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Twin Deficits and the Sustainability of Macroeconomic Policies in Selected European and Mediterranean Partner Countries

Our empirical results validate the Twin Deficit hypothesis in both EU and MED samples, but with diverging findings regarding the direction of causality. While the trade balance seems to be driving the budget deficit in MED countries –thereby validating the current account targeting approach – the relationship appears to run in the opposite direction in the case of EU countries, where the budget balance appears to be driving the current account. Given the well-documented dependence of MED countries on trade with the EU and the fact that most EU countries have implemented austerity policies in the aftermath of the financial crisis – thereby restricting aggregate demand and imports – we argue that the ensuing drop in export income for MED countries has contributed to increasing the budget deficit in these countries, by virtue of the uncovered positive causality between the current account and the budget balance. One natural MED policy makers’ response would be to implement austerity measures; however, such measures which may be necessary, are socially costly in the current social context in MED countries, and would not alone permit to stabilize the budget balance given that they would leave the trade balance unaffected. Our findings thus represent a warning against such ‘ready-made’ macroeconomic policy responses and indicate that austerity policy in EU countries have unexpected consequences for fiscal stability in MED countries. We thus call for better macroeconomic policy coordination between the EU and its Southern peripheral MED countries.

A major policy issue to be faced in the coming years is whether macroeconomic policies have reached a dead end and are in a bind. With respect to the introduction of macroeconomic stabilization programs in the EU and MED countries, there is obviously no room to use both monetary and fiscal policies in tandem to curb those macroeconomic imbalances. For the MED countries of Lebanon and Jordan with very limited fiscal space and fixed exchange rates and open capital accounts, monetary policy is already ineffective in terms of macroeconomic stabilization. Egypt rendered its monetary policy more effective in dealing with external shocks after the recent smart move to a flexible exchange rate regime. Tunisia and Morocco seem to be also moving in that same direction. While fiscal space in the EU is also limited due to the past accumulation of huge public debts, the European Central Bank’s (ECB) Quantitative Easing (QE) policy remains an effective tool in preventing the EU’s unsustainable fiscal policies form developing into further debt crises similar to the Greek debt crisis.

With the current debt crisis unfolding in some EU countries, low GDP growth rates and oil prices and high debt levels in several MED countries, fiscal policy is clearly not a macroeconomic policy option anymore due to limited fiscal space. With one monetary policy conducted by the ECB and the absence of a political union, EU countries have registered over the past decade significant current account and budget deficits. Monetary Policy will remain ineffective as long as expectations of the private sector are not adjusted positively, and banks remain in poor shape, mainly Italian and Greek banks. The Greek Debt crisis is negatively affecting the behavior and expectations of businesses and consumers, and austerity measures are negatively affecting aggregate demand and the growth rate of GDP. In particular, stagnant wages and high unemployment rates are adversely affecting domestic demand, especially in the absence of fiscal space in most MED and EU countries due to the accumulation of large public debts and recurrent budget and current account deficits.

In the MED region, the ineffectiveness of monetary policy is due to the presence of fixed exchange rates and free capital movements. This boils down to no role for government policies (fiscal and monetary) to deal with the current macroeconomic imbalances paving the way for future fiscal and currency crises. Thus, the various EU and MED governments will need to: (1) reduce the public sector in favor of the private sector; (2) channel liquidity to the private sector through loans and encourage investments in productive ventures; and (3) reduce government spending and increase only supply side taxes. Finally, given the ineffectiveness of both monetary and fiscal policies, the private sector needs to take a leading role in addressing macroeconomic imbalances by first improving its expectations in both the EU and MED. This would increase the growth rate of GDP and would render debt more sustainable. Once the above is achieved, introduce austerity and structural adjustment measures. This will insure sustainable economic growth and will reduce the likelihood of a future debt and currency crisis.

2008/2009 Euromed Report: Mediterranean Partner Countries Facing the Crisis

Updated on 5/01/10

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Femise Report on Euromed Partnership 2008/2009

Femise has released its latest report on the Euromediterranean Partnership and the situation of the Mediterranean countries. The subject of this year’s report is to provide information about how the crisis is affecting the Mediterranean Countries.

To address these issues, this report will assess in a first part, the crisis from a general perspective, following three chapters: (i) The first chapter aims to determine how the international crisis is going to affect the Mediterranean countries by focusing on the unprecedented aspects of the processes; (ii) The second chapter will detail the system of interdependence linking the Mediterranean countries with the rest of the world, especially Europe via trade of goods and services, direct investment and transfers; (iii) The third chapter is devoted to give an overview of the current social policies set up in the Mediterranean countries, which will play a decisive role in a context where the MPC population is already struggling with unemployment and under-employment.

In the second part, the report addresses  the current situation of the south Mediterranean economies concerned, country by country.

Download the English version of the Report (210 pages – 5 Mo)

Table of Contents

An inescapable crisis
Part one – General overview: MPCs faced with the world crisis
Chapter I: The international crisis and its repercussions in MPCs
I. Tools for understanding an unprecedented crisis
II. The crisis in MPCs: the financial impact is today marginal but the real impact poses more of a threat
III. A much more dangerous crisis in the real sphere
IV. A macroeconomic balance under tight pressure
V. The beginnings of answers in a context of uncertainties
Chapter II. An essential requirement: consolidation of the regional interdependence system
I. Une ouverture qui s’est accélérée mais avec des fragilités
1. Greater opening to world trade of goods ending in a recurrent deficit
2. Commercial positions in the trade of goods on an underlying downward trend
3. Deterioration accelerated by the crisis and affecting new specialisations
4. Substantial international engagement in services
5. Lessons and stakes of a globalisation process begun 20 years ago
II. Regional allegiance: what dynamics and what protection?
1. A multiplication of regional level trade agreements and a growing de facto
commitment towards the rest of the world
2. The weakness of intra MPC trade is a sign of large development potential
3. A sizeable evolution in sectoral specialisations
4. Understanding the position of MPCs on external markets
5. Specialisation and contribution to the trade balance
6. The enhancement of positions on external markets in terms of specialisations
III. Regional orientation of FDI
1. The acceleration of FDI in the second half of the 2000s
2. A dependence on European and Gulf State flows
3. The economic consequences of this flow of direct investment
4. A post-crisis which requires more attractiveness from the MPCs
5. Conclusions
Chapter III. Social cover in the Mediterranean
I. The social services offer in the MPCs
1. Inventory of social protection systems in the Mediterranean
2. Operating principles: structural limits and questions linked to the context of the crisis
II. The results obtained by the current systems of protection
1. Considerable progress of the healthcare state, but still a marked gap with Europe
2. Varied effectiveness of social policies in the reduction of poverty
3. Evolution of inequalities
III. Leads for recommendations for social policies in a context of crisis
1. Reform of the health sector
2. The strengthening of Social Protection
3. Promote employment and participation in the formal job market and fight unemployment
4. The reduction or elimination of price subsidies and the adoption of alternative regimes
5. The need to find an alternative methodology for measuring well-being
6. The need for pluriannual budgetary programming for optimal visibility of strategic choices
IV. In conclusion
Part two – Detailed situation in MPCs : country sheets