Does the Eurozone need a fiscal capacity?

Table of content

1. Introduction

2. The optimal currency area theory
2.1 Automatic adjustment under a flexible exchange rate regime
2.2 Wage flexibility
2.3 High factor mobility
2.4 Financial market integration
2.5 The degree of economic openness
2.6 Similarities in institutions
2.7 Diversification in production and consumption
2.8 Similarities in inflation rates and preferences
2.9 Political integration and political feasibility
2.10 Fiscal transfers

3. Selected issues on the Eurozone and optimal currency area criteria
3.1 Business cycle convergence
3.2 Inflation differentials
3.3 Current account imbalances

4. Rationale and options for a fiscal capacity in the Eurozone
4.1 Packs, compacts and mechanisms – steps taken so far.
4.1.1 Effect on business cycle convergence
4.1.2 Effect of efficacy on inflation differentials
4.1.3 Effect of efficacy on current account deficits
4.1.4 The Banking Union and its contribution to business cycle convergence
4.2 Automatic stabilisers
4.2.1 Estimation utilising macro models
4.2.2 Estimation utilising micro models
4.2.3 The case for an EMU-wide automatic stabiliser
4.3 European Tax-benefits system and a European economic agency
4.4 Fiscal transfers based on macroeconomic variable
4.5 A EMU –wide unemployment insurance

5. Conclusion and critical assessment

References

Annex A: Own simulation of Enderlein et al. (2012) model

Annex B: Application of 1.2 multiplier on Dullien (2013) model

List of Figures

Figure 1 Idiosyncratic shock and adjustment process in a two country case

Figure 2 Adjustment in the case of downward flexible wages

Figure 3 Heat map of business cycle divergence

Figure 4 Unweighted dispersion of inflation rates in US and EMU

Figure 5 Unweighted development of GDP per Employee 2000-2013 (Index 2000 = 100)

Figure 6 Real interest rate effect of inflation and the effect on competitiveness

Figure 7 Stock of credit to households, non-MFI corporations and non-profit institutions with its counterparty in the EMU (Index 2003 =100%)

Figure 8 Development of Current Account in the Euro Area, North- and GIIPS-countries (in bn. Euro)

Figure 9 Estimated stabilisation effect by channel in case of a unemployment shock (EUROMOD and TAXSIM simulations)

Figure 10 Estimated stabilisation effect by channel in case of an income shock (EUROMOD and TAXSIM simulations)

Figure 11 Results of EUROMOD simulation for automatic stabilisation in case of 5% income shock

Figure 12 Results of modified EUROMOD simulation on stabilisation

Figure 13 Proposed disbursement schedule in a real time setup of the CSI

Figure 14 Simulated effect of CSI on dispersion of output gap relative to observed dispersion

Figure 15 Contribution and benefits relative to central government revenue (Real time simulation data)

Figure 16 Swings in net position based on real time data from EC Economic Forecasts 2000 - 2014

Figure 17 Integration of European basic and national unemployment insurance systems

Figure 18 Simulated effect of EUI on dispersion of output gap relative to observed dispersion

List of Tables

Table 1 Empirical estimates of Fiscal Stabilisation by different channels using macro data

Table 2 Empirical estimates of Fiscal Stabilisation by different channels using micro data

Table 3 Results of EUROMOD simulation for full and partial integration

Table 4 Net flows of funds in EUI simulation (in bn. 2010 Euros)

1. Introduction

The European Monetary and Economic Union (EMU) is often described as a house without a roof. It is nice to be in it when the sun is shining but a horrible place to be when it starts to rain. A roof in this case alludes to the fact that the Euro is a currency without a state. MacDougall (1977) has addressed this issue in the 1970’s where he highlighted the necessity of a fiscal capacity. He proposed that before a common currency could be introduced, some form of federal budget should be established in order to help aligning the member states more closely to each other. While the MacDougall-report argued more with respect to redistribution and equalisation Delors (1989) stressed the shock-absorption provided by a federal budget. He argued that a common currency relies on the existence of federal mechanisms that allow for stabilisation in case of economic shock on state level. During the first years of the Euro it seemed as if these opinions were wrong. The euro was a stable currency that even threatened the supremacy of the dollar. However, these days are long gone. The financial crisis and the subsequent sovereign debt crisis have revealed that the inherent problems of the euro were covered by immense flows of capital from north to south. When these flows abated the Eurozone was left in a state of large disequilibria without any instruments to cope. In the aftermath reforms in exchange for funds were required from ailing governments in order to put the Eurozone back on track. However, as readjustment takes longer than expected the political, economic and social costs have increased strongly (see exemplarily Sinn (2012)).

This master thesis picks up on this topic and tackles the question whether or not the Eurozone needs a common budget or transfers mechanism in order to cope with the challenges of a common currency – in short: does the Eurozone need a fiscal capacity?

In order to do so Chapter 2 will explore the optimal currency theory and try to determine how fiscal transfers can help to cope with idiosyncratic shocks. Subsequently, Chapter 3 analyses the roots of the large disequilibria in the EMU. An analysis of the degree of business cycle convergence and inflation differentials is conducted and compared to one of the oldest and size wise most comparable monetary unions - the United States of America. This will uncover that differences between the US States and the member states are not very large in terms of dispersion but to an even larger extend in terms of persistency. Especially large inflation differentials have had a strong and prolonged diverging effect on the real interest rate in the EMU member states. This resulted in large macroeconomic imbalances. Both factors were reinforced by procyclical fiscal policy and thus lead to the situation at hand. It also highlights the beneficial properties of countercyclical fiscal policy and presents evidence that imply the utmost importance thereof in the EMU. Chapter 4.1. investigates the role of automatic stabilisers as a shock absorption instrument and tries to determine how much insurance it can provide for the regions in existing federations. It also analyses the effect of existing automatic stabilisers within the member states of the EMU. While these are on average more powerful compared to the US it also presents evidence that accentuate the heterogeneity of automatic stabilisation throughout the EMU. This not only implies that countries have different capabilities to deal with idiosyncratic shock but that they also face different effects in case of a common shock. In Chapter 4.2. the efficacy of the enacted changes in the EMU financial, fiscal and economic framework to cope with the existing weaknesses of the EMU structure is determined. Combining the need for countercyclical fiscal policy, the lack thereof, heterogeneous capabilities of automatic stabilisation and shortcomings of the new framework a case for a European stabilisation instrument is made. Concluding, Chapters 4.3, 4.4 and 4.5 are assessing the potential impact of a European tax-benefit systems and European economic agency, transfer mechanism based on a macroeconomic indicator and a European basic unemployment insurance in terms of business cycle convergence, countercyclical properties and their potential problems.

