Causality within the Euro area?: Trade surplus in the North versus public debt in the South

Abstract

The United States subprime mortgage crisis began to spread to Europe in 2008. The worst affected were periphery countries that experienced drastic declines in international competitiveness and thus accumulated large public debts. High public debt drove countries such as Greece, Ireland, Portugal, Cyprus, and Spain to the verge of economic collapse. This study examines whether trade imbalances led to high public indebtedness in the periphery euro area countries. To investigate the impact of northern euro area countries’ trade surpluses on southern euro area countries’ public debt, we estimated bivariate and trivariate Vector Error Correction Models. We then employed these estimated models to test for Granger causality between trade imbalances and public debt. We found that trade surpluses in the northern euro area countries caused an increase in public debt in the periphery countries. However, only limited evidence for reverse causality was found.