Testing for external sustainability under a monetary integration process. Does the Lawson doctrine apply to Europe?

Abstract

Monetary integration, and more specifically, the creation of a monetary union in Europe, raises new economic questions concerning its functioning and governance. In particular, we focus on the implications of high and persistent current account deficits for the economic performance of monetary union members in the medium term. Recent literature has argued that conventional measures of external sustainability are misleading because they omit the effects of capital variations on net foreign asset positions due to, among others, stock or debt market crises. In this paper we revisit external sustainability making use of the database developed by Lane and Milesi-Ferretti (2007) that includes these “valuation effects”. The sample period studied covers from the launching of the monetary integration process in Europe (the creation of the European Snake in 1972) up to 2011. Our econometric methodology accounts for the increasing cross-section dependence among EMU countries as well as for possible structural breaks endogenously determined. The results point to the need of abrupt adjustments, either led by the markets or promoted by pro-active policy measures, in order to offset external disequilibria. These results would give support to the surveillance measures proposed by the European Commission (2009, 2010a) and would reject the Lawson's doctrine of “laissez-faire”.