European Trade and Growth Imbalances

Abstract

The accumulated, persistent trade and economic imbalances between the south euro area (SEA) and the north euro area (NEA) countries brought about severe strains for the euro following the global financial crisis. This paper assesses alternative scenarios suggested to restore the trade imbalances within the euro area. We employ a structural Bayesian Global VAR in which theory-consistent, long- and short-run restrictions are imposed. Empirical results show that a depreciation of the SEA real exchange rate and/or a reduction of the SEA unit labor cost can lead to an improvement of the SEA trade balance through an increase in exports. Evidence also emerges that an expansionary demand in NEA can smooth SEA trade imbalances through a depreciation of SEA rer. A negative demand shock in the SEA can also ameliorate the SEA trade balance by boosting exports and reducing imports. Among the policies that could restore trade imbalances in the SEA, an expansionary NEA demand shock is less painful in terms of adjustment to long-run equilibrium. Counterfactual analysis signal that if policies – improve competitiveness and/or austerity in SEA – were pursued prior to 2010 the European debt crisis could not have been averted. Alternatively, expansionary demand policies in NEA could help to avoid the debt crisis. Finally, a simple loss function exercise shows that an expansionary demand shock in NEA will maximize the welfare of pan-European social-welfare planer-policy maker.

Keywords: European North-South Divide, Global VAR, Structural Impulse Response Analysis