Large current account deficits in European economies, among them Portugal, have been a decisive feature of the European banking and sovereign debt crisis. While the Portuguese current account has undergone a severe adjustment, the level of external debt remains among the highest in Europe and reducing it down to the threshold defined by the EU-Commission’s Macroeconomic Imbalance Procedure is likely to take decades.
Research relates the external imbalances occurring in the run-up to the crisis to a number of factors. There are three dominate theories: (1) a catching up process of the deficit countries; (2) deterioration of price competitiveness; and (3) demand booms fueled via low interest rates induced by monetary unification. All of these hypotheses are largely in line with the observed macroeconomic patterns, but attribute the observed imbalances to different sources and, hence, imply different policy responses.
A large body of literature is investigating the roots of the imbalances, with some focusing on their subsequent adjustment, but most applying reduced form empirical setups that do not take a structural perspective on EMU imbalances. I investigate the structural drivers of Portugal’s current account among other EMU current accounts incorporating the main hypotheses discussed above.
While policy responses to macroeconomic imbalances have emphasized issues related to competitiveness, I find no support for the claim that price competitiveness is at the root of the imbalances. Instead, domestic demand shocks in the deficit countries, including Portugal, contributed substantially to the deterioration of their current accounts (and their subsequent rebalancing), while German imbalances were fueled by foreign demand; the mirror image of domestic demand shocks in the deficit countries. Based on these findings, competitiveness may be an outcome of – but not the source of – EMU imbalances. Policies that aim to prevent future and correct past imbalances in Portugal and other EMU countries should take this into account.