Monday, June 30, 2014

30/6/2014: The Euro Plus Pact: Getting Causality Between Current Account and Competitiveness Backwards

Gabrisch, Hubert and Staehr, Karsten, new paper published by ECB and titled "The Euro Plus Pact: Cost Competitiveness and External Capital Flows in the EU Countries" (February 18, 2014, ECB Working Paper No. 1650. looks at the effectiveness of the Euro Plus Pact which was approved by 23 EU countries in March 2011 and came into force shortly afterwards.

Emphasis in bold in the quotes is mine.

"The Pact stipulates a range of quantitative targets meant to strengthen cost competitiveness with the aim of preventing the accumulation of external financial imbalances."

According to the authors: "The rationale behind the Euro Plus Pact is evident in its original name, the Competitiveness Pact, and also in its current subtitle: “Stronger economic policy coordination for competitiveness and convergence” (European Council 2011, p. 13)."

In virtual obsession of European policymakers with internal competitiveness expressed in terms of cost of labour and production, "Deteriorating cost or price competitiveness in individual countries is seen as a source of economic and financial instability. This view is directly stated in the conclusions from the European Council meeting at which the Euro Plus Pact was adopted (European Council 2011, p. 5): "The Euro Plus Pact […] will further strengthen the economic pillar of EMU and achieve a new quality of policy coordination, with the objective of improving competitiveness and thereby leading to a higher degree of convergence […].""

The authors use Granger causality tests and vector autoregressive models "to assess the short-term linkages between changes in the relative unit labour cost and changes in the current account balance. The sample consists of annual data for 27 EU countries for the period 1995-2012." This allows them to explore the direction and size of the short term linkages between cost or price competitiveness and external capital flows in the EU countries.

"The analyses are particularly pertinent given the adoption of the Euro Plus Pact… The underlying rationale is that deteriorating cost competitiveness is an important factor behind the accumulation of current account deficits and financial vulnerabilities." Thus, the "participating countries must take measures to improve their cost or price competitiveness and thereby reduce the likelihood of financial imbalances accumulating."

First, authors use Granger causality tests to determine "whether lagged values of one variable help explain the other variable when autocorrelation and country fixed effects are taken into account." The result is: lagged changes in the current account balance help explain changes in unit labour costs, while there is no effect in the opposite direction. The results hold for all 27 EU countries, for the EU15 countries and for 10 EU countries.

Second, vector autoregressive models confirmed "qualitative results are in all cases very similar to those of the Granger causality tests. …"

In other words, "changes in capital flows appear to affect cost competitiveness in the short term, while changes in competitiveness appear to have no effect on capital flows in the short term." This is important, as many policy analysts (e.g. Bruegel) and European policymakers (from Commission to national governments) routinely express the view that external imbalances are the result of poor competitiveness, especially in the periphery and especially in the context of driving the momentum of the financial crisis and the great Recession.

Here is what the authors have to say on this: "Increasing capital flows from the core to the periphery of Europe may partly explain the deteriorating cost competitiveness in many countries in Southern and Central and Eastern Europe as well as the improving cost competitiveness in many countries in Northern Europe [prior to the Crisis]. The reversal of these capital flows after the outbreak of the global financial crisis may lead to ensuring changes in cost competitiveness."

But more crucially, there seems to be no reverse direction of causality: pursuit of greater competitiveness does not seem to be a correct prescription for achieving external balances. "...the measures in the Euro Plus Pact to restrain the growth of unit labour costs may not affect the current account balance in the short term."

Now, wait, that is ECB research paper that says 'restraining growth in unit labour costs' (aka: improving competitiveness) may not do much for external balances… Hmm… did anyone hear that Euro Plus Pact tree fall?

And moving beyond the past: is anyone monitoring flows of 'capital' to the 'periphery' in the form of extremely depressed Government debt yields that are prevailing today? Cause you know, that competitiveness might be falling next time we look…

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