Period/Frequency: Annual data from 1981-2005 on EU-15 Dependent Variable: annual trade balances as a ratio of GDP, distinction between intra-Euro area and extra Euro area trade Independent Variables: GDP per capita, EMU-dummy, Non-EMU dummy 1, Non-EMU Dummy 2 Control Variables: fiscal balance, real oil price, average EU GDP per capita, real effective exchange rate, time dummies, constant Estimators: OLS, GLS with control of heteroskedasticity between countries and country-specific autocorrelation of residuals

Estimation Strategy I descriptive statistics Average trade balances Dispersion of trade balances

Estimation Results I dependent variable: intra Euro area trade

Estimation Results I dependent variable: intra Euro area trade

Estimation Results I dependent variable: intra Euro area trade

Estimation Results I dependent variable: extra Euro area trade

Estimation Results I dependent variable: extra Euro area trade

Empirical Results I current account equations Intra-EU trade balances are a positive function of per capita income in EU-15 This effect becomes stronger for insiders after the start of EMU and weaker for outsiders For Extra-EU trade balances the EMU effect is not visible for insiders, for outsiders there is a positive effect after the start of EMU The evidence suggests that EMU has increased capital market integration in Europe.

Estimation Strategy II data and variables Sources: Ameco database (EU Commission) Period/Frequency: Annual data from 1981-2005 on EU-15 Dependent Variable: gross investment rate Independent Variables: gross savings rate, EMU-dummy, Non-EMU dummy Control Variables: time dummies, constant Estimators: OLS, GLS with control of heteroskedasticity between countries and country-specific autocorrelation of residuals

Estimation Results II dependent variable: gross investment rate

Estimation Results II dependent variable: gross investment rate

Empirical Results II investment-saving equations The coefficient on the gross savings rate is lower than in Feldstein and Horioka, but in line with Blanchard and Giavazzi The interaction term with the EMU dummy is significantly negative, the interaction term with the non-EMU dummy is negative but not statistically significant The combined effect for EMU insiders is not statistically different from zero Thus, domestic investment is decoupled from domestic savings in euro area countries which is in line with more financial integration in the euro area

Test Conclusions Current account imbalances in the euro area reflect efficient capital flows The empirical evidence shows that the introduction of the euro has greatly improved capital market integration and efficiency Thus, the imbalances show that EMU works smoothly For the outsiders, EMU may have brought some degree of capital market disintegration Fiscal policy is not necessarily the right policy response to these current account imbalances