Current Accounts in the Euro Area: An Intertemporal Approach * José Manuel Campa IESE Business School. and

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1 Curren Accouns in he Euro Area: An Ineremporal Approach José Manuel Campa IESE Business School and Angel Gavilán Servicio de Esudios Banco de España February 2007 Absrac This paper uses an ineremporal model of he curren accoun o evaluae he flucuaions in curren accoun balances experienced by Euro area counries over he las hree decades. In he model curren accoun balances are used o smooh consumpion and hey are driven by expecaions abou fuure income and relaive prices. Three are he main findings of he paper. Firs, he model is no rejeced for six (Belgium, France, Ialy, Neherlands, Porugal and Spain) of he en Euro area counries examined, alhough i ends o underesimae heir curren accoun volailiy. Second, he relaive conribuions o curren accoun flucuaions of changes in he expecaions abou fuure income and relaive prices differ subsanially across counries. And hird, he esimaed expecaions abou fuure growh increased in all Souhern European counries a he creaion of he Euro, bu hey had considerably diverged by While in Porugal hese expecaions are now below is hisorical mean, in Spain hey are a a hisorical high. We hank Oscar Arce, Juan Francisco Jimeno, David Lopez-Salido, Fernando Resoy, Juan Rojas and seminar paricipans a he Bank of Spain and he European Universiy Insiue in Florence for helpful commens and suggesions. The views expressed in his paper are hose of he auhors and do no necessarily reflec hose of he Bank of Spain. addresses: (Campa) jcampa@iese.edu; (Gavilan) angel.gavilan@bde.es.

2 1.- Inroducion Over he las few years, he curren accoun in he Euro area as a whole has remained essenially balanced, wih small deficis and surpluses very rarely above 1% of GDP. However, his balance a he aggregae level hides he remarkably differen evoluion of he curren accoun balances across member counries. While he curren accouns of Greece, Porugal and Spain have been deerioraing almos coninually since he end of he 1990s, Ausria and Germany have consisenly increased heir curren accoun balances during he same period. These diverging paerns in curren accoun balances across Euro area counries can be seen, a leas parly, as a naural consequence of he higher degree of financial and economic inegraion achieved in inernaional markes over ime and, in paricular, of he creaion of he EMU. Blanchard and Giavazzi (2002) poined ou ha higher financial and economic inegraion reduces he coss and risks of borrowing and lending inernaionally and, by inducing compeiion across counries, fosers he eliminaion of inernal inefficiencies and hus growh. Therefore, his increased inegraion should lead o more dispersion in curren accoun balances across counries. Furhermore, o he exen ha convergence in income per capia wihin Europe is aking place, we should also observe a srong posiive correlaion beween income and curren accoun balances. This is precisely wha we have been observing in he Euro zone. Relaively rich counries wihin he EMU, like Germany, have been experiencing large and increasing exernal surpluses while relaively poorer counries (like Spain, Greece or Porugal) have been experiencing large and increasing exernal deficis. This behaviour of curren accoun balances wihin he Euro area has recenly raised concerns abou is quaniaive dimensions. I is no clear wheher he size of he curren accoun flucuaions ha he member counries have been experiencing over he las few years reflecs a proper adjusmen o he new scenario or insead an over- or under-adjusmen. In his sense, if some counries have increased heir exernal indebedness based on over-opimisic expecaions abou is fuure growh or abou he posiive effecs ha inernaional inegraion would have on i (as poined ou by Gourinchas (2002)), hey should experience a painful adjusmen sooner or laer. The decrease in economic aciviy experienced in recen years by some of he counries wih 2

3 large previous deficis, such as Porugal, seems o give suppor o he over-adjusmen hypohesis. The firs purpose of his paper is o answer he quesion of wheher curren accoun flucuaions in he Euro area are wihin wha should be considered reasonable or have surpassed he reasonable boundaries. A precise answer o his quesion requires a specific model o deermine wha such a reasonable benchmark for curren accoun balances should be and o wha exen exising curren accoun balances are deviaing from i. The curren paper uses he ineremporal curren accoun model developed by Bergin and Sheffrin (2000) as such a benchmark. The model considers a small open economy where consumers smooh consumpion over ime. Thus, opimal consumpion is based on he expecaions of fuure oupu and relaive prices, and curren accoun balances in every period are he difference beween opimal consumpion and ne oupu in ha period. The model considers ime-varying ineres raes and exchange raes (hrough he exisence of raded and nonraded goods), a feaure which could be poenially imporan in he conex of he Euro area. This model is confroned wih he daa over he las hree decades for en Euro area member counries. For Ausria, Finland, Germany and Ireland, he model is rejeced and hus, he ineremporal approach considered in his paper is no a valid represenaion of he behaviour of heir curren accoun balances. The model canno be rejeced for Belgium, France, Ialy, Neherlands, Porugal and Spain. Alhough no rejeced, he model significanly underpredics he volailiy of he curren accoun for Neherlands, Porugal and Spain (on average, he raio of he prediced o he acual curren accoun for hese counries is 60%, 80% and 77%, respecively). In conras, he model considerably overesimaes he volailiy of he curren accoun for Belgium. Finally, he model fis almos perfecly he observed curren accoun flucuaions for France and Ialy. The second purpose of he paper is o analyze, for he six counries for which he model is no rejeced, wha is he main deerminan of heir curren accoun flucuaions. Curren accoun flucuaes in he model due o changes in he expecaions abou fuure income and relaive prices. The relaive conribuion of hese wo componens varies subsanially across counries. For France, Ialy and Neherlands curren accoun 3

