Explaining and correcting trade imbalances between the Northern and Southern Eurozone: An empirical investigation

In this paper we take a novel approach to examining the trade imbalances between the Southern Eurozone countries and the Northern Eurozone countries by aggregating them into a Southern Group and Northern Group. We then explore three possible causes of the trade imbalances, which are the fiscal channel, the investment channel and the competitiveness channel. We find that all three channels are important in explaining the emergence and correction of trade imbalances. In particular, we find that an increase in fiscal deficits in the North are twice as effective in reducing trade imbalances than fiscal consolidation in the South. By contrast, increased investment in the North has a similar impact to reduced investment in the South in correcting the trade imbalances. Finally, we find that a depreciation of the South's real exchange rate is associated with a long run deterioration in the Southern Group's trade balance suggesting that the South needs to seek non-price competitiveness channels to address its trade imbalances.