MSc. Economics 2013 - 2014

Current Accounts: Put It On The Tab

Fintan English ∗

Ignacio Garron Vedia †

Shreyo Malik ‡

June 6, 2014

∗fintan.english@barcelonagse.eu†ignacio.garron@barcelonagse.eu‡shreyo.mallik@barcelonagse.eu

1

Abstract

This paper investigates the effect of tradable versus non-tradable sector invest-

ments on long-run current account sustainability in the European Union (EU). We

test the model proposed by Giavazzi and Spaventa [2010], which says that current

account imbalances in the EU are affected by the lagged sectorial investment deci-

sions of member countries. To capture this effect we have created a variable which

shows the difference in allocation in investment in tradable and non-tradable in-

dustries per country, using the input-output tables for each country to determine

industries tradability as explained by Attewell and Crossan [2013]. Following this,

we ran regressions with robust variables as specified in Jaumotte and Sodsriwiboon

[2010] and Lee et al. [2008]. Our variable seems to be robust in the short run—

yearly regressions— and long run—3-year average regressions where we used our

variables lag—to explain current account fluctuations. In the short run, this agrees

with the common view that many countries that were running large deficits had

their foreign debt allocated to non-tradable sectors (such as construction and con-

sumption). While in the long run we found the persistent effects of investment in

non-tradable goods lead to current account imbalances, as Giavazzi and Spaventa

[2010] suggests.

Keywords: Current Account, Sustainable Borrowing, Investment Allocation

We would like to thank Professor Luca Fornaro for his insightful comments.

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Contents

1 Introduction 4

2 Convergence among EU countries? 6

3 Theoretical Framework 9

4 Empirical Evidence 11

4.1 Data and Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4.2 Regressions on Current Account . . . . . . . . . . . . . . . . . . . . 12

5 Conclusions 15

A Data 18

B Regressions 19

C Calculating the TFP 20

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1 Introduction

The European integration is a phenomenon that was born after World War II,

with the objective to ensure lasting peace and integrate industries among European

countries. This process went from a free trade zone, in which labor and capital

could move with no restrictions, to a monetary union. The process began in 1957

with six countries and evolved to twenty-six countries in 2010. The integration of

these European countries has been seen as a great success for many years, this was

until it faults were visible for the entire world to see, during the financial crisis of

2008. One of the debates that were neglected by both, the academics and policy

makers, was the importance of the high current account imbalances that were being

run by many members of the European Monetary Union (EMU).

Many researchers cite Ingram [1973] as the first paper in which the idea that

under a monetary union, the current account imbalances are no longer relevant came

to the forefront of economic opinion. Moreover, the idea was that since short run

imbalances could be financed completely by the financial market, no monetary policy

was need. However, in the long run this potentially leads to countries accumulating

large amounts of unsustainable foreign debt — the lesser developed countries —.

At the same time, he pointed out the necessity that foreign investment should be

placed on productive sectors.

Addressing this problem, Blanchard and Giavazzi [2002] using an inter-temporal

model, show that foreign borrowing is optimal for a converging country and that

the recommended level of external borrowing is higher, and hence the savings are

lower or the investment is higher. They also point out that the greater the country’s

expected output growth relative to the area average, the lower is the wedge between

the domestic and the foreign interest rate and higher is the elasticity of substitution

between domestic and foreign goods. In the case of the EMU, the single market

reduced the interest rate wedge and increased the elasticity of substitution between

home and foreign goods. For countries at the periphery of the union, with lower

initial levels of per capita income and the optimal levels of external borrowing, this

lead to an excess of investment over savings that resulted in the consequent current

account deficits.

However, this model relies on two key assumption: i) the existence of a catching-

4

up process and ii) that the future surplus in current account offsets its deficits.

Giavazzi and Spaventa [2010] argue that these two are current violations of the

incumbent countries of the EMU. They explain that the sectors in which coun-

tries where using the foreign capital inflows were highly unstable (construction and

consumption). Moreover, since the monetary union removed the external capital

constraint in the short run, classical monetary policy—inflation targeting—could

not do anything against the crazy increases in credits in some countries fueled by

current account imbalances. Clearly, current account still matters.