4 flucuaions are primarily driven by changes in expeced fuure relaive prices. In conras, for Belgium, Porugal and Spain expeced changes in ne oupu are he primary driver of curren accoun flucuaions (60%, 85% and 58%, respecively). Finally, he hird purpose of his paper is o ake a quick look a he esimaed expecaions abou fuure income ha, according o he model, are behind each counry s exernal balance. This exercise poins o some ineresing facs. In he second half of he 1990s counries in souhern Europe (France, Ialy, Porugal and Spain) experienced increases in heir expecaions of fuure oupu. Afer a small correcion around 2001, hese expecaions sabilized for Ialy, coninued o decline for Porugal, and sared o increase again for France and Spain. A his poin Spanish expecaions of fuure oupu relaive o curren oupu are a heir highes value of he las hiry years. Assuming ha in he fuure he shares of invesmen and governmen expendiure o GDP remain a heir acual levels in Spain, hese expecaions would imply a growh in per capia GDP for he nex en years 20% higher han he hisorical average of he pas hree decades. The res of he paper is organized as follows. Secion 2 briefly describes he ineremporal curren accoun model used in his paper and is esable implicaions. These implicaions are esed in secion 4 using he daa described in secion 3. For he counries in which he model can no be rejeced, secion 5 provides more deailed esimaion resuls and addiional implicaions of he model. Secion 6 discusses differen issues relaed o he validiy of he model and secion 7 concludes. 2.- An ineremporal model of he curren accoun As menioned above, he firs goal of his paper is o deermine a benchmark scenario for he behaviour of he curren accoun ha can be compared wih he evoluion of he curren accoun balances in he daa. For ha purpose, we consider he model developed in Bergin and Sheffrin (2000) ha belongs o he class of ineremporal curren accoun (ICA) models. These models, firs inroduced by Sachs (1981), have been exensively used in he lieraure and basically consiue an exension 4

5 of he permanen income hypohesis model o a small open economy. 1 The underlying deerminan of a counry s curren accoun in hese models is heir ciizens desire o smooh consumpion over ime. The mos salien feaure of he model developed in Bergin and Sheffrin (2000) is ha i allows simulaneously for ime-varying ineres raes and exchanges raes. They show, for Ausralia, Canada and he Unied Kingdom, ha he inclusion of hese feaures improves he radiionally poor empirical fi of simpler ICA models ha, eiher do no incorporae exchange raes, or impose consan ineres raes. This feaure is also especially relevan for he analysis of curren accoun flucuaions in he Euro area counries. The Euro has played an obvious role in fixing nominal exchange raes among member counries bu i has also caused a significan change in he average level of ineres raes in many of he member counries. These changes in ineres raes and exchange raes are likely o have affeced he evoluion of he curren accoun and, herefore, ough o be modelled explicily. The model considers a small open economy ha can borrow and lend wih he res of he world a a ime-varying real ineres rae. There are wo goods: raded and nonraded goods. Consumpion and borrowing decisions in he small open economy are aken by a represenaive household who maximizes is discouned life ime uiliy solving he following ineremporal maximizaion problem: max s.. Y E 0 β = 0 ( C T U ( C + P C T N, C N ) I ) G + r B 1 = B B 1 (1) where C and C denoes consumpion by he household in raded and T N nonraded goods, P is he price of nonraded goods in erms of raded goods, Y denoes he value of curren oupu, I is invesmen expendiure, G is governmen expendiure, B is he sock of foreign asses a he beginning of he period, and r is he ne world real ineres rae he counry faces in erms of raded goods. 2 Moreover, assume ha he per period uiliy funcion akes he following Cobb-Douglas form: 1 Some examples are Sheffrin and Woo (1990), Oo (1992), Glick and Rogoff (1995), Ghosh (1995), Iscan (2002), Gruber (2004) and Nason and Rogers (2006). 2 In his model, oupu, invesmen and governmen expendiure are exogenous. 5

6 U ( C T, C N 1 ) = ( C 1 σ a T C ) 1 a 1 σ N. where a!(0,1) is, in equilibrium, he share of consumpion of raded goods in oal consumpion and σ>0 is he inverse of he ineremporal elasiciy of subsiuion. The Euler equaion for his maximizaion problem can be wrien as: 3 ( 1 a )( γ 1) γ γ C P 1 = E ( + ) β 1 r + 1 (2) C + 1 P + 1 where C = C + P C denoes oal consumpion expendiure in erms of T N 1 raded goods and γ = is he ineremporal elasiciy of subsiuion. Under cerain σ condiions, Bergin and Sheffrin (2000) show ha (2) can be wrien in a more racable form as: 4 E c γ (3) = + 1 Er +1 where c = log C 1 γ + 1 logc, r (1 ) = r + a p + consan γ and p = log P + 1 log P. Bergin and Sheffrin (2000) named r he consumpion-based real ineres rae and we will use he same erminology here for simpliciy. Basically, i is a weighed measure of relaive prices, r and P. 5 Equaion (3) esablishes he way in which relaive prices affec he opimal consumpion profile. In his model consumpion change is no a zero-mean randomwalk, a common feaure of many oher models in his lieraure. Insead, expeced changes in consumpion are a funcion of he expeced consumpion-based real ineres rae. Bergin and Sheffrin (2000) highligh he roles ha he ineres rae and he exchange rae have in he opimal consumpion profile: 6 3 See Bergin and Sheffrin (2000) for he exac derivaion. 4 In paricular, hey assume join log normaliy for he gross real world ineres rae, he consumpion growh rae and he percen change in he relaive price of nonraded goods, and ha he variances and covariances beween hese variables are ime invarian. 5 The fac ha r is defined up o a consan will no be a problem for he empirical analysis below since all he relevan variables will be demeaned. 6 Following Rogoff (1992) and Bergin and Sheffrin (2000) we will use he real exchange rae as a proxy for P. This is how we obain implicaions from he model in erms of he exchange rae. 6

