This paper analyses macroeconomic imbalances within fixed exchange rate systems as the European Monetary Union. The leading question is explaining why during the years after the financial crisis of 2007, Institutions such as the European Commission and the IMF made policy recommendations aimed at shifting production resources from the non-tradable to the tradable sector; especially in countries with large current account imbalances and low competitiveness.
Inferring that not accomplishing such a reallocation of production resources will yield a major ‘pain of adjustment’, the paper investigates the role of the non-tradable sector size in the European adjustment process. The mentioned ‘pain of adjustment’ plays a central role and is understood as the time and/or the contraction required for reaching a certain level of external balance in terms of social costs, most notably unemployment.
The conclusions are based on a graphical modification of Krugman and Obstfeld's (2006) model conceived for explaining the rigidities of the Bretton Woods system of fixed exchange rates and suggest that deficit countries with underemployment attempting to reach external and internal balance can reduce the ‘pain of adjustment’ by fostering the tradable sector to the detriment of an oversized, uncompetitive and low productive non-tradable sector.
Table of Contents
Introduction
I. Fixed exchange rates systems prior to EMU and resemblances
1. The Gold Standard
2. The new Gold Standard and the Great Depression
3. The Bretton Woods System
II. The generation of European current account imbalances
1. Diverging competitiveness through price and wage growth differentials
2. Diverging non-price competitiveness
3. The role of tradables vs. non-tradables for the generation of imbalances
About non-tradables
The role of non-tradables for current account imbalances
III. The size of the non-tradable sector and the current account balance
1. Tradability according to actual trade
2. Geographical concentration as a tradability indicator
3. Identification of countries relevant for the analysis
IV. The adjustment process in the euro area
1. Policy alternatives for deficit countries
2. Short-run adjustment and the importance of the external sector
3. Long-run adjustment and the importance of market flexibility
Flexible labor markets
Flexible product markets
4. The role of non-tradables for the adjustment process, a graphical analysis
Outline of ultimate results and critical appraisal
Conclusions
Objectives & Research Topics
This master's thesis examines the structural causes of persistent current account imbalances within the European Monetary Union and analyzes the role of the non-tradable sector in the adjustment process. It explores whether shifting resources from the non-tradable to the tradable sector can reduce the social costs of economic adjustment, particularly for countries facing severe deficits.
- The relationship between economic structure and current account sustainability.
- Historical comparison of fixed exchange rate regimes (Gold Standard and Bretton Woods) with the euro area.
- Drivers of competitiveness divergence, including unit labor costs and productivity growth.
- Impact of the non-tradable sector size on a country's ability to adjust to economic shocks.
- Policy alternatives for deficit countries, emphasizing internal devaluation versus structural reforms.
Excerpt from the Book
The role of non-tradables for current account imbalances
A primary implication of producing a larger share of non-tradable products than other countries is that those products that are not sufficiently supplied by domestic production need to be imported. Alternatively, minor production of exportable goods constitutes an automatic constraint for the ‘plus side’ of external balance. Theoretically, firms would try to fill a domestic market niche and produce cheaper substitutes for the imported products by shifting productive resources toward new sectors, thus improving the current account balance. Yet already alluded distortions such as real estate booms, which cause fanciful expectations about high future earnings, may very well induce firms to remain in construction-related non-tradable sectors instead of shifting toward new tradable sectors.
A more relevant aspect is the reinforcing effect that the non-tradable sector has on prices and wages growth. Input price increases, competitiveness loss and deterioration of the current account seems a logical sequence when talking about tradable goods. However, it is not completely obvious that products both produced and consumed inside a country can have effects on competitiveness and on the performance of the external sector. The main reason for such implication is “the large component of nontradable services included in the .. prices of goods generally classified as entirely tradable.” (Obstfeld and Rogoff 2005, p. 92) There is a direct and an indirect effect. First, higher non-tradable input prices directly affect production costs, just the same as do rises of ULC. Applying the same reasoning as before, to the extent that higher production costs cannot be compensated through lower margins or rises in non-price competitiveness, dearer products lose attractiveness for foreign customers.
Summary of Chapters
Introduction: The introduction outlines the persistence of economic imbalances in the euro area and introduces the thesis's core hypothesis regarding the role of the non-tradable sector.
I. Fixed exchange rates systems prior to EMU and resemblances: This chapter provides a historical review of the Gold Standard and Bretton Woods, highlighting the inherent rigidities that prevent simultaneous external and internal balance.
II. The generation of European current account imbalances: The chapter identifies the drivers of divergence between Northern and Southern euro area countries, focusing on unit labor costs, competitiveness, and the reinforcing role of the non-tradable sector.
III. The size of the non-tradable sector and the current account balance: This section presents the methodology for classifying sectoral tradability and empirically tests the relationship between non-tradable sector size and current account outcomes in the euro area.
IV. The adjustment process in the euro area: The final analytical chapter evaluates policy alternatives for deficit countries and uses a modified graphical model to illustrate how the non-tradable sector affects the "pain of adjustment."
Conclusions: The conclusion synthesizes the findings and advocates for structural reforms that foster the tradable sector to facilitate more efficient economic adjustment.
Keywords
Euro Area, Current Account Imbalances, Tradable Sector, Non-Tradable Sector, Competitiveness, Unit Labor Costs, Internal Devaluation, Structural Reforms, Productivity, Fixed Exchange Rates, Bretton Woods, Gold Standard, Economic Adjustment, Market Flexibility, Fiscal Policy.
Frequently Asked Questions
What is the primary focus of this thesis?
The research investigates why current account imbalances in the euro area have proven so persistent and explores the specific role of the non-tradable sector in hindering or facilitating the economic adjustment process.
What are the central themes discussed in the paper?
The central themes include the structural heterogeneity of euro area economies, the impact of price and non-price competitiveness on trade, and the limitations of policy options for deficit countries within a currency union.
What is the main research objective?
The objective is to explain how an oversized, uncompetitive non-tradable sector complicates the adjustment process and why shifting resources toward the tradable sector is essential for sustainable economic recovery in deficit countries.
Which scientific methods does the author employ?
The author uses historical analysis, comparative empirical assessment of sectoral output across euro area countries, and an extended graphical model based on the "expenditure-changing/expenditure-switching" framework to visualize economic adjustment dynamics.
What does the main body of the paper cover?
The main body examines historical lessons from previous fixed exchange rate regimes, analyzes the drivers of divergence in the euro zone, empirically identifies the size of non-tradable sectors in various member states, and evaluates current austerity-based policy frameworks.
Which terms best characterize this work?
Key concepts include "internal devaluation," "tradable versus non-tradable sectors," "competitiveness divergence," and "structural market rigidities."
Why does the author focus on the "non-tradable sector"?
The author identifies that the non-tradable sector often reinforces inflation and unit labor cost pressures, and because it is shielded from international competition, it lacks the discipline to force improvements in productivity and quality.
What is the author's conclusion regarding the current economic policy in Europe?
The author concludes that while current austerity policies aim for adjustment, they are particularly painful for countries with large non-tradable sectors; therefore, policies that support the growth of the tradable sector are vital to reduce the social costs of adjustment.
- Quote paper
- Jorge Martinez de Paz (Author), 2012, The Role of Tradables vs. Non-tradables for the Adjustment Process in Europe, Munich, GRIN Verlag, https://www.grin.com/document/318228