In this paper we mainly advocate on the allocation of investment and the effect

on the current account. As Ingram [1973] and Giavazzi and Spaventa [2010] suggest,

allocation of investment matter and could potentially lead to problems in the current

account. We model this idea by constructing a variable, that later will be input into

traditional current regressions by (Lee et al. [2008] and Jaumotte and Sodsriwiboon

[2010]). In order to define the allocation of investment within these two categories,

we used the definition of tradable and non-tradable countries used by Attewell and

Crossan [2013] with the mid 2000s input-output tables of each country. We defined

this variable as the difference in shares of investment in tradable and non-tradable

sectors (DINV EST ). The correlations between current account and DINV EST

comes out to be robust with a variety of controls, which means that those countries

who were running a current account deficit also had a large investment in the non-

tradable sector. This is not surprising since it is in line with the common view that

capital inflows mainly financed construction booms. However, following giavazzi we

add a persistence term (the lag of DINV EST ) to check that current account is

somewhat influenced by allocation of investment in previous periods. In this sense,

our strategy was to run 3-year average regressions and incorporate this variable1.

The paper is structured as follows. In section 2, we do a literature review about

the convergence hypothesis in the European Union countries, and contrast it with

our empirical results of a simple Total Factor Productivity set-up. With this we

plan to state the importance of current account in the current EMU. In Section

3 is derived a theoretical model on optimal external borrowing to introduce the

conditions for the sustainability of the external borrowing under sectorial allocation

1The optimal situation would be to have a larger sample of years to analyzing this, however the

availability of the data makes this possible only after 1995.

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of investment financed with foreign debt. Data, variables and regressions are address

in Section 4, as a prelude for the conclusions in Section 5.

2 Convergence among EU countries?

Previous to the economic crash of 2008 it had widely been believed that running a

large current account deficit was nothing to be concerned about. It was just the sign

of poorer countries within the EU receiving investments generated by their higher

rates of returns. Thus, it was believed that poorer countries should run high current

account deficits while the richer countries within the union should be running large

current account surpluses to finance this. With the introduction of the European

Monetary Union it was believed that a combination of both trade and financial

liberalisation would allow for both cheaper and more attractive borrowing. Whilst

allowing for greater integration in the goods market, created greater demand for

countries goods, allowing them to generated revenue and be able to pay back their

debt in the long run.

Ingram [1973] uses the example of Puerto Rico’s integration with the United

States to argue for a European Monetary Union. Explaining how the financial

integration allowed for a jump in investment from 16% to 20% of GDP and an

increase in their current account deficit to 12%. He went on to explain how ”the

traditional concept of a deficit or a surplus in a member nation’s balance of payments

becomes blurred”.

A paper by Blanchard and Giavazzi [2002] goes on to analyse this belief about

current account deficits and check Ingram’s Hypothesis. They use an intertemporal

model to formalise this argument that ”borrowing countries will want to borrow

more. And, by a symmetric argument, lender countries will want to lend more” as

this is optimal in the traditional idea of convergence. They go on to look at OECD

panel data since 1975 and document the evolution of Portugal and Greece at the

time. They found that as investment increased and savings fell, due to future growth

prospects and financial market liberalisation generating a lower saving rate, current

account deficits were driven up. They came to conclude that Portugal and Greece

should not worry or take action to reduce their deficits, and that an attitude of

”benign neglect vis a vis the current account in Euro area countries is appropriate”

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as this was all just part of the convergence process as Portugal and Greece caught

up with the other members of the European Monetary Union. They even came

close to arguing that a U.S style state system could be considered as a possibility,

ending the collection of current account statistics. At the time it seemed hard to

argue against this, as this looked to be the case that convergence and integration

lead to large current account deficits in countries.

In 2008 the European Commission [2008] released a report analysing the progress

of the European Monetary Union since its installation and came to the conclusion

that it was a ”resounding success”. They argued that the large scale investment

spurred by capital inflows were attracted by the prospect of higher rates of return

and that this was driven by financial integration. However, one key important

feature about Ingram’s argument was the fact that large current account deficits

and high external debt only held as long as ”the proceeds of external borrowing are

used for... productive purposes” and that ”to finance unemployment compensations

or other income-maintenance programs by external borrowing would be asking for

trouble!” Following the Financial Crisis in 2008 it came to light that this had in

fact not been the case and that large current account imbalances and low levels

of household savings where in fact not something that could be swept under the

carpet and neglected. It did not appear that these countries were able to satisfy

the underlying economic assumptions; that they were satisfying their inter-temporal

budget constraints through future surpluses.

