Macroeconomic Imbalance Procedure in the European Union. An evaluation of the EU policies to prevent excessive current account imbalances

Table of contents

1. Introduction

2. Theoretical breakdown of the Macroeconomic Imbalance Procedure
2.1 The Implementation and Functioning of the Macroeconomic Imbalance Procedure
2.2 The Macroeconomic Imbalance Procedure’s effect since its implementation

3 Criticism on the Macroeconomic Imbalance Procedure
3.1 The key indicator of the Macroeconomic Imbalance Procedure
3.2 The arbitrariness of the threshold values
3.3 The disparity of European Union member states

4 Conclusion

5 Appendix & Sources

1 Introduction

The Eurozone crisis from 2010 which followed the global financial crisis from 2007 not only disrupted Europe’s economic landscape but also left the European Union member states questioning whether the initial concept of a European single market and a European Monetary Union as part of the European Union was carried out appropriately. As a result, the European Semester was implemented in 2011 as part of the Europe 2020 strategy. The European Semester is the EU’s framework for a more coordinated and anticipatory economic policy and features the Macroeconomic Imbalance Procedure (MIP), which will be subject of this paper with the research question:

How effective is the Macroeconomic Imbalance Procedure in the European Union? - A discussion on and evaluation of the EU policies to prevent excessive current account imbalances.

This paper will examine how the European Semester and the MIP are implemented in European economic and monetary policies and how effective they are at preventing macroeconomic imbalances from occurring. I will specifically look at the challenges which occur from the implementation of the MIP, its evolution since its beginning and I will take a closer look on the situation in Germany, as it has the EU’s highest current account surplus over the past years. After this theoretical part I will discuss the criticism voiced regarding the effectiveness and appropriateness of the Macroeconomic Imbalance Procedure and outline alternative approaches to monitor the economic development of the European Union member states.

2.1 The implementation and functioning of the Macroeconomic Imbalance Procedure

On December 13 th, 2011 the European Union adopted a total of six draft laws which were to ensure a more stable economic landscape in Europe after the financial crises from 2007 and especially after the Euro crisis of 2010/11. Those six drafts are also referred to as “the Six pack” of the European Semester, which represents a new take on macroeconomic governance and policies of control within the European Union. The Macroeconomic Imbalance Procedure was developed to detect worrying trends in the current account balances of the states of the European Union early so that they could be tackled by the EU and the respective country together. An imbalance in the sense of the MIP was defined as

“Any trend giving rise to macroeconomic developments which are adversely affecting, or have the potential to adversely to affect, the proper functioning of the economy of a Member State or of the economic and monetary union, or of the Union as a whole. ” (Regulation (EU) No 1176/2011: Art. 2 (1))

This definition does not exclude a certain type of current account imbalance, meaning the MIP can be both relevant for current account deficits and surpluses. The Macroeconomic Imbalance Procedure features two main instruments. The first one is the annually hold Alert Mechanism Report (AMR). In this first step the European Commission works out which EU countries require special attention. The AMR is based on a total of 14 different macroeconomic indicators, of which the most important one is the 3-year backward moving average of each country’s current account balance.1 The threshold for a deficit is -4% and for a surplus it is 6% of the GDP. If the European Commission agrees based on those indicators that a country requires a more detailed analysis, it then initiates an In-Depth-Review to further evaluate the respective country’s economic state. If the In-Depth-Review, which is done by a specialist group assigned by the European Commission, comes to the result, that the economic imbalance is either causing vulnerability of the European Union or threatening the cohesive functioning of the EU, measures are to be taken in order to prevent these things from happening. In theory, the European Commission in consultation with the European Council can initiate the Excessive Imbalance Review which would include intensive surveillance of a country with a massively threatening imbalance by the European Union as well as the possibility of sanctions or economic penalties. In reality however, the Excessive Imbalance Review has not been initiated so far. The European Commission rather asked the European Council to give suggestions and advice in terms of governance and economic policies to the country which underwent the In-Depth-Review. Those are not necessarily binding yet apply a great amount of pressure to the country and are usually carried out or implemented in the country’s economic agenda.

