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The rise and fall of European current account deficits

Joong Shik Kang and Jay Shambaugh

Economic Policy, 2016, vol. 31, issue 85, 153-199

Abstract: This paper traces the rise and fall of current account deficits in certain euro area countries and in the Baltics. These countries all entered the global financial crisis with sizable current account deficits, and the unwinding of these deficits has been a complex and painful process for most. While much of the general policy discussion of the large pre-crisis deficits has focused on losing export competitiveness, this paper highlights other results in the literature regarding import booms as well as a dimension that is rarely discussed – the drop in the non-trade portion of the current account (transfers and net income balance) in many countries. The paper also examines progress made in unwinding these deficits. Most countries have made tangible progress, but with different degrees: improvement of price competitiveness and a shift of production from non-tradable to tradable sectors has helped increase exports and along with compressed imports, close the current account deficits. The adjustment, though, has taken place against recessions and low growth in the euro area, and the paper also considers what has made the process more painful in some countries rather than others. We find that large current account balances prior to the crisis is the best predictor of a sharp drop in output during the crisis. Supportive macro policies to cushion the adjustment process and keep overall euro inflation at or above target level are necessary. In the longer term, improving institutions to deal with imbalances (and preventing them at future entry) are important.

Date: 2016
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