A balanced current account in the euro area has disguised sizeable net lending imbalances at the country level, exposing the common currency area to severe pressures during the financial crisis.
The key contribution of this paper is an attempt to go beyond an assessment of whether current
account positions are below or above a certain threshold, as done in much of the literature and policy debates on external imbalances until now. The authors decompose the counterpart of the current account, i.e. net lending, at the sectoral level to evaluate how each component would evolve as a function of different shocks and policy-adjustments. From a methodological stand-point this is done by extending the accounting framework of the New Multi Country Model (NMCM), a state-of-the-art large scale structural model that is one of the workhorse models employed at the ECB (Dieppe et al., 2012). The model has been developed for the five largest euro area countries, i.e. Germany, Spain, France, Italy and the Netherlands. For the purposes of this paper it was complemented with a number of additional accounting identities to include euro area flow of funds data for three sectors, public, household and corporate sectors.
Through the use of counterfactual analysis, the NMCM provides valuable insights on the contraction of external imbalances and rise of domestic imbalances stemming from a less favourable external environment, the deterioration of financing conditions, fiscal consolidation efforts as well as worsened consumers and investors' expectations. Their impacts help explain to a large degree the rise in unemployment and the external adjustment process witnessed in Spain. This modelling framework also helps us to assess alternative post-crisis scenarios. To this aim the authors employ a more extended version of the model, which includes together with the five country models a residual block for the rest of the common currency area, allowing for trade and financial interlinkages as well cross-country spillovers.
The authors evaluate four different scenarios of how the rebalancing process could evolve, considering the following shocks: i) a German-led demand recovery; ii) a wage competitiveness adjustment in Spain; iii) a broad-based foreign trade recovery; iv) a rebound in consumer con
dence in Spain. By exploring different scenarios of how the rebalancing may unfold, the difficulty of achieving external and internal rebalancing simultaneously emerges.
Among the shocks considered, only an improvement in wage competitiveness seems to help both the current account and domestic rebalancing process, favouring the recovery of net trade and employment mainly via the competitiveness channel but at the cost of higher net borrowing by households. The stimulus effects on aggregate demand are not very large, as discussed in Galí (2013) and Galí and Monacelli (2013). The economic recovery, but also the external financial position, depends critically on several additional drivers, such as global demand conditions, the value of the euro and the firming of business and consumer confidence.
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