7 An increase in he real ineres rae, r, makes curren consumpion more expensive relaive o fuure consumpion and induces subsiuion oward fuure consumpion wih elasiciy γ. The exchange rae plays a similar role hrough he ne impac of an inraemporal and an ineremporal effec. A change in he exchange rae induces an inraemporal subsiuion effec on consumpion. When he price of raded goods is emporarily low households subsiue raded goods for nonraded goods in consumpion. Given ha he inraemporal rae of subsiuion is one (Cobb-Douglas), his raises he curren consumpion expendiure by (1-a). The ineremporal effec is driven by he relaive price of fuure vs. curren consumpion in erms of he prices of raded goods. When he price of raded goods is emporarily high and expeced o decrease, he fuure paymen of a loan in erms of raded goods is high and also expeced o decrease. This implies ha his fuure repaymen has a lower cos in erms of he full consumpion bundle han in erms of raded goods alone. Thus r rises and lowers he oal consumpion expendiure by he elasiciy γ ( 1 a). As long as γ >1, he ineremporal effec will dominae. To conclude he soluion of he maximizaion problem (1) one sill needs o combine (3) wih he ineremporal budge consrain of he problem. This is can be wrien as: = 0 0 ( RC ) = E0 ( R NO ) = 0 E + B (4) where NO 0 = Y I G denoes he ne oupu per period, R = ( 1+ rj ) j= 1 1 is he marke discoun rae for dae consumpion, and he ransversaliy condiion ( R B ) 0 lim E 0 = is assumed o be saisfied. Again, as for he Euler equaion, Bergin and Sheffrin (2000) consider a more racable expression for his ineremporal budge consrain and log-linearize (4) around he seady sae in which B = 0 (ha is, around he seady sae where ne foreign asses are 0). 7 By doing his, hey ge ha: 7 A his poin, hey use he echniques in Campbell and Mankiw (1989) and Huang and Lin (1993). 7

8 = 1 [ no c ] = no0 c0 β (5) where no NO log NO = log + 1, 0 no 0 = log NO and c 0 = logc0. Taking expecaions in (5) and combining i wih (3) one can hen ge ha: = [ no r ] CA β (6) i E + i γ + i = i 1 afer defining CA no c. 8 Equaion (6) is he more relevan equaion of he model and i clearly illusraes he consumpion smoohing characer of he curren accoun. On he one hand, ceeris paribus, he curren accoun falls when ne oupu is expeced o raise as he represenaive consumer smoohes is consumpion. On he oher hand, ceeris paribus, he curren accoun also falls if he consumpion-based real ineres rae is expeced o decrease. The represenaive consumer subsiues away fuure consumpion for curren consumpion ha increases over is smoohed level Tesable implicaions of he model Empirical applicaions of ineremporal curren accoun models in he lieraure have radiionally exended, o a small open economy, he ess for he permanen income hypohesis model developed by Campbell (1987) and Campbell and Shiller (1987). 9 We will follow his approach here oo. 10 implies ha is, The model oulined above has several esable implicaions. Firs, equaion (6) CA should Granger cause no and r bu no he oher way around. Tha CA should have incremenal explanaory power for fuure values of This can be esed empirically. no and r. 8 In he per period budge consrain in (1) inuiively one could define CA = B B = NO C. The 1 definiion of CA in (6) has he same idea bu wih he variables expressed in log erms. This measure of he curren accoun is approximaely he raio of he rade balance o consumpion in he economy. 9 See, for insance, Sheffrin and Woo (1990), Oo (1992), Ghosh (1995), Iscan (2002), Gruber (2004) and Nason and Rogers (2006). 10 Glick and Rogoff (1995) and Gruber (2002) consider ha Invesmen is endogenous and follow a differen empirical approach. 8

9 A second implicaion of he model ha can be esed empirically is provided by equaion (3), E c γ. I is possible o show analyically ha esing equaion = + 1 Er +1 (3) is equivalen o esing ( 1 ) = 0 E where R CA ( no r ) 1/ β ) CA R Ι γ ( 1. Tha is, he difference beween he forecas and he acual curren accoun is unpredicable, given he relevan informaion se. We will call his es he R-es. There is a hird approach for esing he model if one is willing o make specific assumpions abou how individuals form heir expecaions. This is he approach pursued, for insance, by Sheffrin and Woo (1990). Consider ha he behaviour of he hree variables of ineres, no, CA and r can be modelled according o an unresriced auoregressive process of order 1, VAR(1), of he following shape: 11 z no CA r a = a a a a a a a a no CA r 1 u + u u where u is a 3 dimensional vecor of mean zero, homoskedasic errors (7) i Equaion (7) implies ha E ( z i ) A z + and provides an empirical esimae of he expeced fuure values of hese variables a every horizon. CA is included in (7) because according o he model, as menioned above, CA should have incremenal explanaory power for fuure values of no and r. Equaion (6) can be expressed in his conex as: ( g γg ) = i hz β 1 2 i= 1 where g1 = 2 or as: CA = kz where k = ( g i A z [ ], g = [ 0 0 1] and h = [ 0 1 0]. 1 γg 2 ) βa( Ι βa) 1 11 This can be easy generalized for higher order VARs. 9

10 The vecor k has o equal [0 1 0] implying ha CA = CA. This can also be esed empirically. This es, i is imporan o noice, is a join es of he model and of he process of generaion of expecaions in he economy. We will call his es he k- es. 3.- The daa The model presened in he previous secion provides us wih a benchmark for undersanding flucuaions in a small open economy s curren accoun. According o ha benchmark, flucuaions in a counry s curren accoun are moivaed by a desire o smooh consumpion in a conex of changing expecaions abou relaive prices and fuure income. The following secions will ake his benchmark model o he daa. Bu before ha, his secion describes he daa employed in he empirical analysis and how he relevan variables and parameers are defined. The daa includes all member counries of he EMU excep Luxemburg, whose curren accoun, we believe, is mosly affeced by differen mechanisms han he ones considered in our benchmark model. We are ineresed in undersaing he flucuaions in he curren accoun of hese counries over he las hree decades. We follow he lieraure and use quarerly daa seasonally adjused a annual frequency. 12 The use of quarerly daa excludes Greece from he analysis since we could no find daa of his frequency for his counry ha were comparable o ha of he oher counries. Unless oherwise noed, all he daa comes from he Inernaional Financial Saisics (IFS) consruced by he Inernaional Moneary Fund. The variables needed for he analysis are defined as follows. Curren accoun ( CA ) is defined as he difference beween ne oupu (no ) and consumpion (c ). Ne oupu is he log of GDP (Y ) minus governmen expendiure (G ) and invesmen expendiure (I ). Consumpion is he log of privae consumpion expendiure (C ). All 12 I has been shown in he lieraure ha he empirical evaluaion of ineremporal curren accoun models using annual daa produces misleading resuls. 10

