At the same time, using fiscal retrenchment to offset domestic demand pressures powered by surging credit and intra-regional capital flows might be, to some extent, counterproductive. Fiscal contractions may conflict with other objectives of fiscal policy while their feasibility may be questionable if public debt is low and fiscal accounts are on a sound footing. It is worth noting that in at least two Eurozone periphery countries (Ireland and Spain) fiscal imbalances were nonexistent before the 2008-09 global economic crisis, while public debt was at very low levels. This made it difficult to resort to fiscal tightening as a means of countering the domestic demand boom fuelled by the surge in credit growth.<sup>18</sup> A more coordinated approach to fiscal policy across the Eurozone would facilitate the management of external imbalances without placing an excessive — and often unwarranted — burden on fiscal tightening in countries affected by credit booms. Coordination of fiscal policies could be achieved by rebalancing the fiscal stance across periphery and core countries so as to alleviate the burden of fiscal adjustment in the periphery while boosting domestic demand in the core through some degree of fiscal easing. Fiscal expansion in the surplus countries — to the extent their fiscal positions are sustainable — would boost the external demand faced by deficit countries and would contribute to a more efficient absorption of the external imbalances triggered by periphery domestic demand booms. The EU Commission’s new Macroeconomic Imbalance Procedure could thus benefit by placing symmetric emphasis on steps to restore external balance in deficit countries and on options to reduce excessive surpluses in other countries by expanding demand (also see European Parliament, 2012). More flexibility in the EU’s fiscal compact may also be needed to make possible adjustments to national fiscal policies that would facilitate absorption of intra-zone external imbalances through offsetting changes in the fiscal stance of deficit and surplus countries.

A second corollary of our findings is that the policies of internal devaluation implemented in Eurozone periphery countries, aimed at containing labor cost growth and promoting external competitiveness, may have had only limited effectiveness in restoring the external balance to equilibrium. Internal devaluation through direct wage cuts or aggressive labor market deregulation to contain wage growth certainly helps absorb part of the external imbalances by depreciating the real exchange rate or by reducing unit labor costs. However, our results suggest that the current account adjustment that has been achieved through this channel appears to be relatively minor as the competitiveness channel has not been the main driver of the periphery’s external imbalances. On the other hand, internal devaluation may have certainly contributed to a contraction of domestic demand and, through this channel, helped absorb external imbalances in the Eurozone periphery. However, the policy goal of restoring the external balance would have been achieved inefficiently (if Pareto-efficiency is a criterion for policy making), through the

> 18 In 2006-07, on average, the overall fiscal balance was in surplus, at 1.5 and 2 percent of GDP respectively in Ireland and Spain. Gross public debt in proportion to GDP was 25 percent in Ireland and 38 percent in Spain. During the same period, the average fiscal deficit in the Eurozone was 1 percent of GDP while public debt was, on average, 67.5 percent of GDP (IMF, Fiscal Monitor, October 2012).

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