European Trade and Growth Imbalances : A Sign-Restriction GVAR Analysis

The accumulated, persistent trade and economic imbalances between the South euro area (SEA) and theNorth euro area (NEA) countries brought about severe strains for the euro following the global financialcrisis of 2008. This paper assesses alternative scenarios suggested to restore the trade imbalances withinthe euro area. We employ a structural Bayesian Global VAR in which theory-consistent long- and short-runrestrictions are imposed. Empirical results show that a depreciation of the SEA real exchange rate and/or areduction of the SEA unit labor cost can lead to an improvement of the SEA trade balance through an increasein exports. Evidence also emerges that a negative demand shock in the SEA can also ameliorate the SEA tradebalance by boosting exports and reducing imports. Among the policies that could restore trade imbalancesin the SEA, austerity is less painful in terms of adjustment to long-run equilibrium. Counterfactual analysissignal that if policies – improved competitiveness and/or austerity in SEA – were pursued prior to 2010the European debt crisis could have been averted. Finally, a simple loss function exercise shows that apersistent contractionary demand shock in SEA will maximize the welfare of pan-European social-welfareplaner-policy maker