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

To better understand the convergence process prior and since the European financial and debt crisis, we scrutinise the role of capital flows for competitiveness in Greece and a set of six other euro area countries (Portugal, Latvia, Estonia, Lithuania, Slovenia and the Slovak Republic). For this purpose, the paper extends the seminal Balassa-Samuelson model by international capital markets with a particular focus on their impact on national wage policies. Capital flows are assumed to be able to invert the traditional direction of transmission of real wage increases from the tradable sector to the non-tradable sector and to make real wages increase beyond productivity increases. 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 correlations in line with the Balassa-Samuelson effect, if Greece is excluded from the panel. For Greece, this in turn implies indication in favour of credit-driven real wage increases beyond productivity increases what we call a "pseudo" Balassa-Samuelson effect.