11 hese variables are expressed in per capia erms in order o accommodae he daa o he represenaive consumer assumpion of he model. 13 We use he ex-ane world real ineres rae as a measure of he world real ineres rae (r ) in he model. This is compued as he difference beween he one year world nominal ineres rae and expeced inflaion, where expeced inflaion is calculaed from a forecas based on a 6 quarer window. Bergin and Sheffrin (2000) define he world shor-erm nominal ineres rae combining shor-erm nominal ineres raes, T-bill raes or equivalen measures for he G-7 counries. They hen apply his common world ineres rae o all heir counries. Here we follow a differen approach. In paricular, we define he world shor-erm nominal ineres rae for each counry as he Shor-Term Ineres Rae provided by he OECD Economic Oulook. 14 Excep for he period afer he inroducion of he Euro, his world nominal ineres rae differs across counries. We believe, however, ha his provides a beer represenaion of he world ineres raes faced by each counry han he one used in Bergin and Sheffrin (2000). As menioned in secion 2, we follow Rogoff (1992) and Bergin and Sheffrin (2000) and we use he ex-ane real exchange rae as a proxy for P. In paricular, we use he real effecive exchange rae consruced by he IFS using relaive uni labour coss, and we consruc he ex-ane real effecive exchange rae again from a forecas based on a 6 quarer window. 15 Finally, and following he lieraure, we focus on he dynamic implicaions of he model and de-mean all he relevan variables relaive o heir sample mean. We also need o give values o he hree parameers of he model: a, he relaive share of raded goods in consumpion, β, he discoun rae, and γ, he ineremporal elasiciy of subsiuion. The share of raded goods in consumpion is esimaed from he inpu-oupu informaion for every counry provided by Eurosa. This daa refers o 1995 for mos counries. Given ha 1995 lies in he laer par of our sample and ha he 13 Populaion daa comes from he OECD Economic Oulook. 14 The OECD Economic Oulook does no provide his informaion for Ausria. Thus, for he empirical analysis, we consruced he world shor-erm nominal ineres rae for Ausria combining he informaion abou he Money Marke rae provided by he IFS for his counry prior o he creaion of he Euro wih he shor-erm nominal ineres rae in he Euro area afer he inroducion of he Euro. 15 For Porugal, we use a real effecive exchange rae compued based on relaive consumer prices as he IFS does no provide for his counry he one based on relaive uni labour coss. 11

12 consumpion of nonraded goods in developed economies is likely o have increased over ime, he raio of raded goods in consumpion is likely o have been higher in he earlier par of he sample. Neverheless, we believe his o be an appropriae approximaion and he resuls o be robus o his parameer. For he discoun rae, we 1 defined i as β =, where r denoes, for each counry, he average of he quarerly 1 + r real ineres rae during he period. There exiss a wide range of esimaes for he ineremporal elasiciy of subsiuion in he lieraure depending on he conex and manner in which i is esimaed. In his sense, while Hall (1988) esimaes i o be small and unlikely larger han 0.1, ohers have provided esimaes much closer o one (see, for example, Beaudry and van Wincoop (1996)). Given he lack of agreemen in he lieraure abou his parameer, we ake a neural approach and provide resuls for several values of γ on he inerval (0,1). In paricular, we consider 0.1, 0.25, 0.5, 0.75 and We believe hese numbers cover all he reasonable range for he value of his elasiciy. Table 1 shows for each counry some basic informaion abou he parameer values and he daa used in he esimaion considering γ = The firs row repors he sample period used for each counry. This is he longes ime period for which all he needed informaion is available and, for mos counries, i goes from he lae 1970s o There are wo excepions, Germany and Ireland. For Germany daa only sars in 1991 afer he re-unificaion and for Ireland quarerly daa is only available saring in This cerainly affecs he abiliy of he model o explain he curren accoun flucuaions in hese counries. The model described above implicily considers ha no, CA and r are saionary variables. In fac, i would be difficul o jusify ha hese variables were no saionary over a long period of ime. In a shor period of ime, 16 Bergin and Sheffrin (2000) also consider differen values of γ in heir empirical analysis. In addiion, hey presen he resuls of heir model for an esimaed γ, defined as he value of γ ha maximizes he p-value of he k-es of he model. We found his esimaed γ o be exremely non-robus o minor changes in he specificaion of he model and ha is why we did no pursue ha approach here. 17 Noe ha, as discussed in secion 2, for any of hese values of he ineremporal elasiciy of subsiuion he inraemporal effec of changes in he exchange rae dominaes he ineremporal effec of hose changes. Changes in he real ineres rae have, however, an ineremporal effec. 12