2. The optimal currency area theory

In the discussion about the necessity of fiscal transfers in the European Economic and M-onetary Union (EMU) implications of the optimal currency area-theory (OCA-theory) are used or implicitly referred to. But what is the OCA theory and why should it be important for the question at hand? The optimal currency area theory tries to infer criteria that allow to concluding whether or not a group of countries gains from introducing a common currency. The costs of a currency union derive from the complete loss of monetary policy as a policy tool. This not only entails the ability to control ones exchange rate but also the determination of the quantity of money and short-term interest rates within the economy. This becomes especially evident in the case of high economic diversity as a common central bank cannot react to country specific necessities of monetary policy but only to a currency area-wide shocks (Baldwin & Wyplosz, 2012). The underlying idea is, that the more heterogeneous economies are the more prone to idiosyncratic shocks they become, which are best dealt with a national monetary policy and exchange rate realignments (ibid.). However, even given these shortcoming, it can still be advantageous to form a currency union for a group of countries. Within a currency union countries gain from decreased transaction cost of trade, higher planning reliability of trade through the elimination of exchange rate risk as well as price transparency across the whole currency area (ibid.). Therefore OCA-theory suggests, that there might be certain attributes of countries that increase the benefit of being in a currency union and other attributes, which increase the cost of being in the currency union. Hence OCA-theory tries to establish a framework that allows to determine the factors that contribute to the opportunity costs of being in a currency union. Following the general approach of discussing OCA-theory the adjustment processes of a country subject to a demand shock outside of a currency union is compared to the readjustment within a currency union. This framework will then be used as a benchmark to determine the opportunity costs of a group of countries that are part of currency union. Figure 1 illustrates this with a simple two country case as proposed by Grauwe (2009): Assume two countries of which both are producing one good with the supply function . The supply function has a positive slope indicating that an increase in the domestic price level generates incentives for producers to increase output in order to benefit from the higher prices. The nominal wages have to be considered rigid and all other input costs are assumed to be constant. A change in the input costs results in the in- or outward shift of the curve. Both countries are joined in a currency union and both consume the good they are producing as well as the good of the other country. The functions are the aggregate demand functions for the goods A and B, respectively. The demand function has a negative slope indicating that an increase in the price level decreases the aggregate demand for the locally produced good. The initial equilibrium is indicated by the price level and the respective output .

A shock is introduced by a change of preference towards an increase in consumption of good A. This results in a higher demand for good A and therefore in an outward shift of the aggregate demand curve of country 1. The lowered demand for good B decreases aggregate demand in country 2 and shifts the curve inward. The new equilibria are . The reduced output of the firms in country 2 leads to lay-offs of not needed workers and an increase in unemployment. Country 1 faces a shortage of workers and therefore and upward pressure on the price level.

Abbildung in dieser Leseprobe nicht enthalten

Figure 1 Idiosyncratic shock and adjustment process in a two country case Abbildung in dieser Leseprobe nicht enthalten

Source: Grauwe (2009).

According to Rose and Sauernheimer (2006) two obvious resolutions to return to the initial equilibrium exist: Either workers migrate from country 2 to country 1 or realignments have to be undertaken by the means of monetary policy. The possibilities to ameliorate the effects of the shock are not only twofold as OCA-theory implies. In order to explore the mechanisms that could allow for an adjustment process, the adjustment process under a national monetary policy and a flexible exchange rate regime is illustrated and compared to each other.

2.1 Automatic adjustment under a flexible exchange rate regime

Due to inflationary pressures and assuming for price level stability as the main target for monetary policy as well as introducing two separate currencies in our initial model, monetary authorities in county 1 would increase interest rates to dampen the aggregate demand to lower the upwards pressure on wages. This would decrease domestic demand for all goods. Additionally, a higher interest rate would certainly trigger capital movement from country 2 leading to an appreciation of the currency of country 1. Inversely, monetary authorities in country 2 would decrease interest rates accelerating capital movements and therefore the appreciation of currency of country 1. This exchange rate effect leads to an increase of the price of good A in country 2 and decreases the price of good B in country 1. Aggregate demand for good B increases while aggregate demand for good A decreases. Eventually, these realignments will lead back to the initial equilibrium accompanied by a gradual return of interest rates to the initial values. While these adjustments are rather straightforward and achievable without long realignment processes, it might still be favourable for a country to forego this policy option given relatively high transactions cost between trade partners under a flexible exchange rate regime. Still, in countries in which other adjustment mechanisms are comparably weak, the loss of exchange rate devaluation as a policy instrument might incur higher costs (Mongelli, 2008). However, it must also be questioned whether or not a nominal exchange rate adjustment would really offset a shock to aggregate demand of imported or exported goods. This only holds if and only if the demand for foreign exchange arises only to pay for imported goods and an equilibrium is achieved if the aggregate cost of imports equals the aggregate revenue of exported goods (Martin Berka, Michael B. Devereux, & Charles Engel, 2012). In this case a change in nominal prices is instantaneously translated into an exchange rate adjustment. In reality exchange rates are also influenced by financial flows, which in turn are driven by possibly false expectations. Thus, nominal exchange rate changes could also hamper the described mechanism hence hindering real exchange rate realignments. Therefore, it must be kept in mind that flexible exchange rates do not automatically imply perfect real exchange rate adjustments when weighting this case as a benchmark against other options in a currency union (ibid.). Even as nominal exchange rate adjustments are not possible within a currency union, mechanisms still exist that allow for real exchange rate adjustment within a currency union. Therefore the costs of fix exchange rates and a common monetary policy can still be outweigh if other mechanisms present apt alternatives. In the following the OCA-theory is utilised to explain under which circumstances and how mechanisms are to be considered viable alternatives.

