External Imbalances and Public Finances in the EU

The global financial crisis induced a sharp deterioration in EU countries' public finances with government deficits and debt reaching levels unprecedented in recent times. Importantly, this crisis has also brought attention the fact that the countries that have experienced the sharpest deterioration in their public finances were also those where current account deteriorated most during the decade preceding the crisis. The issues remain wide open regarding the nature and consequences of the linkages between external imbalances and public finances in the EU. As evidenced by this crisis, in absence of nominal exchange rate adjustment, business cycle evolutions may be amplified in countries with structural competitiveness problems and buoyant domestic demand. Three years after the start of the global financial crisis a number of EU countries face the dual challenge of restoring competitiveness and to reduce their public deficits. Both objectives may weigh on the incipient economic recovery, however. Policy choices will need to be made calling for further analysis.

This Occasional paper brings together recent contributions by leading academics analysing the link between external imbalances and public finances in the EU. These contributions show in particular that the build-up of external imbalances in the EU and the euro area during the decade preceding the financial crisis may have signalled contingent budgetary risks through a number of macroeconomic and microeconomic channels.

In addition, this Occasional Paper provides recent research carried out by the Directorate General for Economic and Financial Affairs regarding the challenges posed by external imbalances for the success of fiscal consolidations plans to be implemented in the coming years, drawing on past experiences for EU countries and a sample of OECD countries.