13 however, some of hese variables could be non-saionary. In ha case, hen, i should no be surprising o find a poor empirical fi of he model. 18 The share of raded goods ranges from 0.26 in Neherlands and Finland o 0.42 in Porugal. There is a negaive correlaion beween his share and per capia income. 19 The richer European counries end o have a lower share han he relaively poorer counries. The discoun facor does no show many differences across counries, alhough i is slighly lower for Belgium, Finland and Ialy. Belgium and Ialy were he wo counries wih he larges raio of deb o GDP during he period maybe indicaing he exisence of a risk premium in heir discoun facor. Large differences exis in he mean values of our measure of he curren accoun among counries. Porugal has by far he smalles mean value a In conras, Ireland shows he larges surplus, 0.27, alhough he sample period for Ireland is subsanially shorer. In undersanding hese numbers, i is imporan o recall ha our measure of he curren accoun is approximaely equal o a counry s exernal balance over consumpion. Neherlands also shows a large mean surplus of 7.66% over a 29 year period. All he oher counries have posiive mean curren accoun balances excep Spain, alhough heir absolue values are subsanially smaller. 4.- Tesing he ICA model Table 2 presens he resuls of he R-es, he k-es and he Granger causaliy ess. These ess use he longes ime period available for each counry and hey are performed for each of he five values of γ described in he previous secion. Recall ha he R-es consiss on esing if E ( 1 ) = 0. To implemen his es we simple regress R on lags of no, R Ι CA and r, ha is on I 1, and es he null hypohesis ha he esimaed coefficiens associaed o he independen variables are all 18 The usual Dickey-Fuller and Phillips-Perron uni roo ess are used o evaluae he saionariy of no, CA and r in each counry s sample period. I is very difficul o rejec a uni roo in CA in Germany and Ireland and, o a lesser exen, in Spain and Porugal. Insead, i is easier o rejec a uni roo in no and r in all counries. 19 This correlaion is abou

14 zero. The k-es of he model, as described in secion 2.1, ess he null hypohesis ha he vecor k is equal o [0 1 0]. 20 Bergin and Sheffrin (2000) show ha his es can be implemened using he dela mehod o consruc a χ 2 saisic for ha hypohesis. The values repored on Table 2 for hese wo ess correspond o he p-values associaed o he null hypohesis. Finally, recall ha variable X Granger causes variable Y if i provides any saisically significan informaion abou Y in he presence of lagged Y. Thus, a naural way of implemening his es is o regress Y on lags of Y and X, and hen es he null hypohesis ha he esimaed coefficiens associaed o he lags of X are all zero. Table 2 repors wo values for he Granger causaliy ess. The firs value corresponds o he p- value associaed o esing he hypohesis ha CA does no Granger cause [ no γ ]. r The second value of he Granger causaliy es provided in he able is he p-value associaed o esing he hypohesis ha [ no γ ] does no Granger cause r CA. In his case, a rejecion of he model a a 10% significance level requires ha he firs p- value be greaer han 0.1 and he second p-value be smaller han 0.1. Table 2 also provides informaion abou he number of lags considered for each counry and each value of γ, which is relevan for he consrucion of all he hree ess menioned above. This number of lags is deermined applying he Akaike s, he Schwarz s Bayesian, and he Hannan and Quinn Informaion Crieria o he vecor auoregression composed of variables no, CA and r. When hese hree crieria indicae differen number of lags, we use he mode of he recommendaion. For he case in which all hree sugges alernaive number of lags, he Akaike s Informaion Crieria (AIC) always suggess he larges number. Then, given ha he AIC is known o be biased oward selecing more lags han needed, in hose cases we choose he middle esimae of he hree crieria. The evidence from he R-es indicaes ha he ineremporal model is rejeced for all differen values of γ for Ausria, Finland, Germany and Ireland. For he oher six counries (Belgium, France, Ialy, Neherlands, Porugal and Spain), he model is 20 The vecor k is a hree-dimensional vecor only for a VAR(1). For counries for which a VAR(2) is used k is a vecor wih six elemens. The null hypohesis in ha case is ha k is equal o [ ]. 14

15 always rejeced for values of γ equal or above 0.75, bu is never rejeced for values of he ineremporal elasiciy of subsiuion below The k-es corroboraes mos of he conclusions of he R-es. Namely, (i) he model is always rejeced for Ausria, Finland, Germany and Ireland, and (ii) he model can no be rejeced for Belgium, France, Ialy and Neherlands as long as γ < There are, however, some discrepancies beween he wo ess. In paricular, according o he k-es: (i) he model is always rejeced for Porugal, (ii) he model can no be rejeced for Spain only when γ = 0. 5, and (iii) in some insances he model can no be rejeced eiher for Belgium, France, Ialy and Neherlands when γ Mercereau and Miniane (2004) show ha he k-es may produce misleading resuls if one of he series in he VAR is highly persisen. 22 This is ypically he case for he curren accoun in he counries in our sample. Therefore, we place more emphasis on he predicions of he R-es in inerpreing hese small discrepancies beween he wo ess. Finally, he Granger causaliy ess produce mixed resuls ha are difficul o conciliae wih he resuls of he previous wo ess. This is also he case in mos of he empirical applicaions of ineremporal curren accoun models in he lieraure. This is no surprising since hese ess are really weak ess of he model. For his reason, we follow he lieraure and do no place oo much emphasis on he resuls of hese ess. In order o assess he robusness of he resuls presened in Table 2 we evaluae heir sensiiviy o differen ime periods. Table 3 presens he same informaion as Table 2 for five differen ime periods (1980q1-2005, 1985q1-2005, 1990q1-2005, 1980q1-1998q4 and 1977q1-1998q4). 23 The resuls are broadly consisen wih he ones presened in Table 2. Namely, (i) he model is always rejeced for Ausria and Finland and (ii) in mos of he cases i is no possible o rejec he model for Belgium, France, Ialy, Neherlands, Porugal and Spain for small values of γ. 21 We place he level of rejecion a he 10% significance level. 22 Wih high persisence in one of he VAR series, he dela mehod approximaion needed o es he null hypohesis of he k-es is less accurae. 23 Germany and Ireland are no included in his exercise given heir small sample sizes. 15