Giavazzi and Spaventa [2010], come to find that this belief was flawed in the EU

and that in fact against popular belief at the time growth in ”cohesion” countries

had not been driven by sustainable current account deficits. It came to be found that

these countries had been accumulating large amounts of foreign indebtedness, which

previously had not been a concern when the times were going well, and this was just

seen as part of the process of convergence between member countries. They found

that growth in these countries had in reality not been driven by increases in total

factor productivity, which would have been consistent with convergence theory, but

rather by increases in labour contributions. They note that in Portugal and Spain

the total factor productivity collapsed and in Ireland it declined, with only Greece

representing something closer to a classical convergence model with rising TFP

and declining reliance on factors. It appears that Spanish GDP growth appeared

7

to have relied almost entirely on employment growth and capital deepening. Our

simple TFP calculations, which can be found in the appendix, follow this same

pattern, they do not decline however, but remain at a constant level with no clear

signs of growth rate in factors of productivity, which is consistent with evidence

showing there were no clear signs of convergence on productivity. Also you can

see that growth rates in labour and capital declined dramatically following the

recession. One key argument they make about convergence and the acceptability

of large current account deficits, which we are going to focus on in this paper, is

the ”simple reason is that if a country borrows mostly to finance the production

of non-traded goods it will eventually violate its inter-temporal budget constraint

since it will be unable to generate the export surplus to satisfy the inter-temporal

budget constraint.” This is evidently what happened in Ireland and Spain where

growth was driven by a construction boom which accounted for large shares of total

investment in these two countries.

Sondermann [2012] further develops this argument providing empirical evidence

to see if in reality there has been productivity convergence among euro area coun-

tries. He establishes his argument using a Bai and Ng test and a Pesaran unit root

test and finds that ”the majority of sectors depict no evidence of convergence” also

finding that there is no convergence in the manufacturing industries which largely

produce tradables. Another issue created from the introduction of the EMU and

financial integration was that currency and liquidity risk was eliminated, meaning

that even low yield differentials would attract massive capital flows as explained in

Lane [2010]. As we stated in section 1, it is required that the budget constraint

is sustainable in the EMU in the long run, so that the countries will converge to

the same steady state. However, the recent empirical findings we have shown be-

fore suggest that this is not the case. As a consequence, current account matters

and it is important to keep looking for potential explanation and determinants that

could affect this variable. Before presenting the empirical findings of our current

account regressions, we present a theoretical model that helps our understanding of

the effects in allocations on non-tradable sectors financed by foreign investment on

current account.

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3 Theoretical Framework

In this section we derive the model proposed by Giavazzi and Spaventa [2010], which

addresses the problems of investing in non-tradable sectors and their repercussions

in the current account. Even though this is a simple model of two periods, with

no labor and households optimally conditions, it gives the understanding of the

implications of having one country borrowing mainly to finance the production

of non-tradable sectors. The intuition is that since the capital allocated in these

sectors cannot be traded, then it cannot contribute to achieve future surpluses to

stabilize the current account. In other words, in the model countries eventually

end up violating their budget constraint condition. Other models proposed by

Blanchard and Giavazzi [2002] and Fagan and Gaspar [2008], while having a general

equilibrium set up, they first assume that labour is the only factor of production,

and that all capital could be traded in the economy. Clearly, these models cannot

address the particular question we want to analyze, does Allocation of Investment

in non-tradable Sectors Matter for the current account sustainability?

The set up of the model is as follows Giavazzi and Spaventa [2010]. The model

has two periods, t and t + 1, and the economy exchanges traded goods in both

periods. Agents consume in each period, non-tradable N and tradable goods T .

Consumption decisions are not analyzed, since we are mainly interested the inter-

temporal budget constraints of the countries. In both periods can exchange traded

goods with the rest of the world. In the case of non-tradable goods we have the

condition CNt = Y Nt , where CNt denotes the consumption and CNt domestic output

of N at time t. There is no condition for tradable goods as Y Tt is fixed. Domestic

output is divided by tradable and non tradable goods, and it is expressed as follows.