2.2 Wage flexibility

Figure 2 illustrates the case of flexible wages. If wages are flexible, the necessary realignments due to the demand shock will conduct a faster return to the initial equilibrium and renders the use of exchange rate realignments unnecessary. If wages are not downward rigid, unemployment associated to the decrease in demand for good B in country 2 will lead to lower wages, as the reservation price of workers decreases thus shifting the supply curve downwards. This will in turn decrease the price of good B and make it more competitive in relation to good A. Hence, aggregate demand for good B increases. Inversely, upward pressure on the prices results in higher wages and therefore further increases the prices for good A thereby decreasing aggregate demand (Grauwe, 2009). The more downward rigid wages are, the longer a phase of high unemployment has to last in order to decrease prices strongly enough to increase aggregate demand via the competitiveness channel (Mongelli, 2002). Another option would be for country 1 to increase inflation and wages thereby shifting the supply curve upwards and lower competitiveness of good A. The burden of adjustment would then be carried by country 1 and not by country 2 (ibid.).

Figure 2 Adjustment in the case of downward flexible wages

Abbildung in dieser Leseprobe nicht enthalten

Source: Grauwe (2009).

2.3 High factor mobility

In his ground laying paper, which is considered the beginning of OCA-theory, Mundell (1961) indicates that given downward wage rigidities it is optimal for countries to join into a currency union if there is a high degree of factor mobility between the countries. Instead of the necessity to decrease wages in country 2, laid-off workers could instead move to country 1 taking advantage of increased labour demand, simultaneously decreasing inflationary pressures by decreasing the momentum for second round effects. However, the pace of adjustment is limited as for example direct investments need time to be raised in one country and absorbed in the other. It takes considerable time to move quasi-immobile physical capital. Also it takes some time before a workers misery is large enough to encourage her to migrate to another country despite considerable costs in monetary but also in social terms (Mongelli, 2002). The benefit of a common currency is therefore directly positively related to the ability of factor mobility as it minimizes the potential impact of monetary policy. Still it might be possible that the movement of means of production could take longer to be executed, than the duration of a temporary shock, diminishing the gains from high labour mobility (Baldwin & Wyplosz, 2012). This is especially true if the absorption of new workers prerequisites the creation of new production facilities which might take considerable time to be accomplished (ibid.).

2.4 Financial market integration

Financial market integration allows for a smoothing of income in case of a temporary shock by capital inflows. This is possible via holding of cross-country assets that ensure constant capital inflows from surplus countries, which are not hit by the shock or decumulation of net assets for the duration of the shock. Additionally, financial markets allow corporations who are hit by the decrease of aggregate demand to issue debt or take a loan, helping them to continue operations (Mongelli, 2008). Higher financial market integration deepens the markets and therefore allows for a larger smoothing of shocks (ibid.). Financial markets thereby fulfil an important insurance function and enable risk-sharing between member states allowing for a certain degree of absorption of a demand shock (Grauwe, 2009). However, in the case of a permanent shock, financial markets can only help to smooth the transition to a new equilibrium. In the case of a persistent shock the readjustment still has to be borne by adjusting prices and therefore by deflation and lower wages or by inflation and higher wages in countries not affected by the shock (ibid.).

2.5 The degree of economic openness

The rationale for this argument builds upon the fact, that countries who have a high degree of openness also have a large share of imported goods on their markets. A country trying to readjust after a shock via a devaluation of its currency will also face higher import prices. As high openness translates in a high share of an imported goods in the consumption bundle of the population, inflation will increase rather strongly. Thus the competitiveness enhancing properties of a devaluation will be offset by higher wage demand of workers. Money illusion would not hold and wages in turn increased as workers try to keep their real wages constant. Therefore the loss of monetary policy becomes less costly for countries with a high degree of economic openness in a currency union. This is due to the larger share of imports in the frame of reference used to determine the height of inflation. Therefore money illusion cannot take effect and no decreases of real wages are possible (McKinnon, 1963). Conversely, countries who have a high degree of economic openness generate even larger gains from decreasing transaction costs when becoming member of a currency union.

2.6 Similarities in institutions

Differences in institutions can play an important role in cost-benefit analysis of the membership in a currency union. A good example for this is labour market institutions such as unions. Unions and their aggressiveness in wage negotiations differs strongly across countries (Grauwe, 2009). While some countries have centralized wage negotiations between the social partners, some countries have rather decentralized wage negotiations. Research shows that centralized unions take the inflationary effect of their wage negotiations in account when determining their respective demand (ibid.). The working mechanisms is as follows: Large unions present a large part of the working labour force in their respective country. Correspondingly large wage agreements will have a rather strong impact on inflation rate. Therefore overly aggressive wage demand would increase the inflation rate and hence decrease real wages and decrease the benefits for their members. Thus large unions have no incentive for excessive wage demand. Smaller unions on the other hand will not have to do so because they represent a smaller group of workers. Excessive wage agreements will not have a strong impact on inflation and therefore increase the real wage of their members constituting an incentive to engage in free-rider behaviour (ibid.). If smaller unions dominate in a country, their cumulated wage agreements will generate a higher inflation than it will under the centralized scenario. Depending on the size of unions dominating the labour markets of a country, the reaction to a demand shock will be different. This will have an especially detrimental effect on the benefits of a currency union as the economies reaction towards symmetric shock will have different outcomes on the price and wage levels of the individual member states. This renders a common monetary policy response less accommodating for the individual members and hence decrease the benefit of a currency union.

2.7 Diversification in production and consumption

Brought forward by Kenen (1969) the diversification argument revolves around the fact that shocks seldom hit every part of an economy as a whole, but rather hit a certain sector of an economy. If the share of this part of the economy is large enough, the whole economy is affected by the shock. This is the case in introduced standard model, where both countries produce only one good. If countries are well diversified, a shock to a certain sector creates less of an adjustment need, decreasing the need for internal devaluation. Therefore, less welfare costs in terms of unemployment is incurred. Hence a group of countries that are all highly diversified will be more likely to gain from a currency union than a group that has highly concentrated sectors and is therefore prone to idiosyncratic shocks (Mongelli, 2008).

2.8 Similarities in inflation rates and preferences

Persistent differences in national inflation rates have adverse effects on members of a currency union. The reasons for differences can be manifold such as differences in the labour market institutions, structural developments but also economic policies and preferences (ibid.). However, two effects of persistent differences in inflation rates significantly lower the benefits for members of the currency union.