16 Summing up, we view his empirical exercise as providing broadly suppor o wo main conclusions. Firs, ha he model is rejeced for Ausria, Finland, Germany and Ireland regardless of he value of γ. As menioned above, rejecion for Germany and Ireland is no surprising given heir small sample sizes. Finland is also a somewha special case given is special economic relaionship wih he former Sovie Union, especially in he early par of he sample. Rejecion for Ausria is harder o explain. And second, ha for he oher six counries (Belgium, France, Ialy, Neherlands, Porugal and Spain) rejecing he model is more difficul especially for values of he ineremporal elasiciy of subsiuion smaller han Implicaions from he ICA model: curren accoun dynamics The resuls presened in he previous secion indicae ha i is no possible o rejec our benchmark model for Belgium, France, Ialy, Neherlands, Porugal and Spain as long as he ineremporal elasiciy of subsiuion is no oo big. Flucuaions of he curren accoun balances in hese counries over he las hree decades can be undersood as he reacion of hese counries o changing expecaions abou fuure income and relaive prices in heir aemp o smooh heir consumpion over ime. Given he performance of he model for hese six counries and for small values of γ, we explore in his secion more of is implicaions. In doing ha, we focus, in he case in which γ = We choose o show he addiional implicaions of he model for his value of γ for exposiional convenience and because i is broadly in he middle of he range of values of γ for which he model performs well. Mos of he resuls presened below also hold when γ = 0. 1 or γ = Table 4 repors, for each counry, he esimaes of he parameers composing he VAR companion marix in equaion (7) wih heir corresponding sandard errors. As he heory suggess, ceeris paribus, a curren accoun surplus predics smaller changes in ne oupu in he fuure. The esimae of no : LCA is negaive for all counries wih he excepion of France. 24 Consisen wih he heory, we also find ha, ceeris paribus, a curren accoun surplus implies higher consumpion-based real ineres raes in he 24 For France, we do find, however, ha he coefficien of he effec ha second lag of he curren accoun has on oupu is also negaive. 16

17 fuure. The esimae of r : LCA is posiive for all counries. Mos of hese coefficiens, alhough wih he expeced sign, are saisically insignifican, as expeced given he mixed performance from he Granger causaliy analysis discussed above. Table 5 repors, for each counry, he esimaes of he parameers composing he k vecor, wih heir corresponding sandard errors. As shown in Table 2, i is no possible o rejec ha he k vecors for Belgium, France, Ialy and Neherlands are equal o he predicions of he model. I is rue, however, ha he esimaed parameers have very large sandard errors and ha, in some cases, he poin esimaes are far from heir expeced values. For insance, he poin esimae of he coefficien on CA for Neherlands, alhough no saisically differen from 1, is below 0.5. In conras, Porugal has a poin esimae of he k vecor far from he model s predicion and rejecs he null hypohesis of he k-es. Spain, ha is on he margin of rejecing he null hypohesis of he k-es according o Table 2, has poin esimaes of he componens of he k vecor closer o he model s predicion Prediced versus acual curren accoun Figure 1 shows, for each counry, he evoluion over he sample period of he prediced curren accoun, compued according o he esimaed k vecor, and of he acual curren accoun. From he figure, i is clear ha he model makes a relaively good job in capuring, qualiaively, he flucuaions in each counry s curren accoun. Quaniaively, however, he model performs beer for France and Ialy (he fi is almos perfec) han for he oher counries. The op panel in Table 6 complemens he impressions obained from he visual analysis in Figure 1. The firs row of Table 6 repors, for each counry, he raio of he sandard deviaion of he acual and he prediced curren accouns. This raio is almos equal o 1 for France and Ialy, i is clearly above 1 for Belgium and i is subsanially below 1 for Neherlands, Porugal and Spain. The fac ha he prediced curren accoun for he las hree counries exhibis less volailiy han he acual one should no be surprising since his is a common feaure of he empirical applicaions of ineremporal 17

18 curren accoun models in he lieraure (see Obsfeld and Rogoff (1995)). 25 Insead, i is somehow surprising, given his evidence, he excess volailiy we find in he prediced curren accoun for Belgium. An alernaive summary saisic of he relaive performance of he model is he average over he sample period of he raio of he prediced value of he curren accoun and is acual value. This raio is repored in he fourh row of Table 6. This raio is almos one for France and Ialy, larger han one for Belgium, and smaller han one for Neherlands, Porugal and Spain. For hese laer counries, he model no only underpredics he volailiy of he curren accoun buy also is level Decomposiion of curren accoun flucuaions Curren accoun flucuaions in he model are due o changes in expecaions abou fuure ne oupu or abou fuure relaive prices. We can use equaion (6) o decompose he prediced curren accoun ino hese wo componens. In paricular, we can express he prediced curren accoun as: CA = E i= 1 i i β ( no ) E β ( γ r ) (8) + i + i= 1 + i where x denoes he esimaed value from he VAR of variable x. The second and hird rows in Table 6 repor he average percenage conribuion o he prediced curren accoun of hese wo componens over he sample period. 26 Figure 2 also shows, for each counry, he relaive conribuion o he prediced curren accoun of hese wo erms hroughou he sample period. There are imporan differences across counries. Expecaions of fuure relaive prices are he key componen of he curren accoun flucuaions prediced by he model for France, Ialy and Neherlands. For he las wo counries hey represen above 70% of hese flucuaions. Insead, for Belgium, Porugal and Spain, he key componen are he 25 There have been a number of suggesions in he lieraure o increase he volailiy of he curren accoun prediced by ICA models. For insance, Gruber (2004) shows ha including habis in he consumers uiliy funcion helps a lo in maching he observed volailiy. 26 In order o focus on he sources of variaion for balances away from zero, we have only compued he breakdown for he subse of observaions for which CA >