Y Nt+1 = AN (KN

t )α, α = (0, 1) (1)

Y Tt+1 = AT (KT

t )α, α = (0, 1) (2)

where AN and AT denotes the productivity in their respective sectors, and KNt

KTt the amounts invested at time t in the respective sectors. We assume decreasing

returns to capital, no labour, and all capital is financed with foreign capital. Also, we

assume that all capital is capital in time t coming from foreign borrowing F . That

means F finance investment in both sectors in time t: F = KNt +KT

t . Optimality

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conditions are defined when both functions (1) and (2)are equal to their marginal

contribution E(PNt+1) and E(P Tt+1). Thus, we can get the following relation by taking

derivatives and equalizing (3) and (4):

∂Y Nt+1/∂K

Nt = αAN (KN

t )α−1 = E(PNt+1) (3)

∂Y Tt+1/∂K

Tt = αAT (KT

t )α−1 = E(P Tt+1) (4)

(∂KNt /∂K

Tt ) = (AN/AT )1/(1−α)E(PNt+1/P

Tt+1)

1/(1−α) (5)

Note in (5) that that an increase PNt+1, shifts the optimal investment towards the

non-tradable sector, and vice versa. Thus, the trajectory of investment is of the

equilibirum allocation between these two sectors.

Now lets consider the inter-temporal budget constraint of this economy, where F

has to be equal to a current account deficit in the same period, as a consequence of

an excess in consumption over production of tradable goods at time t. The following

period, however, the constraint requires that net exports are sufficient to balance

the debt incurred the previous period:

∂Y Tt+1 − CTt+1 = Ft(1 +R) (6)

KN/KT ≤ [(αAT /(1 +R))(1− CTt+1/YTt+1)]− 1,K = 0 (7)

Basically equation (7) intuition is that the marginal discounted product of tradeable

goods times the share of the exported production of tradable goods in t+ 1, has to

be positive or equal to 0. This budget condition only holds if foreign borrowing is

used to increase the countries’ productivity in tradable goods.

Now, we replace the linearized production function around Y N = 0 to get the

sustainability condition. This means, that a positive value of KN has to be matched

with the future discount surpluses (sustainability condition).

Y N/Y N ≤ [(αAN/(1 +R))(1− CTt+1/YTt+1)]− 1 (8)

The intuition behind (8) is that borrowing money for production is equivalent

as borrowing for consumption inside the countries, as non-tradable goods cannot

be exported by definition. Therefore, the sustainability condition and the budget

constraint are not compatible. We try to model this by adding the lagged of the

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variable we constructed which will be presented later, this attemtps to show that

as countries have increased investment in non-tradables their current accounts have

increased in the long run and show no sign of decreasing to equalise their budget

constraint.

4 Empirical Evidence

4.1 Data and Variables

We have used the data of 25 European countries, collected mainly from the Organ-

isation for Economic Cooperation and Development (OECD), European Central

Bank (ECB), and European Statistics (ES) databases for the period 1995-2012. We

also use for the data base from the World Economic Outlook, International Mone-

tary Fund, United Nations Population (UN), and the data constructed by Lane and

Milesi-Ferretti [2007].

The variables were created following Lee et al. [2008] and Jaumotte and Sodsri-

wiboon [2010] definitions (see Appendix: A Data). They performed an analysis of

the determinants of the current account for different set of countries, with an em-

phasis in the EMU current account determinants, due to the potential consequences

of the large current account deficits that these countries experienced. Their results

show that these variable seem to be robust enough to explain the current account

imbalances of the EMU, and hence we use them. Construction and measurement of

these variables is explained with more detail in appendix (A Data).

