Determinants of Current Account Imbalances in the Eurozone : A Politico-Economic Analysis

The recent "eurozone crisis" called attention to the substantial current account imbalances within the euro area which had built up in previous years. This "crisis" was primarily triggered by unsustainable fiscal debts and deficits, but it has frequently been suggested that the underlying factors go beyond fiscal profligacy alone and include eventually unsustainable movements in the current account. The pre-crisis eurozone was characterized by large and persistent current account imbalances effectuated by substantial intra-area competitiveness differentials and financed by credit flows from surplus to deficit countries. Monetary union not only eliminated exchange rate movements as external equilibration mechanism but also contributed to imbalances by facilitating intra-area credit flows. Current account movements were influenced primarily by policies managing the domestic level of wages and prices. In the pre-crisis eurozone, due to diverging configurations of domestic interests and the logic of “increasing returns”, a political equilibrium emerged at the domestic and the central levels of decision-making which favored the growth of imbalances. Powerful domestic (sectoral) interests opposed rebalancing in deficit and surplus countries alike as well as coercive policies at the central level. Political decision-makers, dependent upon the political acceptance of these powerful groups, were thus incentivized to let imbalances grow. When the financial crisis triggered a decline in credit flows, deficits became unsustainable and severe economic pain was inflicted upon European economies, particularly those in deficit. Whether or not “excessive” current account imbalances will reemerge in the eurozone once the dust settles in credit markets will crucially be determined by the ability of decision-makers to design institutions that prevent them from making time-inconsistent choices as well as the interplay between markets and politics. This question is, to date, still awaiting a definite answer