The central bank of a common currency will have to base her interest rate decisions on the economic situation of the currency area as a whole. However, if members of a currency union face persistent differences in inflation, they also face a different real interest rate. Members with higher inflation rates face a lower real interest rate than members with a lower inflation rates. This in turn triggers higher investment and consumption rates, which again increases aggregate demand, accelerating inflation even more. Countries who face lower inflation will conversely face higher real interest rates, therefore lower aggregate demand, resulting in even lower inflation (Enderlein et al., 2012). This effect is well known as a modified ‘Walters critique’. The higher the differentials the larger is the wedge between the national real interest rates and the less effective the common monetary policy becomes. If this effect becomes strong enough to lower the real interest rate below the natural interest, bubbles can emerge, reducing the benefit of a common currency further (Baldwin & Wyplosz, 2012).

However, as it is shown in the initial example, the real exchange rate effect of higher inflation leads to a decrease of competitiveness of the exported good, decreasing aggregate demand for the good. Thus, labour is set free and unemployment rises. Consequently, the economy cools down, inflation rates decrease until the economy is back in its initial equilibrium. However, depending on wage rigidities, this process might take a significant amount of time, which is decreasing the benefit of the common currency (Enderlein et al. 2012).

When it comes to policy preferences on how to react to a shock, differences might be significant and could play a crucial role on the effect of a shock on the economy. There rarely exists a ‘optimal’ policy response, therefore the choice of how a shock should be handled is influenced by national preferences (Baldwin & Wyplosz, 2012). Several reactions to a shock are conceivable: One could be to weaken the exchange rate in order to increase competitiveness of exporters. Another one could be to maintain purchasing power by keeping the exchange rate high. Thereby increase domestic demand by decreasing the share of costs accrued from imports (ibid.). Decision mechanisms within the countries that determine the policy actions could imply different stances in terms of preferences and therefore come to different conclusions about which policy action should be taken. Consequently, a policy reaction on a symmetric shock could lead to different necessities towards the subsequent monetary reaction, making it difficult for the monetary authorities to decide on an apt monetary reaction (ibid.). Therefore the opportunity costs of being member of a currency union increase with the heterogeneity of preferences as it becomes harder to establish a welfare increasing monetary policy reaction. Therefore a currency union becomes more beneficial if its members share a certain degree of consensus on how to react on shocks. Additionally, in regards to the detrimental effect of inflation differentials it becomes apparent that the higher the degree of similarities in institutions and thereby the higher the homogeneity of economic reaction towards a common shock the more beneficial the currency union becomes for its member states.

2.9 Political integration and political feasibility

Given the uncertainty which of the aforementioned criteria is qualitatively and quantitatively most important or which share of the criteria can be replaced by another, it is rather unlikely that a currency area can be ‘optimal’ (Baldwin & Wyplosz, 2012). Therefore, political factors become increasingly important. Political will can be recognised as one of the most important factors of the functioning of a currency area (Mintz, 1970). It increases the likelihood of politicians to adhere to common rules and joint commitments even if political cost might arise in their respective legislative district. Additionally, it requires that politicians are willing to undertake trade-offs between their own policy preferences and the ones of their political partners in other member countries (Mongelli, 2002). The other side of this coin is an inclination of the citizens of member states to endure a certain degree of deviation of conducted policies from their preferred policies. The larger this will of enduring hardship or perceived deviation from policies that are in the national interest in order to accommodate for ‘the greater good’, the less certain disadvantages are weighted in comparison to the benefits of a currency union. Given the lack of an apt monetary policy and under the assumption of rigid wages this argument aims at a willingness of the citizens of the nation states to undergo long phases of high unemployment and politicians to enact possibly harsh competitiveness increasing reforms regardless the political cost in order to accommodate the restrictions of a currency union. Hence, the larger this will, the larger the volition to cope shocks without an individual monetary policy, thus the lower the costs of abandoning monetary policy. This in turn increases the political feasibility of costly political compromises (Baldwin & Wyplosz, 2012).

2.10 Fiscal transfers

Fiscal transfers can help to ameliorate the effects of an asymmetric shock by transferring funds from country 1, which is experiencing inflationary pressures to country 2, which suffers from a slump in aggregate demand. The transferred funds would decrease aggregate demand in country 1 and help increase aggregate demand in country 2. In case of a temporary shock, readjustment could be rendered unnecessary as transfers could bridge the demand gap for the duration of the shock. In case of a persistent shock, transfers could help to smooth the transition until prices adjusted to the new situation (ibid.). In theory, both countries gain because transfers mitigate the adverse effects in both countries therefore decreasing the advantage of a country specific monetary reaction. In country 1 transfer are decreasing it closer to its pre-shock levels thereby smoothing consumption, and conversely consumption is increased towards pre-shock levels in country 2. In essence this system of fiscal transfers acts as a public insurance system against asymmetric shocks (Baldwin & Wyplosz, 2012; Grauwe, 2009). ). However, it is also possible that transfers hamper price adjustment and therefore become permanent (Grauwe, 2009; Gros & Alcidi, 2013). Additionally, moral hazard remains as a problem. The shock insurance is only mutually beneficial if the occurrence of shocks is randomly distributed. If this is not the case and some countries are more likely to be hit by a shock, they might become net recipients while others become net contributors (Baldwin & Wyplosz, 2012). In this case, the benefit of being a member of a currency union decreases for the net contributors.

Fiscal transfers create a fiscal shock absorber within the currency union similar to fiscal shock absorbers that are in place in most countries. These transfers within countries take different forms such as transfers based on per capita income or taxing capacity or unemployment insurance. The fiscal transfer criterion is often used as rationale for calls for various kinds of additional fiscal transfers within the Eurozone.

3. Selected issues on the Eurozone and optimal currency area criteria

After explaining the building blocks of OCA-theory in Chapter 2, the following chapter will address several issues of the Eurozone concerning its optimal currency area properties. The focus is on the role of inflation differentials and current account deficits as well as questions of business cycle convergence and financial market integration. An assessment of their role in the run-up to the crisis will be conducted. Ultimately, understanding processes that have led to the sovereign debt crisis will help to deduct the rationale for a fiscal transfer mechanism by assessing whether or not an automatic stabiliser or discretionary fiscal transfers on a European level could have prevented the aberration of the Eurozone economies.