In order to address the effect of investing in non-tradable sectors, we construct

a variable that measures the difference of investment shares of Tradable and the

Non-Tradable Sectors (DINV EST ) for each country from 1995 to 2010. We used

the input-output tables for mid 2000s from the OECD database for each of the 25

countries included in our study. These input output tables contain the information

of use (domestic or foreign) and production for i sectors— such as Construction,

Education, Mining and quarrying, etc, according to National Accounts disaggrega-

tion. With this information, for each sector i we calculate the proportion of imports

(Impi) and exports (Expi) from its respective Output Oi. The calculations are as

follows:

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Imppropi = Impi/Oi (9)

Exppropi = Expi/Oi (10)

Each sector or industry is then classified as tradable or non-Tradable based on

the criteria used in Attewell and Crossan [2013]. This paper provides a definition

of the Tradable and Non-Tradable industries within the production based on input

output tables. This way, each sector is defined as tradable if 10% or more of that

industry’s output is exported Exppropi, and/or 20% or more of the supply to that

industry is imported Imppropi. Otherwise, it is defined as non-tradable.

After we classify each sector as Tradable or Non-Tradable, we use it to split

investment in two groups: tradable and non-tradable for each year. As a result,

we define our variable as the difference of investment shares of tradable and the

non-tradable sectors (DINV EST ) for each country from 1995 to 2010. This vari-

able (DINV EST ) is our principal covariate of interest for explaining the current

account.

4.2 Regressions on Current Account

We performed a yearly and a 3-year average regression by Generalized least Squares

(see Appendix: B Regressions) which focuses on long run determinants of the cur-

rent account. The panel covers 25 country members of the EU from 1995 to 2010.

Details about the data, measurements and definitions are found in appendix (A

Data). Table 1 illustrates the preferred specification of the short-run model, where

columns denote the inclusion of (1) standard variables, (2) growth opportunities,

(3) demographics and financial factors (4) EMU factors. Except for the lagged sav-

ings rate which is not significant, the government balance—negative effect—, the

catching up process of the growth rate (relative to the US)—decreasing effect—,

the increasing effect of demographic variables, and financial factors signs are as ex-

pected. Regarding the EMU and euro factors effects, we can see that the integration

process overall decreased the current account in the countries, except for north Eu-

ropean Countries that belong to the EMU. We can see that our variable DINV EST

is positively significant during this period, meaning that allocation of investment in

non-tradable sectors is correlated with current account deficits. This is in part due

12

to many investments which went to non-tradable goods (such as construction) that

were harmed during the financial crisis that started in 2008.

Current Account as % of GDP

Dependent Variables (1) (2) (3) (4)

DINVEST 1.61* 2.27*** 1.64** 1.40*

LAGGEDNFA 0.00*** 0.00*** 0.00*** 0.00***

GOVBAL -0.12*** -0.08** -0.07* -0.07*

GDPGR -0.07** -0.06** -0.07**

RELINC 0.12*** 0.10*** 0.10***

POPGR 0.73*** 0.73***

CDR 0.04 0.02

ODR 0.14** 0.18***

DUMMYFC 2.74*** 2.90***

LAGGEDSR 0.01 0.01

DUMMYSEMU -0.47

DUMMYNEMU -0.37

DUMMYSE -1.52***

cons 0.14 -7.73*** -13.44*** -13.05***

chi2 41.10 169.80 208.36 225.55

N 381 381 377 377

∗(p < 0.1), ∗ ∗ (p < 0.05),∗ ∗ ∗(p < 0.01).

Table 1: Yearly Regressions (1995-2010) on Current Account (% GDP)

However, we are not interested perse in the contemporaneous correlation be-

tween the current account and DINV EST . As Giavazzi and Spaventa [2010] sug-

gest, we are interested in testing that past sectorial allocation in investment could

cause large deficits in the current account. This is mainly due to the fact that

the budget constraint and the sustainability condition will not match when foreign

investment is going to non-tradable sectors. To test this, we take 3-year averages

of the panel and run the same regression changing DINV EST for DINV ESTt−1

and again we check its robustness.

