Current Account Deficits in the Euro

Some countries in the Euro are experiencing unusually high current account deficits with the rest of the world. One of the main reasons for the size of the current account deficit is that they are unable to allow their currency to depreciate to restore competitiveness.


Source: OECD Statistics

Both Portugal and Greece have a current account deficit of near 10% of GDP - amongst the highest in the developed world.

• Other countries struggling include Spain. They have seen a fall in the current account deficit from 10% of GDP in 2008 to over 3.5%. But, this is still high.
• Ireland has also seen a decline in its current account deficit from 5% of GDP to just a small deficit. However, this has been at the cost of a sharp slowdown in consumer spending on imports.

If the UK was in the Euro, we would almost certainly be facing a larger current account deficit.
Since the credit crunch hit the UK, the value of sterling has fallen 20%. To some extent demand for UK exports seem quite inelastic (the fall in price hasn't seen a big increase in demand. see: terms of trade in UK) But, if we had been in the stronger Euro, our exports would be less competitive and imports more attractive.

The Euro isn't the only reason for a Current Account Deficit. Other reasons include

• Large budget deficits in Greece and Portugal.
• Property boom in Ireland and Spain which attracted foreign capital flows financing domestic consumption, until it dried up after credit crunch
• Demographic factors. A young population tends to consume more. Germany has a relatively older population so tends to consume less and save more, contributing to their current account surplus.
• Labour Costs and Labour Productivity. e.g. Greece experienced unit Labour costs rising by almost double figures in 2007, 2008 and 2010. (Unit Labour Costs OECD)

Netherlanders an overvalued exchange rate exacerbates these fundamental factors causing a current account deficit.

How Else To Reduce Current Account Deficit in the Euro?

The problem facing Portugal, Greece and to a lesser extent Spain is how do they restore competitiveness when they can't rely on depreciation in the exchange rate? They need to rely on:

• Deflation. Increase taxes and lower spending
• Wage restraint. Cutting public sector wages and putting downward pressure on private sector wages.
  
• Supply side policies to improve competitiveness, e.g. privatisation, more flexible labour markets, deregulation and greater competitiveness.
  

Supply side policies may help in the long term, but in the short term, restoring competitiveness requires a painful period of deflation to slowly improve competitiveness. Of course, this leads to higher unemployment, slower growth and the protests we are seeing in Greece and Spain.

Spain has an unemployment rate of 21%, which is almost 45% amongst young workers. This shows that there number one priority should be tackling unemployment, yet the constraints of their current economic situation mean they are pursuing deflationary policies, when really the economy needs the opposite.

In a recent post, we looked at how members of the Eurozone were more likely to experience rising bond yields. See: Problem of Euro in Recession

Related

• Does a current account deficit matter?
• Factors affecting a current account deficit
  

Problems of Monetary Union in Recession

Since the credit crisis,UK government bond yields have stayed low, despite having similar levels of government borrowing to Spain, Portugal and Ireland.

Why have members of the Euro faced more difficulties in financing debt than the UK?
(It is a similar story for US and Japan where interest rates have stayed low despite high levels of borrowing.)

Essentially members of the Euro need to finance their budget deficit, but they don't control their own monetary policy.

1) Devaluation

Since the credit crisis, the value of sterling has fallen considerably. This helps boost exports and growth. This boost to economic growth helps reassure investors the government will have more ability to pay back debt. The devaluation in sterling also makes sterling assets appear more attractive and so may encourage foreign investors to buy.

2) Bank of England could buy government bonds as last resort.

If the UK has difficulty in financing the deficit, the Bank of England can act as lender of last resort and buy up government bonds. This mechanism gives investors more faith that the UK can remain solvent. There is no danger of a liquidity crisis.

If Spain or Ireland has difficult selling bonds to the private sector, investors will sell Spanish bonds, however, this won't cause a depreciation in the value of the Spanish currency (because there is only the Euro). Therefore unlike the UK, Spanish assets don't become more attractive. Also, Spain will face a stronger currency than is ideal for the state of their economy.

Spain also can't ask the Spanish Central Bank to buy Spanish bonds. In theory the ECB could, but they are reluctant to for various reasons.

The markets know that Spain is more vulnerable - they can't benefit from devaluation and they can't ask their Central Bank to buy bonds. This increases the risk that Spain faces a liquidity crisis (can't raise enough money) Therefore, investors will be quick to move out of Spanish bonds into something more secure. The fear of a liquidity crisis in Eurozone countries means they are much more vulnerable to worries over increase in debt.