3.1 Business cycle convergence

A lack of business cycle convergence might have been at the centre of the recent crisis. This is due to the fact that a different positions in the business cycle corresponds to different properties for an individually apt monetary policy. Furthermore, OCA-theory implies that costs are incurred when monetary does not the fit the individual need of an economy. Therefore, business cycle convergence is an important factor when determining the suitability of countries within a currency union. The conduct of a common monetary policy can only be apt for the individual business cycle position if countries are on average at the same position. Otherwise, it becomes increasingly difficult for monetary authorities to decide on the monetary policy reaction: Countries that are in a recession need low interest rates, countries that are in a boom need a higher interest rate by trend. OCA research suggests that one of the most important ingredients for business cycle convergence is trade. The idea was brought forward by Frankel and Rose (1996) in which they research on the correlation of business cycle convergence and trade patterns. They come to the conclusion that closer trade links automatically lead to more tightly correlated business cycles. Even though closer trade links could also induce a stronger specialization of industries of trade partners, which would lead to lower correlation due to industry sector specific shock, they find that integration yields higher convergence due to common demand shocks and higher intra-industry trade. They also imply an endogeneity of OCA criteria because being member of a currency union has a trade enhancing effect for trade between union members, therefore business cycle convergence increase as a ‘side-product’.

The following analysis is focused on the comparability of business cycle convergence within the EMU to the United States (US). Afterwards possible reasons for higher dispersion in the EMU are presented. Figure 3 is a heat map plotting the number of member states that are in the same territory in terms of business cycles for the Euro Area, the US states as well as a North country group and the GIIPS country group^[1]. Every member state experiencing positive growth rate is assigned a 1. Every member state that experiences a negative growth rate a 0. These Figures are cumulated and divided by the number of member states. Thus, the index 1 and 0 represent a state in which all member states have either a positive or negative growth rate respectively. The lower and upper bound are green as in these areas monetary policy faces a uniform direction of growth. The red area shades the area where 50% of the member states have a positive and 50% have a negative growth rate. This represents a situation, in which monetary policy becomes increasingly more difficult to conduct, because a one-size-fits-all of monetary policy fits none. However, when interpreting this graph it must be noted that this degree of abstraction does not convey how large the differences are and also no weighting has taken place. So possibly monetary policy might on average be better by a value of 0.5 because if only small economies face a crisis, the larger economies have a higher influence on the interest rate and the ‘fit’ of monetary policy in any case. The heat map retains informative character because when not weighting for the size of the economy, because it is possible to deduce the benefit of being a member of a currency union for the individual country. It does not matter for a country how good a given monetary policy fits other members but politicians will most likely consider the value that is generated for their own country.

Figure 3 Heat map of business cycle divergence

Abbildung in dieser Leseprobe nicht enthalten[AK1]

Source: AMECO, Bureau of Economic Analysis, own calculation.

When comparing the EMU with the US, it is apparent that the US states show a larger degree of divergence and are closer inward than the EMU-12. However, the divergence has increased for the EMU-12 since the introduction of the Euro, while the US states seem to show more closely correlated business cycle. This becomes especially apparent when accounting for the post-financial crisis period. The US states and the EMU members show similar pattern as a reaction to the financial crisis, however the business cycle seem to converge more strongly outwards after the crisis while the EMU members show a seemingly more erratic pattern.

A review of recent literature confirms this picture to some extent. Pasimeni (2014) concludes that the degree business cycle divergence has somewhat decreased judging by dispersion of growth rates and other indicators. Crespo-Cuaresma and Fernández-Amador (2013) state that there has been significant convergence in the early nineties, with the process stopping with birth of the EMU. Gächter, Riedl, and Ritzberger-Grünwald (2012) find a convergence of business cycles until 2007 and a strong divergence from there on forwards. They state that a divergent reaction on the financial crisis has led to a marked increase in divergence. This shows that the recovery from the crisis started at different points in time with a different pace of recovery. In a more recent paper Gächter and Riedl (2014) state that not only stronger trade links within a currency union facilitate a stronger business cycle convergence but also that a common monetary policy creates less shocks than an autonomous one, which in turn leads to a smoothing of business cycles. Still, as Enderlein et al. (2012) state, that even in case of a common shock a heterogeneous reaction of countries can lead to a desynchronization of business cycles.

Business cycle convergence as the outcome of many OCA criteria is key for a pareto optimal monetary union (Crespo-Cuaresma & Fernández-Amador, 2013) and convergence has been observed for the better part of the last 20 years. However, the picture turned after the introduction of the Euro as business cycles seems to split the EMU into booming, capital importing southern states and a lumping capital exporting northern economies. After the crisis this structure reversed and the former booming south is laden with a debt overhang and deteriorating growth perspectives. The North is meanwhile experiencing strong investment and consumption driven growth – a mirror image of the past years. The root of this development lies with ‘endogenous asymmetries’ (Enderlein et al., 2012, p.27) that arise from inflation differentials. These inflation differentials could have had two possible explanations: A rather unlikely catching-up process of the southern states or a strong real interest rate effect.

3.2 Inflation differentials

When talking about the occurrence of persistent inflation differentials in the EMU it is good practice to compare it to the US as an at least partially comparable counterpart given the economical size of the EMU.

When comparing the inflation differentials of the US and the EMU the most striking problem is the difference in the statistical census of the US. Rather than measuring the inflation rate on state levels, the Bureau of Labor Statistics (BLS) defined 26 metropolitan statistical areas (MSAs), which represents data for large cities and their wider urban area. Furthermore, most of the MSA data is available only bimonthly in either odd or even intervals. Only three MSAs^[2] inflation rates are available on a monthly basis. Additionally, there is inflation data for the four US census regions. The US inflation data is not directly comparable to the EMU because the MSAs are too small and the US census regions are too large to have a direct counterpart in the EMU (Aldasoro & Žďárek, 2009). However, as the US still represents the best approximation to a large currency union such as the EMU, comparing the US to the EMU might still allow for some conclusions. For Figure 4 only the MSAs were selected, which have their data released every even month. The three MSAs for which monthly data was available data of odd months were omitted. Following the approach of Mongelli (2008) it shows the dispersion of inflation rates within the US and the EMU. Plotted is the dispersion in standard deviations of the four US census regions and the EMU-12 from January 1990 until December 2014 and the dispersion in standard deviations for the EMU-18 and 10 MSAs from January 1998 (December 1998 for the MSAs) to December 2014.

