12 November 2012

Buti/Turrini: Slow but steady? External adjustment within the eurozone starts working

This column by DG ECFIN's Marco Buti and Alessandro Turrini argues that there is heartening evidence that eurozone imbalances are adjusting. However, for external adjustment really to work, it is crucial that financial markets start to take a lead supportive role.

A more supportive role of financial markets appears to be the single most important prerequisite for the fulfilment of the conditions for rebalancing. The re-direction of cross-border private capital flows away from deficit countries and towards surplus countries that followed the financial and debt crises contributed to narrowing current account deficits. However, this withdrawal of financial resources also implied reduced investment rates and reduced room for total factor productivity improvements. Moreover, by increasing non-labour costs, reduced investment rates contributed, together with lack of progress on product market reforms, to the incomplete pass through of labour cost competitiveness gains into price competitiveness gains.

Fragmented financial markets also imply delayed and reduced benefits from structural reforms in vulnerable countries. This is because part of the future gains from reforms can accrue much sooner, provided efficient and developed financial markets help bring forward these gains in terms of higher asset values. Going forward, orderly investment conditions will be needed to compensate for the loss of capital and to get total factor productivity growing again. Orderly investment conditions are also needed for a durable adjustment of unit labour costs and for the political sustainability of protracted wage moderation.

Completing the monetary union with a Single Supervisory Mechanism for the banking sector – and eventually a banking union – will help redress the the interwoven nature of sovereigns and banks, a relationship that segments financial markets and could permit capital flowing downhill again. An effective framework for macro-prudential policy as well as structural reforms in recipient countries will be needed to ensure that, unlike the pre-crisis period, capital is channelled towards productive uses.

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