As the European Semester and with it the Macroeconomic Imbalance Procedure are still relatively new to the European Union’s catalogue of controlling instruments, it cannot be said whether the European Commission generally is to hesitant to initiate the Excessive Imbalance Review or wants to establish the mechanism first before deepening the impact this could have on the single member states’ economic policy decisions.

2.2 The Macroeconomic Imbalance Procedure’s effect since its implementation

When the MIP was introduced into the European Union in 2011 Europe was still in midst of the Eurozone crisis. The Eurozone crisis was caused by several dynamics and reasons, yet the trade balances (current account balances) of the EU member states played a big part in it. That is why often the Eurozone crisis is also referred to as the Sovereign Debt Crisis. When looking at Figure 1 it can be seen that many EU member states had current account deficits closely moving around the current threshold value of - 4% with countries like Greece, Portugal or Italy surpassing that value by far. Germany, the Netherlands and Luxemburg already were the counterparts to the rest of the European Union with surpluses of 5% to 7,5%. While sovereign debt is reflected in a country’s balance-of-payments, the current account balance is heavily connected with it. A deficit in the current account balance has to be financed by a positive net capital inflow into the country with a deficit. In the case of the Eurozone crisis the recession broke out/deepened when the capital inflow abruptly stopped for many countries and the current account deficit was no longer balanced by the external capital, thus

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Figure 1 – Current Account Balances of EU countries in % of GDP in 2011

pushing up sovereign debt in those countries. In the aftermath of the crisis this posed one of the main incentives for the implementation of the Macroeconomic Imbalance Procedure. When the first Alert Mechanism was published in 2012 there were a total of 12 EU member states that required an In-DepthReview and with the exception of Denmark, all of those 12 member states had a current account deficit.2 In 2014 the Report included the Netherlands and Germany for the first time, both were diagnosed with an excessive current account surplus after the In-Depth-Review.3 From 2014 on both countries have been identified as excessive imbalance countries for each subsequent year. While the more usual cause for economic recession seemed an excessive current account deficit for the EU at first, they now also payed stricter attention towards current account surpluses. If the external balance has such a high surplus it retrieves certain risks for the economic functioning of the European Union. In the case of Germany, the economically strongest country within the European Union the high current account surplus comes along with a low amount of domestic investing, a high amount of foreign capital stocks - especially in emerging markets - and a long-term decrease of real capital stock. This means that Germany is on the one hand missing out on public investing that could be done and also partially depends on the continuing inflow of capital.

If a country with the power of Germany has such a high trade balance surplus there are also political implications arising, as can be seen in form of the tariff conflict with the USA over the German automobile exports.

As the Macroeconomic Imbalance Procedure is there to reduce risks within and for the European Union however, the prevention of a single country’s economic problems is not the primary goal. Thus, one of the main worries that a current account surplus of the extent and continuity of Germany and the Netherlands is associated with is the negative spill-over effects for the economically weaker countries

within the European Union. For example, if the Euro depreciates as a result of the surplus countries’ heavy exports this will have negative effects on the deficit countries as they are in the monetary union. Therefore, to prevent imbalances of any kind to threaten the coherence of the European Union the EU pays attention to both current account surpluses and deficits.