The time-series for the EMU-18 and the MSAs are truncated due to data restrictions as full availability of data is only given for the last two years of the 1990s onwards. The data clearly shows that there has been a marked decline of dispersion of inflation rates within the last 24 years, bringing the inflation dispersion broadly in line with the US over the course of nine years between 1990 and 2000. However, the outbreak of the sovereign debt crisis the EMU has resulted in an increase in dispersion. Dispersion is decreasing since 2012 and brings the EMU back to pre-crisis level, comparable to MSA levels in the US. While the difference between the dispersion rates of the EMU and the US has declined. The strong increase in the dispersion of the EMU-18 is mostly driven by Estonia and Latvia, which were not yet part of the EMU and can thereby be explained by the unweighted dispersion, which biases the composite unproportionally.

Figure 4 Unweighted dispersion of inflation rates in US and EMU

Abbildung in dieser Leseprobe nicht enthalten

Source: Mongelli (2008), Eurostat, National Bureau of Labor, OECD, own calculations.

The distinct feature of the EMU is, however, the persistence of differentials over time and their structural pattern (Aldasoro & Žďárek, 2009; Mongelli, 2008). Most countries displayed inertia in terms of inflation differentials to the EMU-average. Countries that experienced higher than average inflation rate experienced them up until the rise of the sovereign debt crisis, mirrored by lower than average countries. This has changed in the aftermath of the sovereign debt crisis mostly due to the sharp reversal of the inflation differentials in the GIIPS-countries (Mongelli, 2008).

The question remains how the persistent inflation differentials are explainable. Before the turmoil of the financial crisis and the following government debt crisis, the prevailing view of the benignity of the persistent inflation differentials in the EMU was explained by the occurrence of a Balassa-Samuelson-effect. This effect describes differences in the productivity growth of catching-up countries which in turn leads to faster wage growth and therefore higher inflation rates (Grauwe, 2009; Mongelli, 2008). In case of a Balassa-Samuelson-effect a marked increase in the productivity of the catching-up countries should be visible. However, plotting the productivity in Figure 5 clearly shows that no extensive catching-up process has taken place before the crisis. Comparing the GIIPS-countries^[3], which represent the epicentre of the sovereign debt crisis with the North^[4] show a near synchronous movement. While Italy’s productivity stayed virtually unchanged between 2000 and 2013, only Ireland realized an increase of about 24%. However, it is unlikely that the persistent dispersion is mainly explainable by a Balassa-Samuelson-effect (Bertola et al., 2013).

That a strong catching-up effect is not the main cause of high inflation differentials, could be indication for the existence of a real interest rate effect. This effect describes how diverging inflation rates in member states of a currency union affect interest rates that are commonly determined. The real interest rate determines the cost of credit when adjusting for nominal price changes. It is therefore the real price for financing. If the interest rate is commonly decided on but inflation rates differ, the real exchange rate and thereby the real cost of credit is different in the member states. Agents in a higher than average inflation economy, facing lower real financing costs will have a larger demand for credit than an agent will in a low inflation economy. The resulting higher demand for credit will then trigger a higher output, growth and thus higher inflation. This leads to further decreases of real interest rates making credit cheaper and leading to an increase in credit growth, thus to an increase in aggregate demand and even higher inflation. Second round effects lead to circle of increases in inflation rates.

Figure 5 Unweighted development of GDP per Employee 2000-2013 (Index 2000 = 100)

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Source: Bertola et al. (2013), Eurostat, own calculations.

The counteracting mechanism that brings economies back to equilibrium is the real exchange rate effect. Within a monetary union, no exchange rate exists and therefore no nominal price readjustment is possible. Higher domestic price levels increase export prices of the economy relative to all member states of the currency union. With increasing prices, the competitiveness deteriorates and aggregate demand for domestically produced goods decreases. The output retracts, the inflation rate decreases leading to lower price levels and thus to increasing competitiveness (Enderlein et al., 2012). Thus, a marked decrease in real interest rate and a corresponding decrease in competitiveness should be visible. Figure 6 plots the unweighted real long-term interest rate of the GIIPS-countries and North-countries compared to their competitiveness captured by their unweighted real effective exchange rate based on the development of unit labour costs in the total economy (REERulc) as proposed by Mongelli (2008). While a strong divergence in the long-term interest rate is obvious, it is also possible to see a marked decline in competitiveness of the GIIPS-countries while the competitiveness of the North-countries essentially remain the same over the sample. Figure 7 plots the credit stock growth to the non-MFI private sector indexed on the year 1999 and allows to relate the data of Figure 6 to a market increase in credit expansion in the GIIPS-countries. This suggests that the credit boom could have been the root of strong inflation, which lead to a virtuous (or vicious) cycle of increasing inflation and real interest rate effects (Matthes, 2009).

Figure 6 Real interest rate effect of inflation and the effect on competitiveness

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Source: Ameco, Eurostat, own calculations.

This gives evidence for the existence of a considerable real interest rate effect due to higher than average inflation in the GIIPS. In turn, the competitiveness of the GIIPS countries decreased as measured by the real effective exchanger rate (REER). Further indicative evidence shows that inflation in the GIIPS was mainly driven by cyclical elements which further lower the probability of the prevalence of a Balassa-Samuelson effect (Aldasoro & Žďárek, 2009). Long-term interest rate remained in negative territory until the onset of the financial crisis and has been increasing until the strong interventions of ECB and Mario Draghis infamous ‘whatever-it-takes’ speech (Mario Draghi, 2012). The loss of competitiveness as plotted by the REER illustrates the equilibrating mechanism of the competitiveness-channel: Rising wage levels due to high inflation lead to decreasing export volumes and therefore lower aggregate demand (Matthes, 2009).

