Current account imbalances can be caused by trade-related factors such as differences in cost competitiveness or financial factors such as asset price dynamics that influence capital flows. We argue that in past decades, financial factors have been more important than competitiveness.
Current account imbalances, highlighted as a major problem in the Eurozone, have been growing since the mid-1990s. Whilst there has been some rebalancing since the Great Recession, overall, substantial imbalances persist. In a recent paper (Guschanski and Stockhammer, 2020) we provide a theoretical framework and an empirical analysis that assesses the validity of explanations for current account positions in 28 OECD countries. Determinants of current accounts are a subject of intense debate. In our paper, we distinguish between two dominant approaches: cost competitiveness in trade-related channels and finance-centred mechanisms based on capital flows.
Explanations within the “cost competitiveness” camp come in orthodox as well as in progressive incarnations. Orthodox economists largely blame excessive wage growth for the trade deficit of Southern European countries (Belke and Dreger, 2013; Sinn, 2014), whilst progressive explanations place emphasis on low unit labour cost (ULC) growth in Germany, where wages didn’t keep up with productivity (Flassbeck and Lapavitsas, 2013). While the identification of the culprits and thus policy implications differ, these contributions emphasise wage developments (relative to productivity) as a major driver of current account positions.
A different strand of literature highlights how gross financial flows can impact the exchange rate and domestic demand. For example, Badarinza and Ramadorai (2018) show that London house prices increase during crises abroad, since residential property provides a ‘safe haven’ for international investors. This suggests that gross financial inflows can fuel asset price bubbles, including property price bubbles such as in Spain and Portugal. Asset price inflation, in turn, can increase domestic and import demand, with negative effects on the current account. Less technically, rather than cost differentials, it’s the housing boom that fuels growth, sucks in imports, and thus reduces the trade balance.
How can these different arguments be reconciled? In the paper we propose a simple Keynesian model of the current account that synthesises trade-centred and finance-centred approaches, captured by nominal ULC and financial flows, respectively.
Both ULC and financial inflows impact the current account via two channels – first, via price competitiveness, and second via domestic demand. Taking ULC first, an increase in nominal ULC can reduce the competitiveness of exports by appreciating the real exchange rate, thus leading to a deterioration of the current account. Additionally, an increase in nominal ULC can lead to an increase in real ULC, which translates into a rise in the wage share. Such redistribution of income from capital to labour can have a positive impact on consumption. This would increase imports and induce a further deterioration of the current account.
Tackling financial flows next, a surge in gross financial inflows, triggered, for example, by an asset price bubble, can also impact competitiveness as well as aggregated demand. This time, the effect on competitiveness works via the nominal rather than the real exchange rate: increased demand for domestic assets is reflected in demand for domestic currency and will appreciate the nominal exchange rate and reduce competitiveness. In turn, financial inflows can fuel asset price bubbles, thus leading to effects on domestic balance sheets, and increasing consumption and investment. Figure 1 illustrates these four channels.
Using a sample of 28 OECD countries over the 1972-2014 period, we estimate a current account equation with ULC, the key variable capturing trade-centred channels, and house prices, the key financial variable (as well as other controls). (While our sample includes many countries outside of the Eurozone, we conduct additional tests for Eurozone members, which suggest that the results hold for Eurozone as well as non-Eurozone countries.) Our findings indicate that residential property prices and to a lesser extent share prices, led to a deterioration of current accounts. The impact of asset prices is particularly strong for the 1995-2014 period, which witnessed an acceleration in the divergence of current account positions. In contrast, we find no robust impact of nominal ULC on the current account, suggesting that trade-centred channels were less relevant.
These empirical results have two important implications. First, our findings support the view that financial flows have played an important role in worsening current account positions. This could have happened via a nominal exchange rate appreciation or a rise in domestic demand due to asset price inflation. As the nominal exchange rate is fixed in a currency union, the latter channel is more plausible for the Eurozone. Arguably, asset price rises do not require cross-border financial flows, as they could be triggered by domestic demand and financed through domestic credit. But it is hard to believe that in, say, Spain or Ireland, financial inflows didn’t contribute to the housing boom.
Second, our findings cast doubt on the relevance of cost competitiveness (as captured by nominal ULC) for current account positions. Still, we find that real ULC, which are almost equivalent to the wage share, have a statistically significant effect on the current account. Thus, if wage growth changes the income distribution, there might be a negative effect on the current account.
The results of our analysis have important policy implications for OECD countries and the EU. Most recommendations for rebalancing current accounts focus on measures of cost competitiveness, mainly through reducing ULC in deficit countries (Belke and Dreger, 2013) or increasing ULC in surplus countries (Flassbeck and Lapavitsas, 2013). This continues to be a major focus of the Macroeconomic Imbalance procedure of the European Commission (see here).
Our findings indicate that policy interventions focusing on ULC will be futile unless there is regulation of financial flows and asset markets. Such regulation could involve capital controls, especially on portfolio flows, particularly during boom phases. Macroprudential regulation, for example by expanding the Basel III countercyclical capital cushion, is another option to reduce excessive credit growth and limit the risk of asset price bubbles (Rey, 2015). While these policies are increasingly on the agenda to reduce financial fragility, they have not yet been highlighted as a tool to regulate current account imbalances.