Current Account Deficits in the Euro Area: The End of the Feldstein-Horioka Puzzle?

Abstract

IN 2000-01 THE CURRENT account deficit of Portugal reached 10 percent of its GDP, up from 2-3 percent at the start of the 1990s. These deficits are forecast to continue in the 8-9 percent range for the indefinite future. Greece is not far behind. Its current account deficit in 2000-01 was equal to 6-7 percent of GDP, up from 1-2 percent in the early 1990s, and again, the forecasts are for deficits to remain high, in the 5-6 percent range. This is not the first time that some of the small member countries of the European Union have run large current account deficits. In the early 1980s, for example, Portugal ran deficits in excess of 10 percent of GDP. But those deficits had a very different flavor from today's: Portugal then was still reeling from its 1975 revolution, from the loss of its colonies, and from the second oil shock; the government was running a large budget deficit, in excess of 12 percent of GDP. The current account deficits were widely perceived as unsustainable, and indeed they turned out to be: between 1980 and 1987, the escudo was devalued by 60 percent, and the current account deficit was eliminated. In contrast, Portugal today is not suffering from large adverse shocks; the official budget deficit has been reduced since the early 1990s (although with some signs of relapse in 2002, as current estimates imply that Portugal may exceed the limits imposed by the 1997 Stability and Growth Pact among the countries participating in European monetary union); and financial markets show no sign of worry. The fact that both Portugal and Greece are members of both the European Union and the euro area (the group of countries that use the euro as their common currency), and the fact that they are the two poorest members of both groups, suggest a natural explanation for today's current account deficits. They are exactly what theory suggests can and should happen when countries become more closely linked in goods and financial markets. To the extent that they are the countries with higher expected rates of return, poor countries should see an increase in investment. And to the extent that they are the countries with better growth prospects, they should also see a decrease in saving. Thus, on both counts, poorer countries should run larger current account deficits, and, symmetrically, richer countries should run larger current account surpluses. This paper investigates whether this hypothesis indeed fits the facts. We conclude that it does, and that saving rather than investment is the main channel through which integration affects current account balances. We proceed in four steps. First, we use a workhorse open-economy model to show how, for poorer countries, goods and financial market integration are likely to lead to both a decrease in saving and an increase in investment, and so to a larger current account deficit. We also discuss how other, less direct implications of the process of integration, such as domestic financial liberalization, are likely to reinforce that outcome. Second, we look at panel data evidence from the countries of the Organization for Economic Cooperation and Development (OECD) since 1975. We document that the recent changes in the current account balances of Portugal and Greece are indeed part of a more general trend: the dispersion of current account positions among OECD countries has steadily increased since the early 1990s, and current account positions have become increasingly related to countries' income per capita. This trend is visible within the OECD as a whole but is stronger within the European Union, and stronger still within the euro area. The channel through which this occurs appears to be primarily a decrease in saving--typically private saving--in the countries with widening current account deficits, rather than an increase in investment. Third, we return to the cases of Portugal and Greece. …