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Current Account as % of GDP

Dependent Variables (1) (2) (3) (4)

DINVESTt−1 0.63* 3.13*** 2.82*** 2.56***

LAGGEDNFA 0.00** 0.00*** 0.00*** 0.00***

GOVBAL 0.50*** 0.29*** 0.22*** 0.26***

GDPGR -0.65*** -0.57*** -0.61***

RELINC 0.12*** 0.13*** 0.12***

POPGR 1.94*** 1.65***

CDR 0.03 0.02

ODR -0.04 -0.04

DUMMYFC 0.17 0.14

LAGGEDSR 0.01 0.01

DUMMYSEMU -0.61

DUMMYNEMU 0.43

DUMMYSE -1.55

cons -1.12** -6.57*** -8.39*** -6.98**

chi2 30.84 1541.35 1966.91 1543.36

N 98 98 98 98

∗(p < 0.1), ∗ ∗ (p < 0.05),∗ ∗ ∗(p < 0.01).

Table 2: 3-year Average Regressions (1995-2010) on Current Account (% GDP)

Table 2 shows the results of the long-run regression on current account explained

above. We verify that the current account is positively correlated with the invest-

ment allocation in non-tradable sectors, meaning that there seems to be a persistence

effect as Giavazzi and Spaventa [2010] suggest. More interestingly, this leads to ex-

plain the idea against popular belief before the recession that foreign investment

and accumulation of debt was not a good idea. In fact current accounts should have

been kept in check as countries were being allowed to accumulate large amounts

of unsustainable debt whilst there was no supervision that they were allocating it

efficiently. As countries borrowed more, with the promise that they would be able

to pay it back in the future, they were in reality investing in non tradables and

14

growing their current account deficits as can be seen in our 3-year average regres-

sions. As we can see, all variables have followed the same pattern as the yearly

regressions, however, EMU and EU factors, are no longer significant at explaining

long run current account. This could mean, that integration has more of a short

run effect than long run on current accounts.

5 Conclusions

Accumulation of large current account deficits had previously just been seen as a

sign of a poorer country, once joining the monetary union, following the path to

convergence as presented so many times in neo-classical models. However, as the

economic crisis of 2008 has come to show, the theory is not always matched by

reality. It was believed that if countries were able to assign their investments effi-

ciently then within the EMU current accounts deficits could be ignored, as in the

long run they would equalise. This paper presents empirical evidence to support the

arguments presented by Giavazzi and Spaventa [2010] that countries had been naive

about the consequences of their allocation of investment with foreign debt, and thus

affecting current account sustainability. Overall, as others have also found (Sonder-

mann [2012], Giavazzi and Spaventa [2010]), in the long-run as current accounts

had been increased across countries in the EMU, these countries do not appear to

have converged as neo-classical growth theory suggests.

As in Giavazzi and Spaventa [2010], we attribute the deficit in current account to

the past allocation of investment that went more into non-tradable industries than

tradable industries. In order to test this hypothesis, we ran regressions specifica-

tions used in other works (Jaumotte and Sodsriwiboon [2010] and Lee et al. [2008])

with our variable DINV EST , that captures this idea. The results show that our

variable seems to be robust both in the short run—yearly regressions— and long

run—3-year average regressions where we used our variables lag—to explain cur-

rent account fluctuations. In the short run, this agrees with the common view that

many countries that were running large deficits had their foreign debt allocated to

non-tradable sectors (such as construction and consumption). While in the long run

we found the persistent effects of investment in non-tradable goods lead to current

account imbalances, as Giavazzi and Spaventa [2010] suggests.

15

This is an explanation of what happened in many of the ’cohesion’, countries as

they opted to invest in temptations such as construction and consumption, which

falsely lead them to believe that their economic growth was going to last forever

and that their current account deficits were not important. Also, as presented by

our TFP calculations, many of these countries invested in capital and labour factor

deepening, rather than improving their productivity which would have been far

more prudent.

To conclude, we are not arguing against the accumulation of current account

deficits, but rather for investments that lead to expansions in factor productivity

within the given country, such as investments in RD and innovative sectors. At

the same time, countries should adjust their investment structure to move away

from such large proportions in non-tradable industries and expand their allocation

of foreign debt towards tradable industries.

