by Mouhamadou Sy,Vox
Article appeared originally at Voxeu.org 09 November 2015
From the introduction of the euro in 1999 to the Greek crisis in 2010, the Eurozone witnessed external imbalances between countries at its core and those at its periphery. These imbalances have been attributed either to differences in competitiveness or to the effect of financial integration.
This column argues that in order to understand the imbalances within the Eurozone, it is necessary to consider credit costs and capital flows. The lower real cost of credit for high-inflation countries must be taken into account, as well as the inflow of capital to the non-tradable sector that this implies. Monetary policy cannot be conducted in a ‘one size fits all’ manner.
One of the most prominent features of the Eurozone Crisis has been the large current account deficit accumulated by countries at the periphery relative to those at the core (Baldwin and Giavazzi 2015). These imbalances (see Figure 1) are commonly attributed to differences in competitiveness as manifested in persistent differences in the unit labour costs, or to the effect of financial integration through the creation of optimistic expectations. Based on empirical evidence, in this column I take a different perspective on the matter. I argue that in order to understand imbalances within the Eurozone, it is necessary to consider the lower real cost of credit for high inflation countries, as well as the inflow of capital to the non-tradable sector this implies. These two effects – the credit channel of monetary policy and the Dutch disease syndrome – and their interaction are important in order to understand the balance of payments imbalances within the Eurozone.
Figure 1. Illustration of the external imbalances within the Eurozone
The standard explanation
A number of recent papers have studied the sources of current account imbalances in the Eurozone. As noted by Chen et al. (2013), two traditional explanations have been put forward to explain these imbalances. The first one is based on the effect of financial integration following the adoption of the euro. The second is based on divergences in unit labour costs and market rigidities in the periphery.
The first hypothesis highlights that the cuts in the currency risk premium (Figure 2) should have led to real convergence between members of the monetary union. Free movement of capital induced by a low risk premium should have resulted in more productive investment after joining the union. In principle, this mechanism conduces to a catch-up period for lagging countries.
The second hypothesis is based on differences in unit labour costs. It highlights that the periphery experiences a rapid growth in wages while retaining low productivity. Since there is downward rigidity in the nominal wages, this induced higher unit labour costs (Figure 3) and a loss in competitiveness.
Figure 2. Ten-year government bond yields in the European Monetary Union
Figure 3. Unit labour costs in the European Monetary Union
An alternative explanation, based on the Dutch disease syndrome
Within the Eurozone, countries that witnessed low real interest rates experienced the highest growth rates in credit. In return, the countries that experienced the highest growth rates of credit showed the highest current account deficit. Therefore, the credit channel is likely to play an important role in explaining imbalances within the Eurozone. To explain the link between credit growth and the current account imbalances, I rely on the theory of the Dutch disease (Sy 2016).
The credit channel in the European Monetary Union
Before the advent of the Economic and Monetary Union (the Eurozone), each country had its own monetary policy. If the economy was overheating, the central bank increased its nominal interest rates. As a consequence, real interest rates increased, and with it there was a fall in the supply of credit. In the absence of a monetary union, there is no reason to expect a relationship between increasing rates of credit and real interest rates. This insight is confirmed in European countries before 1999. As shown by Figure 4a, there is no correlation between real interest rates, defined as the difference between nominal interest rates and inflation, and the growth rates of real credit.
With the advent of the Eurozone, the link between real interest rates and the growth rate of credit changed. Indeed, in a monetary union, countries with inflation rates higher than the average have low real interest rates by definition. Countries with inflation rates below the average have high real interest rates. This real interest rate heterogeneity caused by the monetary policy is known as the Walters’ critique (Walters 1990). This policy stimulates credit, which in turn drives up investment – productive or otherwise – and leads to lower savings rates. Economic activity is thereby boosted, and inflation rates increase in the first group of countries. In the second group of countries it reduces credit availability due to the higher real interest rates.
This argument is illustrated in Figure 4b, which shows the negative relationship between the real interest rate and the average credit growth rate – countries with low real interest rates (periphery) have higher credit growth, while countries with low real interest rates (center) experienced lower credit growth.