These persistent inflation rate differentials constitute a ‘one-size-fits-none’ problem (Enderlein et al., 2012): The ECB is conducting a monetary policy which is fitting for the Eurozone on average. If a country is not broadly in line with the Eurozone average, the ‘one-size-fits-all’ policy has adverse effects. Either it is too expansive for countries already with a positive output gap or it is too restrictive for countries with a negative output gap (ibid.).

Figure 7 Stock of credit to households, non-MFI corporations and non-profit institutions with its counterparty in the EMU (Index 2003 =100%)

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Source: ECB statistical data warehouse, Central Bank of Greece, own calculations.

Concluding, the OCA-criterion of low inflation dispersion is fulfilled in terms of the magnitude being comparable to the US. However, the EMU shows structural and persistent differences in inflation rates for several countries. These persistent differentials create a real interest rate effect that perpetuates a boom and bust cycle as a result of counter-cyclical interest rate movement. Eventually this effect has allowed for the emergence of unsustainable growth patterns, the formation of asset bubbles and the loss of competitiveness. Due to a lack of an exchange rate mechanism, inflation differentials have a negative effect on competitiveness and create the need of readjustment trough real depreciation.

3.3 Current account imbalances

The mirror image of the persistent inflation differentials are current account imbalances within the EMU. Figure 8 shows that the development of the current accounts deficits since the start of the euro. There are two things that stand out: First, the current account of the Eurozone is close to balance over the course of the past 15 years and shows significant improvement since 2009. This implies an increase in the external position or the accumulation of net assets vis-à-vis the world by persistent net exports. Therefore, one cannot derive a competitiveness problem vis-à-vis the world for the Eurozone as a whole. Second, when differentiating the Eurozone aggregate to a finer granulation consisting only of the North- and GIIPS-countries it becomes obvious, that large and persistent current deficits and surpluses have formed during the first decade of the Euro between both country-groups. The problem becomes even more apparent when considering the size of stock accumulated deficits over the last 15 years: The stock of deficit of the GIIPS sums up to about 1.4 trillion Euros (Bertola et al., 2013). Still, this does not necessarily constitute a problem if the high negative external position is solely due to a catching-up process that involves high investment and an increase in capital stock that results in higher output and productivity. In this case, the necessary return on the investment to repay debt and interest would be already ensured by the return of the investment. However, as most of the credit was spend on consumption and uncalled-for construction, therefore unprofitable investment, which in turn triggered high imports, the stock of external debt represents a debt burden that has to be refinanced and eventually paid back by net exports of the same amount.

Figure 8 Development of Current Account in the Euro Area, North- and GIIPS-countries (in bn. Euro)

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Source: AMECO, own calculations.

The imbalances originate in massive flows of capital from the north to the south after the introduction of the Euro (ibid.). With the disappearing of exchange-rate and redenomination risk investors fell into ‘irrationally exuberance’ as coined by Greenspan (1996). Investors optimism over their investments was fuelled by the way expectations about return were formed: Investors calculated with the high nominal growth rates of the GIIPS while disregarding that the high growth was only sustained by immense capital inflows (Gros, 2012b). Additional impulses came from the structure of the Eurozone’s financial systems themselves: The savings-rich north was confronted by the GIIPS-countries that just experienced a marked fall in overall interest rates due to the introduction of the Euro. Differences in the financial structure between the north and the south gave rise to extremely different credit conditions, paving the way for overinvestment (Gros, 2012). Additionally, banking regulation created a home bias of banks to invest in Eurozone countries. This in turn accelerated the flow of capital leading to an unprecedented convergence in interest rates of government and private debt. When the financial crisis disturbed the flow from the savings-rich north to the south and risk aversion of investors increased, flows reversed (Gros, 2012b). Credit dried up and the boom in the GIIPS countries ended abruptly leaving the economies with high debt and without a sustainable growth model (Grauwe, 2013). Gros and Alcidi (2013) studied the effect of the ‘sudden stop’ of funding for European countries within and outside of the EMU. The main difference is the availability of financing through the TARGET2-system for the GIIPS: While the so-called ‘BELL-countries^[5] ’ had a hard budget-constraint in form of the unavailability of credit, the GIIPS could draw ‘implicit credit-lines’.

The TARGET2-system is a real-time gross settling system that enables all EMU banks to conduct cross-border transfers of money in real-time. Commercial banks have an account with their national central bank, which have accounts with the European central bank (Kokkola, 2010). Transactions that are being conducted within a country are settled with the national central banks. Transactions that are cross-border are settled between the central banks, which in turn either credit or debit the account of the commercial bank. If disequilibria arise between the amount transferred and received from cross-border transactions, e.g. a central bank transfers more money abroad than it receives, it creates a liability to the Eurosystem, and the net receiving central bank creates a claim on the Eurosystem. Abstracting from the pure financial settlement system, the TARGET2-balances of a country can also be understood as having the same indicative role as currency reserves within a fixed exchange-rate system: If the amount of money transferred out (or imports exceed exports), a currency has the tendency to devaluate. In order to defend the exchange rate peg, the country with the devaluating currency has to sell foreign currency. It can do so until it runs out of foreign currency at which point the exchange rate peg falls. Within the Euro, the TARGET2-balances fulfil the same role: If a country becomes a net sender of transfers to other countries, the liabilities represent the counterpart of selling currency. They are a liability to the system to reimburse them for creating money on the sending countries behalf (Sinn & Wollmershäuser, 2011).

As these claims and liabilities are mere balances, there is no natural limit to how much money a country can transfer to other EMU countries. This however also means, that no foreign financing is necessary in order to realize import of goods (Fahrholz & Freytag, 2011). Rather than finding a foreign bank that is willing to give credit or exchange the foreign currency, a simple transaction from one banking account to another suffices. This has more than one implication: First, there is no sudden stop for a EMU country in terms of financing, because the TARGET2-system guarantees that a Euro created by a Greek bank can be used to buy goods in Germany (Sinn & Wollmershäuser, 2011). Second, there is no backstop for capital flight. Usually a capital flight would lead to a depreciation of the currency; therefore bringing capital out of the country is costly due to exchange rate losses. These costs increase with the duration of the capital flight and eventually exceed gains of repatriating funds. As these costs do not exist within the EMU, little can stop a capital flight, essentially desiccating the financial system of a country (Fahrholz & Freytag, 2011). Third, a country can sustain current account deficits without external financing.