16

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A Data

Our sample includes data from the following 25 countries from the European Union

(EU) spread across 16 years from 1995 to 2010: Belgium, Bulgaria, Cyprus, Czech

Republic, Denmark, Estonia, France, Germany, Greece, Hungary, Ireland, Italy,

Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania,

Slovak Republic, Spain, Sweden and United Kingdom. As we already discussed, this

data was collected mainly from the Organisation for Economic Cooperation and De-

velopment (OECD), European Central Bank (ECB), and European Statistics (ES)

databases. We also use the database from the World Economic Outlook, Interna-

tional Monetary Fund, United Nations Population (UN), and the data constructed

by Lane and Milesi-Ferretti [2007]. The groups of control variables are the ones

thought to be robust by Jaumotte and Sodsriwiboon [2010] and Lee et al. [2008],

and are defined as follows:

(I) Standard Variables

• Lagged Net Foreign Assets (LAGGEDNFA): It is measured as the ratio of

NFA to GDP prevailing at the beginning of each 4-year period. We used the

database constructed by Lane and Milesi-Ferretti [2007].

• General Government Balance (GOV BAL): It gives the government’s proposed

revenues and spending for a financial year expressed as percentages of GDP.

(II) Growth Opportunities

• Real GDP Growth Rate (GDPGR): It gives the percentage growth of real

Gross Domestic Product (GDP) over the years from 1995 to 2010.

• Income per capita relative to the United States (RELINC): It is measured

as the ratio of per-capita PPP income to the US level, both in constant 2000

international dollars.

(III) Demographics

• Growth Rate of Population (POPGR) : It gives the percentage change in the

population over the period 1995-2010.

• Child-dependency Ratio (CDR): It is the ratio of population aged <= 24 per

100 of the population aged 25− 64.

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• Old-age Dependency Ratio (ODR): It is the ratio of population aged 65+ per

100 of the population aged 25− 64.

• Lagged Savings Rate (LAGGEDSR) : It is measured as the percentage change

in the lagged savings over the years from 1995 to 2010.

(IV) Financial Factors

• Dummy Variable for Financial Center (DUMMY FC): It is the indicator for

the years the respective country is a financial center.

(V) EMU and Euro factors

• Northern EMU Dummy Variable (DUMMYNEMU): It is the indicator for

the years the countries in the Northern European Area (NEA) belong to the

EMU.

• Southern EMU Dummy Variable (DUMMYSEMU): It is the indicator for

the years the countries in the Southern European Area (SEA) belong to the

EMU.

• Northern euro Dummy Variable (DUMMYNE): It is the indicator for the

years the NEA countries use Euro as their Currency.

• Southern euro Dummy Variable (DUMMYSE): It is the indicator for the

years the SEA countries use Euro as their Currency.

B Regressions

We estimated the specification showed in Table 1 and Table 2 by Generalized Least

Squares (GLS) with Random Effects (RE). This estimation was preferred for two

reasons: i) there was a persistence auto-correlation and heteroscedasticity in the

error term; and ii) according to Haussman test, RE was preferred over Fixed Effects.

Therefore, GLS with RE allows both, the estimation in the presence of AR(1)

auto-correlation within panels and cross-sectional correlation and heteroscedasticity

across panels. We did not include time effects, since these were collinear with the

Euro Factors dummies.

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C Calculating the TFP

When calculating the TFP we took logarithms of the Solow-Swan model and as-

sumed alpha to be 0.7 as the contribution of capital as is the common opinion among

economists. Like so:

Yt = AtK0.7t L0.3

t (11)

LogYt = LogAt + 0.7LogKt + 0.3LogLt (12)

we assume:

Kt+1 = 0.5Kt + It (13)

We collected our data from the Penn World Table and calculated Y as the Population

multiplied by the PPP converted GDP per capita (at 2005 constant prices). L as

PPP converted GDP per capita divided by population multiplied by PPP converted

GDP chain per worker (at 2005 constant prices). I was calculated as Y multiplied

by investment Share of PPP converted GDP per capita (at 2005 constant prices).

We set the initial level of capital as Y in 1950. Following this we calculated the

logarithms and growth rates of each value to be able to calculate the Total Factor

Productivity in each country. Results for Greece, Portugal, Spain, Ireland and Italy

are shown below:

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Figure 1: TFP evolution on Greece (1952-2010)

Figure 2: TFP evolution on Spain (1952-2010)

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Figure 3: TFP evolution on Portugal (1952-2010)

Figure 4: TFP evolution on Ireland (1952-2010)

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Figure 5: TFP evolution in Italy (1952-2010)

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