Figure 4. Illustration of the credit channel in the European Monetary Union
Figure 4a. Before the Eurozone
Figure 4b. After the Eurozone
What could be the effect of this credit growth? Figure 5 shows the correlation between credit growth and current accounts – the current account is lower (in the sense of a higher deficit) in countries with a higher rate of credit growth.
Figure 5. Illustration of the credit and the current account imbalances nexus
The Dutch disease syndrome in the periphery of the Eurozone
Figures 4b and 5 show that countries in the periphery experienced a credit boom due to lower real interest rates. As a result of this credit boom, they experienced current account deficits. However, a credit boom is not enough per se to explain the balance of payment crisis that these countries face. My main argument is that these credit booms induced a balance of payment crisis due to their misallocation across sectors.
When credit booms induced by lower real interest rates are mainly spent in the non-tradable sector, the real exchange rate appreciates through an increase in the price of non-tradable goods. This effect is more acute in a monetary union with strong trade and financial linkages, like the Eurozone. Indeed, in a well-integrated monetary union, the assumption of the law of one price is less restrictive (Cavallo et al 2014) and in this case, it can be shown that the real exchange rate between the core and the periphery depends only on the ratio between their respective prices for non-tradable goods. Any difference in the prices of non-tradable goods induces a real exchange rate appreciation to the disadvantage of the area with the highest non-tradable price.
Figures 6a and 6b give further evidence of the Dutch disease phenomenon in the Eurozone. Figure 6a shows the evolution of the output for the non-tradable and tradable sectors in the core and periphery of the monetary union. Since the beginning of the Eurozonein 1999, the non-tradable sector has developed to be much stronger than the tradable sector in peripheral countries, while one can observe the opposite in the core countries.
Figure 6b shows the evolution of prices in the two sectors. The prices in the non-tradable sector in the periphery grow very rapidly, while the other three sectors record much slower inflation.
Figure 6. Illustration of the Dutch disease in the European Monetary Union (1999 = 100)
Figure 6a. Tradable and non-tradable output
Figure 6b. Tradable and non-tradable prices
The above results can be interpreted as an effect of the loosening of the credit constraint in the non-tradable sector in the periphery following the beginning of the Eurozone. The increased value of non-tradable goods could be used as collateral and thus loosened the credit constraint on these countries. As a consequence, more money flowed in and further increased the non-tradable goods prices. A positive feedback loop was thus created, which further loosened the credit constraint for the periphery, thus detaching the amount of credit from corresponding changes in creditworthiness.
However, it also meant that credit was not used in the sector in which it offered the most productive use. For this reason, the accumulated debt was unsustainable in the sense that accumulated assets – real estate in particular – could not easily be liquefied for repayment.
The sources of the balance of payments imbalances are still an open question. In a forthcoming paper (Sy 2016), I propose a general framework that focuses on the build-up of the crisis rather than the crisis itself. The analysis presented here highlights the difficulty of conducting monetary policy in a policy domain which cannot use fiscal transfers to equilibrate imbalances – summarised succinctly as “one size does not fit all”. It is thus essential to find an appropriate way to implement a differentiated macroprudential policy within the (Sy 2016). The analysis also identifies the need for an internal devaluation, meaning that balances need to be restored through a decrease in the non-tradable prices of the peripheral countries.
Author’s note: The views expressed here are those of the author and do not necessarily represent those of the institutions with which he is affiliated.
- Baldwin, R and F Giavazzi, eds, (2015) The Eurozone Crisis: A consensus view of the causes, a VoxEU.org eBook, 07 September.
- Cavallo, A, B Neiman and R Rigobon (2014) “Currency unions, product introductions, and the real exchange rate”, The Quarterly Journal of Economics, 129(2): 529–595.
- Chen, R, G M Milesi-Ferretti and T Tressel (2013) “External imbalances in the eurozone”,
- Economic Policy, 28(73): 101–142.
- Sy, M (2016) “Overborrowing and balance of payment imbalances in a monetary union”, Review of International Economics, forthcoming.
- Walters, A A (1990) Sterling in danger: Economic consequences of fixed exchange rates, Fontana Press.