19 expecaions of fuure oupu changes, especially for Porugal where hey represen more han 80% of he prediced flucuaions Expecaions abou fuure ne oupu The resuls above show ha curren accouns over he las few decades in Belgium, France, Ialy, Neherlands, Porugal and Spain are broadly consisen wih heir ciizens smoohing consumpion according o heir expecaions abou fuure income and abou fuure relaive prices. Thus, according o our benchmark model, he size and susainabiliy of curren accoun imbalances in hese counries depend on he feasibiliy of he expecaions abou fuure oupu and relaive prices which are driving hem. The emphasis on feasibiliy is key. If hese expecaions urn ou o be far from wha seems like a reasonably feasible oucome presen curren accouns may signal fuure poenial problems. This is, for insance, he concern posed by Gourinchas (2002) when analyzing he evoluion of curren accoun deficis in some Euro area counries. If hese counries expecaions are over-opimisic or, simply, unrealisic, large curren accoun deficis based on consumpion smoohing may lead o sharp adjusmens on he curren accoun once hese expecaions are no realized. 27 We can use he decomposiion of he deerminans of he curren accoun highlighed above o exrac more informaion abou he counries expecaions abou fuure ne oupu and relaive prices. We will focus on he expecaions abou fuure ne oupu. To begin wih, noe ha one can manipulae equaion (8) and rewrie he curren accoun prediced by our benchmark model as: CA = ( ) no no + E i= γ β r (9) 1 i + i where E no is defined in such a way ha: 1 + no (10) β i i β no i = β no = i= 0 i= 0 1 In words, equaion (10) simply saes ha no is he level of ne oupu such ha an infinie flow of ne oupu fixed a ha level has he same presened discouned value 27 The lieraure has named hese sharp adjusmens curren accoun reversals. 19

20 as he flow of ne oupu expeced by he counry s represenaive consumer, { no + i } i=0,1,2,.... Thus, in a sense, no has a similar inerpreaion o he permanen income in consumpion models and we will refer o i as he counry s srucural ne oupu. Wih his concep in mind, hen he consumpion smoohing inerpreaion of equaion (9) is very clear: absracing from he role of he consumpion-based real ineres rae, a counry mus experience a curren accoun defici when his srucural ne oupu is greaer han his curren ne oupu and, herefore, i is expecing o grow. Figure 3 shows he evoluion over ime of he raio of each counry s srucural ne oupu ( no ) o is curren ne oupu ( no ). 28 There are some ineresing paerns in hese figures. The creaion of he Euro increased fuure oupu expecaions in he Souhern European counries. For France, Ialy, Porugal and Spain he raio of he srucural ne oupu o he curren ne oupu began o increase a some momen in he second half of he previous decade and coninued increasing unil approximaely Since hen he paern has differed across hese counries. While all counries experienced a downward adjusmen in his raio around ha period, for France and Spain i quickly sared again an upward rend ha coninues oday. For Ialy, however, he raio sabilized and for Porugal i has coninued o decrease reflecing more conservaive Poruguese expecaions abou is fuure growh. The experiences of Belgium and Neherlands are compleely differen. For hese counries, he raio of he srucural ne oupu o he curren ne oupu, alhough flucuaing, has exhibied no rend around or since he creaion of he Euro. Figure 3 provides some insighs abou he feasibiliy of a counry s expecaions abou is fuure ne oupu. In each counry, he expecaions of fuure growh a he las observaion of is sample, =T, can be proxied by he value of he raio no T. One can evaluae he feasibiliy of such expecaions by placing ha value no T in an hisorical perspecive. An alernaive way of evaluaing he feasibiliy of each counry s expecaions abou is fuure ne oupu is o compue, for each counry, some 28 In our model a counry s curren accoun depends on is expecaions abou fuure income and fuure relaive prices. The consideraion of he laer expecaions makes ha Figure 3 does no correspond exacly o he inverse of he prediced curren accoun showed in Figure 1 for each counry. 29 For Porugal his raio declined briefly around 1999, bu his decline was quickly revered. 20

21 implied growh raes from his fuure ne oupu and o compare hem wih hisorical growh raes. This can be approximaed by he following exercise. Focusing on he las observaion for each of our six counries (=T), ne oupu equals no T and each counry s represenaive consumer expecaions abou fuure ne oupu are given by { no T + i } i=0,1,2,..., wih an associaed srucural ne oupu equal o srucural ne oupu we know ha: E i β not + i = i= 0 i= 0 i β no T no T. By definiion of he Now noe ha he fuure ne oupu flow expeced by he counry s no represenaive consumer, { T + i } i=0,1,2,..., may be very erraic. Insead, le us consider a smooher one wih he same presen discouned value. In paricular, consider ha he counry s ne oupu grows, saring a (quarers) and hen says a he reached level, same presen discouned value as { T + i } i=0,1,2,... equaion: E i= 0 no T, a consan rae g(p) during P periods no P, forever. This smooher flow has he no as long as g(p) saisfies he following P i i i β not + i = β ( not + ig( P)) + β nop (12) i= 0 i= T + 1 where no = no Pg(P) P T + Obviously, g(p) is a decreasing funcion of P. The longer a counry has o reach is consan level of oupu, he smaller he growh rae in he inerim period will have o be. Table 7 repors he resuling g(p) for several values of P. In paricular for P equal o 12, 20, 40 and 80 quarers, which correspond o ransiion periods of 3, 5, 10 and 20 years respecively. The firs panel of Table 7 repors he values of g(p) compued according o equaion (12) and expressed in annual erms. When analyzing hese numbers i is imporan o noe ha, in our analysis, all he relevan variables have been demeaned, and ne oupu (no) is a zero-mean variable. The g(p) numbers should be inerpreed as incremenal growh raes beyond each counry s growh rae over he 21

