Efficiency of Demand Shocks in Order to Reduce Current Account Imbalances in the EMU

With the current European sovereign public debt crisis and current account imbalances difficulties in the EMU, many papers now underline that the problem of the European construction is its lack of institutional framework and common economic governance necessary to make a monetary union viable. According to these papers, the solution would lie in a stronger economic cooperation, with the Northern European countries contributing to lighten the burden of the Southern debtor countries. In this context, our model shows that a symmetric positive demand shock in the EMU could only slightly reduce the external indebtedness of the Southern European countries but would efficiently reduce their public debt levels. To the contrary, an asymmetric positive demand shock in the creditor Northern European countries (e.g., an increase in German wages) could reduce the current account deficits of the Southern European countries, in particular for countries with the highest openness to trade. Nevertheless, it would worsen the indebtedness levels, and it would also increase the recessionary risks in these countries. 1. Introduction In the framework of a monetary union, the member countries loose variations in nominal exchange rates and in interest rates in order to adjust to cyclical economic variations and to stabilize asymmetric shocks. Therefore, real exchange rates can only vary thanks to variations in relative prices. However, at least in the short run, wages and prices are not very flexible. Therefore, budgetary policies must compensate for the price rigidity to allow the adjustment of the output and labor markets. In the absence of any centralized transfer and adjustment mechanism, as in the European Economic and Monetary Union (EMU), the weight of the stabilization can then become too heavy for budgetary policies. So, a growing literature underlines today the problem inherent in the European framework. Monetary unification did not go with a parallel fiscal integration. Thus, an imperfect monetary union without a fiscal union can be at the origin of current account imbalances, which can contribute to accentuate fiscal difficulties and create the conditions of a public debt crisis. 1.1. Current Account Imbalances in the EMU European authorities mostly blamed the fiscal laxity of some European governments for the financial and sovereign public debt crisis since 2008. Nevertheless, many recent economic papers have also stressed the role of current account imbalances for the current European crisis. Indeed, since the 1970s, Northern European countries have accumulated