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Figure 2 - Current account balances of EU countries in % of GDP in 2017

Looking at the current account balances of the EU member states as of 2017 (Figure 2) a positive trend can be marked for the deficit countries of 2011 (Figure 1). Spain was able to turn its deficit into a surplus of 2% and Portugal evened out the current account balance at values closely around +/- 0%. Greece, the country with the biggest current account deficit in 2011, reduced it from around -10% to -2%. Cyprus still has a massive current account deficit, but it resembles such little economic relevance within the European Union that it will not be further addressed here. This positive trend is also another explanation for why the EU is paying more attention to surplus countries such as Germany, the Netherlands and Luxemburg. When comparing the data from 2011 with the data from 2017 Germany and the Netherlands have both increased their current account surpluses. Germany went from approximately 6% in 2011 to 8.0% in 2017, while the Netherlands went from 8.6% in 2011 to 10.5% in 2017. Both countries follow that trend in 2018 and 2019 as well, so a further increase of their surpluses is subject of debate in many aspects in the European Union.

When trying to assess the effectiveness of the Macroeconomic Imbalance Procedure, it is hard to formulate a clear statement. While for the trend for the deficit countries was positive, it cannot really be said if that resulted from the preventative measure of the European Semester or if it was rather an effect of austerity measures and general economic upturn within Europe in the past few years. Therefore, the next part of this paper will address points of criticism that are related to the Macroeconomic Imbalance Procedure in order to develop a more differentiated view towards the MIP.

3.1 The key indicator of the Macroeconomic Imbalance Procedure

While there are a total of 14 different indicators on the scoreboard which is used for the In-DepthReview the current account balance as the key indicator remains most spoken about and has the most impact on the decision making linked to the Macroeconomic Imbalance Procedure. The indicator is a backward­looking indicator which means that it resembles the averaged current account balance of a country over the last three years. The European Semester and therefore also the Macroeconomic Imbalance Procedure is a tool to prevent imbalances causing economic downfalls or crises from happening. Therefore, the fact, that the scoreboard is using a backward-looking indicator rather than a forward-looking one can be criticised. A forward-looking indicator offers a better understanding of current trends that can be observed within the EU and thus would be more appropriate for a preventative tool such as the MIP. The disadvantage of using a forward-looking indicator though is having to rely on the forecast data of the current account balance. When comparing the current account balances of key EU countries in 2012, the difference in how the indicator is used becomes very clear. Using the backward-looking indicator, Germany (+6.6%) and the Netherlands (+6.7%) are countries which surpass the upper threshold and Greece (-9.9%), Portugal (-6.5%) and Spain (-3.2%) are countries with excessive imbalances or a value very close to the threshold. When using the forward-looking indicator instead, Germany (+6.9%) and the Netherlands (+9.1%) not only remain above the threshold but have even higher values. The deficit countries on the contrary all show better values. Greece (-3.2%) was able to reduce its deficit just underneath the threshold, Portugal (0.0%) was able to even out its balance and Spain (+0.9%) turned its deficit into a slight surplus.4 When looking again at the more current values from 2017 (Figure 2) it shows, that the forward-looking indicator actually was better at forecasting the trends which the countries’ current account balances followed. The criticism on the MIP’s key indicator is therefore justified and should be discussed in a broader context.

3.2 The arbitrariness of the threshold values

Again, the current account balance indicator is the point of criticism. The threshold values of +6% and -4% were chosen in 2011 and since then not changed. The reasoning behind why exactly those numbers were chosen is not clearly given and also why these numbers have not been changed or adjusted throughout the 8 years in which the Macroeconomic Imbalance Procedure exists. This is at the expense of the transparency of the European Semester, as the chosen values for the MIP can be called arbitrary or wrongly justified.

3.3 The disparity of European Union member states

Even though the European Union stands economically and politically as a united force against the rest of the world, one must not forget that there still is a very large disparity within the different EU member states. When looking at the relative share of the total EU GDP from each country (Figure 3), the difference between the EU member states’ economic situation, power and influence becomes apparent. The five [six] economically strongest countries (GE, [UK,] FR, IT, ES, NE) of the EU represent approximately 75% of the total economic power with Germany being the number one at 21.1%. Not only does this explain, why the surpluses of Germany and the Netherlands are of such interest. Countries with a GDP of that dimension have more far-reaching effects on the rest of the European Union than for example Slovenia, with just representing 0.3% of the total EU GDP.