Vicious Cycle

As Spain struggle to finance its deficit, it may rely on a bailout from the EU. This provides liquidity but also the ECB impose conditions (punishment). The EU make Spain and Ireland pursue austerity (spending cuts) and accept higher interest rates on bonds. The higher interest rates and spending cuts will lead to lower growth, deflation and higher unemployment. But, this fall in economic growth also leads to lower tax revenues which increases debt and makes Spanish debt more unattractive.

The result is that in a recession, Euro members have become much more vulnerable to problems in the bond market. It also means that their response to a recession needs to focus on deflationary measures (strong exchange rate, higher interest rates and spending cuts). However, this is exactly the wrong response that you need in a recession.

Also, these countries still face an interest rate set by the ECB for the whole Eurozone. The ECB have already indicated that recovery in Germany and France will lead to higher interest rates. But, higher interest rates is not what Ireland needs given they currently have deflation.

UK bonds are relatively more attractive because:

• The economy has more flexibility to devalue and restore competitiveness
• They can pursue quantitative easing to boost economic growth
• The Bank of England has the independence to help buy government securities.
• There is less risk of deflation and a recession.
• Longer date on maturity of UK bonds.

Members of the Euro have been much more vulnerable

Related

• Problems of the Euro
• Facts on Euro Debt Crisis
  
• Managing Fragile Eurozone at Vox

Factors Affecting Interest Rates

Generally, central banks seek to target low inflation. The ECB target 2%. The Bank of England's inflation target is CPI 2% +/- 1. The most important factor in influencing interest rates is whether inflation is likely to deviate from this target.

• If the Bank forecast inflation to rise above the target, they will increase interest rates to moderate economic growth and reduce the inflation rate.
• If the Bank forecast inflation to fall below the target, they will cut interest rates to boost consumer spending and economic growth.

Temporary Inflation and Underlying Inflation

In some circumstances the headline inflation rate may rise above the target, but the Bank may choose not to increase interest rates. This is because they believe the underlying (Core) Inflation rate is still close to the target. (see: difference between CPI and Core CPI)

For example, in a period of commodity price inflation (e.g. rising oil price) or increased taxes, the Bank may view this is a temporary factor. In this case it may be more important to target economic growth and reducing unemployment - rather than the spike in headline inflation.

For example, in 2011 we have inflation rising about the target in UK, EU and US. But, this is primarily due to more temporary factors like rising oil prices, (and in UK higher taxes and devaluation). If we strip away factors that tend to be volatile, underlying inflation is lower and close to target. In 2008, inflation rose to 5% just before recession and RPI later become negative.

A key test is wage inflation. If wage inflation is much lower than the headline rate, this is an indicator that the temporary inflation is not feeding through into permanent inflationary pressures.

See: Does temporary inflation lead to permanent inflation?

Priorities in Setting Interest Rates.

The ECB have indicated that they consider targeting inflation to be the most important factor. Even if inflation is due to temporary factors, they prefer to increase interest rates to prevent any potential of inflation.

The UK has taken a more relaxed view regarding inflation. CPI inflation recently increased to 4.4% (well above upper limit of target) yet interest rates were kept at 0.5%. This indicates the Bank viewed inflation as a temporary phenomena and they were more concerned about weak economic recovery and persistently high inflation. However, this situation does prevent a dilemma for the Central bank; members of the MPC have been split on this issue.

Key Factors Influencing Inflation / Interest rates

• Economic growth rate vs underlying trend rate. If the underlying trend rate is 2.5%, economic growth above this target is likely to cause inflationary pressure.
• Spare capacity. A key test is the amount of spare capacity in the economy, though this can be difficult to calculate. For example, in a recession how much potential capacity is lost?
• Wage inflation. Rising wages lead to higher costs for firms and higher spending. This is a very important factor as it can be self-reinforcing leading to a wage price spiral.
• Unemployment. High unemployment tends to depress wage inflation and therefore keep inflationary pressure low.
• Commodity prices. Rising commodities will tend to increase inflation. However, some commodities have a tendency to be volatile meaning it is more unreliable as a guide to underlying inflation.
• Exchange Rate. A depreciation in the exchange rate will cause inflationary pressures. This is because imports become more expensive, and there will be greater demand for exports.
• House prices. House prices don't directly influence the CPI. However, rising house prices causes a positive wealth effect and therefore higher consumer spending
• Consumer confidence. Higher confidence leads to higher spending.

Related

• Factors affecting economic growth
• Interest rates explained
• How the MPC set interest rates