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A financial side to a macroeconomic

story: macro imbalances and financial
integration in the euro area
Inarecentpaper,Ilookedattheevolutionoffinancialcyclesintheeuro
areaandattheirlinkwithcapitalflows.Here,Ifocusonhowthose
findingsinformourunderstandingofeuroareamacroeconomic
imbalances,revisitingtheanalysisofnationalsavingsandinvestment
correlation.
BY: SILVIA MERLER DATE: JANUARY 18, 2016

Back in 1980, Feldstein and Horioka (1980) highlighted the existence

of an economic puzzle for financial integration. Running a cross-
country regression of domestic investment rates on domestic savings
rates, they found a large, positive coefficient suggesting strong and
positive correlation of national savings and investment, resulting in
more or less balanced current account positions. They interpreted
this as a sign of sizable financial frictions in international capital
markets, hindering capital flows and indirectly limiting risk sharing.

In 2002, Blanchard and Giavazzi (2002) documented persistent

current account divergences and a significant drop in correlation of
national investment and national savings, across euro area countries.
The finding was consistent with what theory would predict for
countries undergoing a strong process of financial integration, and
was welcomed as a sign that capital was finally flowing downhill.
But the paper ignored the potentially negative effects that flows can
eventually have in allowing bubbles to flourish.

Table 1 updates and extends the analysis in Blanchard and Giavazzi

(2002) and yields interesting results. The first column shows the
coefficients of a regression of national investment on national savings
in percentage of GDP, estimated on a panel of 11 Euro area countries,
over sub-periods between 1975 and 2012. As a comparison, the same
analysis is also run for a panel comprising all the 27 EU Member
States and for the EU as a whole.

Table 1: Correlation of national savings and

investments
Using as an alternative time threshold the entry into force of the
Maastricht Treaty (end-1993) rather than the introduction of the
euro (1999), the results hold for the euro area and the EU as a whole,
as well as for the EU panel. For the EA panel, the result is a negative
coefficient over the period 1994-2007, but the coefficient is not
significant. This suggests that the signing of the Maastricht Treaty,
which established the completion of the EMU as a formal objective,
created a significant anticipation effect connected to financial
integration and the single currency. The correlation between savings
and investment correlation started to decline, but it became negative
only from 1999. For the euro area as a whole, considered as a single
country, the picture is very different: at the aggregate level, no
decoupling of savings and investment is evident from 2000-2008.
The break of the link between savings and investment from 1999
-2007 is stronger for the euro area than for the EU.Source: own
calculations using data from AMECO ESA 2010.

The regression shows a positive correlation between cross-country

savings and investment for euro area members until 1998. The
correlation became negative and significant between 1999 and 2007,
and it again became positive and significant during the crisis.

Figure 1 Savings-Investment Correlation in EA and EU,

1980-2014 (Estimated correlation coefficients)
A negative correlation between savings and investment between 1998
and the crisis was characteristic of euro area countries, as shown in
figure 1. This followed a gradual decline in correlation, starting in the
early nineties.

The correlation started to increase again in 2008 both in euro-area

and non euro-area countries, and returned to positive in 2009. By
2012 it had returned to 1993 levels. This is consistent with the
disruption in financial integration that occurred in the euro area
since 2008, and with the consequent rapid adjustment of southern
countries current (and financial) account positions, which reverted
from large external deficits back to the positive territory.

The belief that current account imbalances within a monetary union

would be harmless was proven wrong by the crisis. The reason for
this is twofold. Firstly, models establishing the optimality of a
succession of current account deficits implicitly assume that the
intertemporal budget constraint is satisfied, so that the accumulation
of foreign liabilities is matched by future surpluses.

Giavazzi and Spaventa (2010) show that fulfilment of that condition

constrains the destination of foreign capital inflows even in a
currency union. In the EA, the bulk of this credit ended up into non-
tradable construction and real estate, casting doubts on the
fulfilment of this intertemporal solvency constraint (figure 3).

Second, the fact that the growth of macroeconomic imbalances was

financed mostly via capital flows internal to the monetary union,
which could not be limited with explicit capital controls, made the
outflows especially easy and fast. This became evident in 2010-2012,
when countries in the south of the euro area effectively underwent a
balance of payment crisis with capital flights that would have
qualified as a fully fledged sudden stop, a sudden and disruptive
halt in the inflows of foreign capital (as discussed here).

Figure 2 South: Bank credit to private sector by sector

and purpose (euro bn)
Current account imbalances embodying the disconnection of
national savings and investment have been widely discussed since
the outbreak of the crisis. The acknowledgement of their importance
has led to the EU (belatedly) setting up a dedicated Macroeconomic
Imbalance Procedure.

Part of the literature has attributed them to southern countries loss

of competitiveness. In a recent paper, I argue that in order to
understand the real nature of these imbalances it is key to include
financial integration into the picture.

Monetary policy unification in 1999 caused interest rates to converge

to very low levels; this translated into the divergence of credit cycles
across countries, with credit demand booming in the South; the
elimination of the exchange rate risks spurred massive intra-euro
area capital flows that allowed credit supply in the South to expand
beyond the domestic deposit base and meet credit demand.

In these countries, the inflow of foreign capital allowed investment to

dis-anchor from national savings and expand significantly beyond it.
As a result, the current account balance (which represents the
difference between national savings and investments) went
persistently deeper into negative territory and imbalances grew.
There is indeed a strong correlation between pre-crisis dispersion of
credit growth and pre-crisis dispersion in current accounts, across
euro area countries, as figure 4 shows.

Figure 4 Dispersion in credit vs. dispersion in current

account
According to this narrative, the euro-related interest rate shock
triggered divergence in financial cycles across euro area countries,
and financial integration (and the capital mobility that came with it)
ultimately allowed savings and investment to dis-anchor.

The current account divergence is the macroeconomic counterpart of

an underlying financial imbalance, and the loss of competitiveness
was the result of the fact that capital inflows ultimately financed an
increase in credit mostly to non-tradable sectors.

While the pre-crisis financial cycle divergence can be very much

retraced to the interest rate shock that followed the currency
unification, which might not be repeated in the future, the euro area
will likely remain heterogeneous, and financial and economic cycles
may still deviate in different member states.

Monetary policy cannot be country-specific and might even reinforce

the build-up of imbalances in some parts of EMU while being too
restrictive in others (see here), the rationale for an effective macro-
prudential policy is especially strong.

The inclusion of this financial integration side in the macroeconomic

imbalance story provides a strong ground in support of the
importance of macroprudential policy in the Euro area, but it also
highlights the importance of the MIP.

If effectively run, the macroeconomic imbalance procedure could be

synergised with preemptive macroprudential policy, as it is supposed
to address the underlying macroeconomic roots of financial
imbalances.

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