22 sample. For ha reason, he second panel of Table 7 repors he same annual growh raes of he firs panel bu expressed relaive o each counry s sample means. Counries whose curren ne oupus ( no ) are above heir srucural ne oupus ( no ) have expecaions of fuure growh ha are below heir hisorical levels. This is T he case for of Belgium, Neherlands and Porugal. On he opposie side, France, Ialy and Spain, have curren ne oupus in he las period ( no ) below heir srucural ne oupus ( no ). Thus, hey have expecaions of fuure growh ha are above heir T hisorical levels. T T Belgium and Spain are he wo mos salien counries. They are, by far, he counries wih he mos pessimisic and opimisic expecaions, respecively, abou fuure ne oupu growh. According o our esimaes, on a 5 years ime period, Belgium s expecaions would imply a growh 24% slower han is hisorical mean. Spanish expecaions, insead, are a an hisorical high (as illusraed in Figure 3) and would imply a growh over he same period of ime 44% faser han is hisorical mean. If we assume ha he shares of governmen expendiure and invesmen o GDP remain consan, his is equivalen o an increase in GDP per capia during his period of similar magniude. 30 Moreover, i is somehow worrisome ha, despie considering hese high expecaions of oupu growh in Spain, he model can only explain 64% of he Spanish acual curren accoun defici a he end of 2005 (hird row in he las panel of Table 6). 6.- Discussion The empirical analysis developed above imposed, for each counry and for he whole period of analysis, sabiliy of he VAR parameers ha deermine he way in which consumers form expecaions abou fuure ne oupu and relaive prices. One could argue agains his assumpion of sabiliy ha he creaion of he EMU and he inroducion of he Euro have modified he way consumers use pas informaion o form hese expecaions. In his sense, he drasic implicaions ha he Euro has had on member counries in erms of real ineres raes and volailiy of exchange raes, srongly 30 In Spain, however, he share of invesmen o GDP in 2005 was subsanially higher han he hisorical average. Thus, par of his adjusmen could ake place by a reversal of he share of invesmen in GDP o is hisorical average. 22

23 sugges he possibiliy of a srucural break in he formaion of expecaions oo. Srucural break in his conex implies ha he VAR parameers in equaion (7) may have changed afer he creaion of he EMU. This secion analyses, o some exen, his possibiliy. There are a number of ess in he lieraure o evaluae he presence of a srucural break in a given process. 31 The basic idea behind mos of hese ess hough is he same. If he dae of he break is known, hese ess esimae he process separaely before and afer he break, and hen compare saisically he wo ses of parameer esimaes. When he dae of he es is unknown or here is more han one break poin, he ess are more elaboraed bu hey mosly keep he same basic idea. For obvious saisically reasons, however, hese ess do no perform well when he break poins are close o he beginning or o he end of he sample period. Inuiively, he esimaion of he process on he smalles subsample is no reliable if ha subsample is oo small. For his reason we can no apply he mos common ess of srucural break o our problem. We believe ha he srucural break, if any, should have manifesed almos a he end of our sample. Then, wih very lile observaions in he pos-break sample, our esimaion of he VAR in ha subsample is no reliable. In fac, in mos cases, our variables are no saionary in such a shor period of ime, as assumed by our benchmark model. 32 Given he limiaions for our purposes of more convenional mehodologies, we pursue a more informal empirical approach o evaluae he possibiliy of a srucural change in he process of generaing expecaions wih he inroducion of he Euro. In paricular, for each counry, we compare he curren accoun prediced by he model under wo differen scenarios. In he firs scenario, he model is esimaed, for each counry, using he longes ime period available. Insead, in he second scenario he model is esimaed using only he pre-break sample, ha is, up o 1998:q4. This is a paricular case of rolling esimaion and, inuiively, if here has been a srucural break around 1999 one would expec ha he wo model s predicions exhibied some 31 For insance, he Chow es, he CUSUM es, he Nyblom s L Tes or he Andrews-Ploberger es. 32 We ried wo alernaive approaches in rying o overcome he problem generaed by he small posbreak sample. The firs one was o perform panel esimaion of he VAR for our six counries on he posbreak sample. The second one was o use he mehodology developed by Pesaran and Timmerman (2006), which suggess he use of an opimal amoun of pre-break informaion in a (pos-break) esimaion of a model ha will be used o make forecass. In boh cases, here were imporan limiaions ex-ane for applying hese wo approaches o our problem. No surprisingly, our resuls using hem were no very reliable. 23

24 differences. Figure 4 shows, for each counry, hese wo predicions (pca Whole Sample and pca Subsample, respecively) ogeher wih he acual evoluion of he curren accoun (ca). 33 For mos counries, he prediced curren accoun using he parameer esimaes from he wo differen periods are very similar suggesing ha here has no been any srucural change around 1999 or ha, if a srucural change has happened, his has been small. France and Belgium are wo excepions. For hese counries, he prediced curren accoun from he subsample is quie differen from ha obained from he full sample esimaion. The former is also much more volaile han he laer. The second and hird panels in Table 6 provide addiional informaion abou he possible exisence of a srucural break wih he inroducion of he Euro. 34 These panels reproduce, respecively, he informaion of he firs panel of he able for he pos-break sample (second panel) and he las observaion (hird panel). The relaive conribuions of he wo componens of he prediced curren accoun do no seem o have changed subsanially beween he firs and he second panel for he counries considered. The raio of he volailiies of he prediced and he acual curren accoun does no change subsanially eiher. The excepions o hese paerns are Belgium and Neherlands, for whom he raio is significanly closer o 1 in he pos-break sample. The main change occurs on he average raio of he prediced o he acual curren accoun in his las par of he sample. This raio ges significanly smaller for Ialy, Neherlands, Porugal and Spain while for Belgium i increases considerably. 35 To summarize, alhough he creaion of he Euro could have caused a srucural break in he behaviour of he curren accoun, he evidence presened in his secion is no srongly supporive of he exisence of such a break. Alernaively, if he break did happen, i does no seem very large. 33 Noe ha, by consrucion, for each counry pca Whole Sample is idenical o he model s predicion ploed in Figure 3. Noe also ha he pre-break sample, as opposed o he pos-break sample, is long enough o guaranee he reliabiliy of our VAR esimaes and he saionary of he relevan variables. Table 3 repors he resuls of he ess of he model for he shorer sample. 34 Recall ha he decline in real ineres raes experienced in many Euro area counries afer he inroducion of he Euro does no consiue a srucural break in our model since he effecs of his variable are explicily modelled. Insead, as menioned before, we look for a srucural break in he formaion of expecaions. 35 In he case of Porugal, he srange behaviour of his raio has o do mainly wih he fac ha is acual curren accoun is very close o 0. 24