When credit dried up, the GIIPS were able to sustain their current account deficits and also increase their budget deficit in order to enable their automatic stabilizers to work. In consequence, the fiscal position of GIIPS-country governments deteriorated due to high legacy cost of bank bailouts, high cyclical deficits, additional Keynesian fiscal stimulus programmes and rising unemployment rates fostering even stronger growth of deficits throughout the crisis. Thus, shifting market sentiment towards a more negative perception of debt sustainability in the GIIPS (Kowalski & Shachmurove, 2014). The BELL on the other hand faced immediate devaluation of their national currency, a drop in imports, a surge in financing cost and a strong reduction in output. Another key difference is the structure of the banking system. While the banking system of the Eurozone countries is mostly dominated by national banks, the BELL banking systems are dominated by foreign banks, which provided a shock absorbing function to some extent. Additional cushioning is provided by lower legacy costs as the final creditor to the banking systems are not the BELL but other states (Gros & Alcidi, 2013). Gros and Alcidi (2013) stress that soft budget and liquidity constraints have delayed fiscal and external adjustment in the GIIPS, while the BELL had to readjust quicker and faster ,leading to a lower debt stock and better macroeconomic performance. However, it remains diffuse if higher welfare costs arise from a slow or a fast readjustment.

The supremacy of the real interest rate effect over the real exchange rate effect has created irrational exuberance, assets bubbles and softened the budget restrictions of governments and the private sectors throughout the GIIPS (Enderlein et al., 2012). This paved the way for macroeconomic imbalances before the crisis by weakening competitiveness and fuelling government deficits. Also, the credit boom has facilitated an economic structure that is characterised by high imports, low competitiveness of domestically produced goods and a unsound sectorial composition (Fahrholz & Freytag, 2011). When the financial crisis hit in 2007 interest rate levels remained low, allowing the full use of automatic stabilisers. A hard readjustment trajectory was prevented. However, this has left the GIIPS with a humongous stock of debt and delayed necessary readjustment.

Preventing these patterns of boom and bust in the future should be the main goal of all measures to enhance stability of the Eurozone. All actions taken to be taken must be measured along either ability to prevent these imbalances or their ability to alleviate the burden of readjustment without preventing corrections and increasing the social and economic costs of doing so.

4. Rationale and options for a fiscal capacity in the Eurozone

The foregoing chapter has pointed out three distinct aberrations inherent to the EMU structure that are interrelated to one another: First, business cycle convergence on par with the US but exhibiting prolonged persistence. Second, inflation differentials, which are closely related to missing business cycle synchronisation and real exchange rate effects. Third, current account imbalances that are related to the financial structure and a lack of fiscal prudence. In the following chapter, an attempt is made to find a conclusive answer whether a fiscal capacity could be an instrument apt to counter these inherent flaws. The chapter is organised as followed: first, the steps taken to strengthen the EMU monetary, fiscal and financial framework are deduced. This is followed by an assessment of their impact in terms of problem solving capability of the aforementioned core issues of the EMU. In a next step, the task and the impact of automatic stabilisers in a fiscal system are recapitulated and the case for a Eurozone wide fiscal capacity is made by inferring the rationale from shortcomings of the current system under the aspect of business cycle convergence. The deduction is concluded by a detailed analysis of several proposed mechanisms to be introduced as fiscal capacity.

4.1 Packs, compacts and mechanisms – steps taken so far.

The past years were paved with Euro summits that introduced a new legislative, supervisory and financial framework for the EMU. The following chapters will be devoted to the assessment of problem solving capabilities of these introduced measures. It will also point out possible rationales for an EMU-wide fiscal capacity. Subsequently it is elaborated on existing automatic stabilisers in the US and the EMU, possible ways of introducing automatic stabilisers on an EMU level and discuss their possible impact on the established errors in the construction of the EMU.

After the escalation of the European sovereign debt crisis,several legislative initiatives have resulted in the introduction of a revised European fiscal and economic framework as well as the Banking Union. Aim was the containment of capital markets distrust towards European sovereign debt sustainability, the reestablishment of capital market access in the GIIPS-countries and the reduction of sovereign-banking system feedback. A tight mesh of rules and surveillance measures was established to keep EMU government’s debt bias in check, insure long-term debt sustainability and increased coordination of fiscal and economic policy. At the core of these reforms lies the Six Pack, the Two Pack, the Fiscal Compact, the European semester and the ESM. The Banking Union introduces three main institutional changes: first, the single resolution mechanism (SRM), second the single supervisory mechanism (SSM) and third a common rulebook for deposit insurance.

The Six Pack strengthens the preventative framework of the by enhancing the Stability and Growth pact (SGP) and introduces new tools such as the macroeconomic imbalance procedure (MIP) (Begg, 2012). The rules of the SGP revolve around the Medium-term budgetary objective (MTO). The MTO gives an individual threshold for the medium term sustainable average limit for a countries structural deficit for the member states, the 3% deficit criterion and further obliges the correction of debt above the 60% threshold (European Commission, 2014). Member states deviating from the MTO in a year or cumulative in two successive years are subject to the excessive imbalance procedure, which eventually leads to a fine of up to 0.2% of GDP for non-complying member states (ibid.). The MIP is based on a scorecard of indicators that measure potentially threatening macroeconomic developments in the individual member states. Recommendations are issued by the European Commission (EC) and if an excessive imbalance is identified, member states are obliged to create a binding corrective action plan. Progress is being monitored by the EC (ibid.). The excessive imbalance procedure is further specified by the trajectory of debt reduction, determining a 1/20th reduction until the debt-to-GDP ratio has fallen under the 60% threshold. Fines can eventually be levied if a member state subject to the MIP is not complying with the corrective action plan (ibid.).

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^[1] North group consisting of Austria, Belgium, Germany, Finland and the Netherlands and South group consisting of Greece, Italy, Ireland, Portugal and Spain.

^[2] Monthly data is provided for Chicago, Los Angeles and New York

^[3] Greece, Ireland, Italy, Portugal and Spain

^[4] Germany, Austria, Finland, Belgium, Netherlands

^[5] Bulgaria, Estonia, Lithuania and Latvia [AK1]Add new graph and add new explaination