Will the Alert Mechanism Report 2014 improve economic rebalancing?
The Macroeconomic Imbalance Procedure (MIP) of the European Commission (EC) was established in December 2011 and was implemented for the first time in 2012. It aims at detecting, preventing and correcting macroeconomic imbalances that would jeopardise the functioning of the European Union. Through a number of steps, the MIP identifies trends which could lead to 'booms and busts' and helps in deciding the appropriate policy reactions to mitigate and manage these risks. Every year the EC adopts the Alert Mechanism Report, which is the initial screening device and the first step of the procedure, whereby the Member States that need detailed scrutiny are identified. In the 2014 report, the EC decided to include Germany, alongside the other large current account surplus countries, in its ‘in-depth’ review. While this is welcome, we deem it unlikely that countries such as Germany and the Netherlands enter the excessive imbalance procedure. Meanwhile, the periphery countries have made great strides in correcting their external imbalances. However, this has come at the cost of moving further away from internal balance. Unemployment rates and public as well as private indebtedness remains high. To smoothen the adjustment process, the EC is well-advised to force current account surplus countries to take measures to buoy domestic demand. Otherwise, the crisis-hit countries will go through a painful rebalancing phase going forward.
What’s wrong with current account surpluses?
Germany is always proud of its large current account surplus, which it sees as a testimony of its ultra-strong competitiveness. However, Germany’s macroeconomic policy has been receiving a great amount of criticism lately. A critical US Treasury report on top of the disapproving article published by Germany’s ‘five wise men’ has put the country’s policymakers on the defensive. The European Commission (EC) added insult to the injury upon publication of the ‘Alert Mechanism Report 2014’, which is the initial screening device that the EC uses to identify Member States warranting detailed scrutiny in the Macroeconomic Imbalance Procedure (MIP). In the latest release, Germany was added for the first time to the list of countries that must receive an ‘in-depth review’ – expected to be completed in February or March next year. According to the EC, Germany’s surplus is not only the result of “strong competitiveness and specialisation in the sectors for which the world demand is stronger“ but it also mirrors “subdued domestic demand”, especially low investment-to-GDP ratio (figure 1). The household saving rate in Germany is among the highest in the monetary union despite the second-lowest share of private sector debt-to-GDP in the euro area and favourable financial conditions.
Although Germany has been a strong advocate of objective policymaking and stringently sticking to European rules, they are now calling foul play because they may end up in an excessive imbalance procedure (EIP). To be sure, the chance of that occurring is slim because even Spain and Slovenia got away with their excessive imbalances identified by the EC last year (see Rabobank Special “Why the eurozone needs stronger institutions”). And therein lies the problem. Countries that are considered political heavyweights, especially Germany, are least likely to ever receive a fine for having economic imbalances. Therefore, current account surplus countries, which are part of the powerful ‘core’ group, will not feel compelled by the MIP in taking any significant measures to bolster domestic demand. No wonder that the external rebalancing process in the Eurozone has been asymmetric (figure 2) whereby periphery countries have lowered their current account deficits substantially during the crisis.
The periphery countries have done a lot, but much remains to be done
Looking more broadly, from the 14 major advanced European countries in our sample, only one (Austria) is not going to have an in-depth review in this round. Ireland, Greece and Portugal are exempted because they still receive financial assistance in exchange for programmes that specify austerity and structural reforms. France also has four indicators crossing their respective thresholds thanks to the country’s high indebtedness (private and public), falling export market share and real effective exchange rate. The Netherlands has the same indicators flashing plus its excessively large current account surplus, which is the highest as a share of GDP in the European Union.
The periphery countries have made quite a substantial progress in correcting their external imbalances. In particular, a reduction in budget deficits combined with significant improvements in cost competitiveness, stimulated by structural reforms, have resulted in a sharp drop in current account deficits. Of course, it will take a while for net international investment positions of these countries to drop to sustainable levels. Meanwhile, further progress is needed to address internal imbalances. The rate of unemployment in all countries, excluding Italy, is now above the threshold. Public debt-to-GDP ratios are also markedly above the 60% threshold. Three of the countries (Ireland, Portugal and Spain) also have excessive levels of private debt-to-GDP ratios. The good news is that none of the countries in our sample has an imbalance when it comes to the extreme rise in (i) real house prices, (ii) credit-to-GDP ratios (iii) financial sector liabilities and (iv) unit labour costs.
Indeed, we are pleased to see that external imbalances are shrinking in the periphery countries and that some indicators are no longer crossing their thresholds in the 14 countries we focus on in this piece. However, the current account surplus countries are not taking necessary measures to boost domestic demand. According to the EC, these surpluses “will not fall substantially any time soon”. This is a shame as policymakers do not realise that shrinking surpluses would contribute to the sustainability of growth without impairing their competitiveness. Besides, the external rebalancing process of the crisis-hit countries will become less painful when the adjustment takes place in a symmetric manner. The surplus countries must understand that rebalancing must happen in the entire monetary union and not a single region. Regrettably, it is improbable that surplus countries take appropriate measures in the “North” because they do not deem it highly likely that they will ever enter EIP and eventually receive a fine in case of non-compliance. To ensure desirable correction of economic imbalances within the euro area, the EC must start treating all countries, irrespective of their political clout, similarly. Clearly, this does not mean that a country will actually enter the EIP since the Council must finally approve EC’s recommendation.