Beyond Balassa and Samuelson: Real convergence, capital flows, and competitiveness in Greece

The paper scrutinizes the role of capital flows for competitiveness in a set of seven Euro Area member countries (Greece, Portugal, Latvia, Estonia, Lithuania, Slovenia and the Slovak Republic) in the context of real convergence and crisis with a specific focus on Greece. For this purpose it extends the seminal Balassa-Samuelson model for international capital markets with a particular focus on their impact on national wage policies. Capital flows are assumed to be able to inverse the traditional direction of transmission of real wage increases from the tradable sector to the non-tradable sector (inverted Balassa-Samuelson effect). The augmented Balassa-Samuelson model is extended to trace cyclical deviations of real exchange rates from the productivity-driven equilibrium path.

Panel estimations for the period from 1995 to 2013 reveal strong evidence for the Balassa-Samuelson effect (especially, if Greece is left out from the panel), evidence in favour of the inverted Balassa-Samuelson effect (if Greece is included) and thus mixed results for the role of capital markets for international competitiveness. The best specifications include a crisis dummy as 1 for 2008 to 2013 and 0 otherwise. Seen on the whole, thus, there is significant evidence of the inverted or reverse Balassa-Samuelson effect in Greece and in some cases also in other Euro area member countries.

Generalised for the whole country sample, this impact may cover both capital inflows which contribute to productivity-driven inflation and capital inflows which are translated directly into inflation and are not backed by respective productivity gains. Our estimation efforts can be seen as an approach to also capture the cyclical capital inflows which may contribute to non-productivity backed inflation and therefore to a structural loss in competitiveness.