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Figure 3 - Relative Share of EU’s GDP by member states in 2016

The criticism, which can be voiced in this context is the contradiction of a standardized macroeconomic indicator when in fact the economic circumstances and capabilities of the EU countries differ from each other. Using the same indicator for every single country contains the risk of not assessing the imbalance of a country in a sufficient way regarding its respective role and impact within the European Union. Therefore, a simple modification could solve this issue. It was proposed to compare the current account balance of every country to the EU average current account balance .5 As this indicator has not been used in the Macroeconomic Imbalance Procedure yet, the assumption that it would be more appropriate to assess the different EU member states is of a theoretical nature.

4 Conclusion

In conclusion it can be said, that the Macroeconomic Imbalance Procedure has yet to prove its absolute necessity within the European Semester. It grounds its legitimacy in the urgency to take action after the Euro crisis and therefore has not been questioned by many. As a preventive tool it is designed to hinder the outbreak of a new crisis and the macroeconomic trends within the European Union generally are positive when it comes to the decrease of current account imbalances. However, as the European Commission and the European Council as the out carrying entities of the MIP have been very passive over the last years and contented themselves with giving advice and counsel to the member states rather than launching an Excessive Imbalance Procedure or imposing economic sanctions, it is hard to tell whether the MIP actually played an essential part in decreasing the current account balances or if it is mainly the result of the economic prosperity in huge parts of Europe and the recovery from the 2011 crisis. Naturally, one cannot expect the EU to live in a period of economic boom forever, so an early warning tool such as the MIP can and most likely will be very important where prosperity becomes scarce. Yet, the design of the MIP should not remain untouched and the European Union should consider developing a procedure which is adapting better to the prevailing economic situation of both the European Union as a whole and the respective member states. This would give the European Semester a boost in efficiency, legitimacy and transparency. The points of criticism discussed in 3.1 - 3.3 are not necessarily the only, but at least some of the more obvious points on which the European Union could work to enhance its procedure.

5 Appendix & Sources

5.1 Footnotes and Figures

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5.2 Literature

Baldwin, Richard, Thorsten Beck, Agnès Bénassy-Quéré, Olivier Blanchard, Giancarlo Corsetti, Paul de Grauwe, Wouter den Haan, Francesco Giavazzi, Danile Gros, Sebnem Kalemli-Ozcan, Stefano Micossi, Elias, Papioannou, Paolo Pesenti, Chrisopher Pissarides, Guido Tabellini and Beatrice Weder di Mauro (eds.) (2015) Rebooting the Eurozone: - Step 1 - Agreeing a Crisis Narrative. Center for European Studies, http://www.cepr.org

Borger, K., 2017. Leistungsbilanz: Überschuss reduzieren, Deutschland stärken. URL:

https://www.kfw.de/KfW-Konzern/Newsroom/Aktuelles/News-Details 428224.html (June 12th 2019)

Corsetti, Giancarlo, Lars P. Feld, Ralph Koijen, Lucrecia Reichlin, Ricardo Reis, Hélène Rey, and Beatrice Weder di Mauro (2016) Reinforcing the Eurozone and Protecting the Open Society. Monitoring the Eurozone 2. CEPR

De Grauwe, Paul (2011) The EU Governance of the Fragile Eurozone. CEPS Working Document. Center for European Studies. Thinking Ahead For Europe. WP No. 346.

De Grauwe, Paul (2013) Design Failures in the Eurozone - Can they be Fixed? Economic Papers No. 491/2013. http://www.ec.europa.eu/economy_finance/publications (June 15th 2019)

Gros, Daniel and Matthias Busse (2013) The Macroeconomic Imbalances Procedure and Germany: When is a Current Account Surplus an „Imbalance“? CEPS Policy Brief Nr. 302, Centre for European Policy Studies, Brüssel, 13, November 2013.