nep-eec New Economics Papers
on European Economics
Issue of 2012‒02‒20
seventeen papers chosen by
Giuseppe Marotta
University of Modena and Reggio Emilia

  1. The Euro area sovereign debt crisis: safe haven, credit rating agencies and the spread of the fever from Greece, Ireland and Portugal By Roberto A. De Santis
  2. Who's afraid of sovereign bonds? By Silvia Merler; Jean Pisani-Ferry
  3. The debt challenge in Europe By Alan Ahearne; Guntram B. Wolff
  4. Expected inflation and inflation risk premium in the euro area and in the United States By Marcello Pericoli
  5. Further Austerity and Wage Cuts Will Worsen the Euro Crisis By Andini, Corrado; Cabral, Ricardo
  6. Contagion during the Greek Sovereign Debt Crisis By Mark Mink; Jakob de Haan
  7. "The Euro Crisis and the Job Guarantee: A Proposal for Ireland" By L. Randall Wray
  8. On the Self-Fulfilling Prophecy of Changes in Sovereign Ratings By Ingmar Schumacher
  9. Real term structure and inflation compensation in the euro area By Marcello Pericoli
  10. Synchronization and Diversity in Business Cycles: A Network Approach Applied to the European Union By David Matesanz Gomez; Guillermo J. Ortega; Benno Torgler
  11. Fiscal adjustment in Greece: In search for sustainable public finances By van Aarle, Bas; Kappler, Marcus
  12. The Convergence Processes in Europe and Latvia By Aleksejs Melihovs; Igors Kasjanovs
  13. Quantifying the qualitative responses of the output purchasing managers index in the US and the Euro area By Philip Vermeulen
  14. Excessive Imbalance Procedure in the EU: a Welfare Evaluation By Andrzej Torój
  15. An assessment of Stability and Growth Pact Reform Proposals in a Small-Scale Macro Framework By Jerome Creel; Paul Hubert; Francesco Saraceno
  16. Liquidity, risk and the global transmission of the 2007-08 financial crisis and the 2010-2011 sovereign debt crisis By Alexander Chudik; Marcel Fratzscher
  17. Taxes and Labor Supply: Portugal, Europe, and the United States (Conference Version) By Andre C. Silva

  1. By: Roberto A. De Santis (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany and CEPR.)
    Abstract: Since the intensification of the crisis in September 2008, all euro area long-term government bond yields relative to the German Bund have been characterised by highly persistent processes with upward trends for countries with weaker fiscal fundamentals. Looking at the daily period 1 September 2008 - 4 August 2011, we find that three factors can explain the recorded developments in sovereign spreads: (i) an aggregate regional risk factor, (ii) the country-specific credit risk and (iii) the spillover effect from Greece. Specifically, higher risk aversion has increased the demand for the Bund and this is behind the pricing of all euro area spreads, including those for Austria, Finland and the Netherlands. Country-specific credit ratings have played a key role in the developments of the spreads for Greece, Ireland, Portugal and Spain. Finally, the rating downgrade in Greece has contributed to developments in spreads of countries with weaker fiscal fundamentals: Ireland, Portugal, Italy, Spain, Belgium and France. JEL Classification: G15, F36.
    Keywords: Sovereign spreads, credit ratings, spillovers.
    Date: 2012–02
  2. By: Silvia Merler; Jean Pisani-Ferry
    Abstract: The crisis has underlined the strong interdependence between the euro-area banking and sovereign crises. To understand the role domestic banks have played in holding sovereign debt, a breakdown of government debt by holding sectors is required. The data shows that at the start of the crisis, most continental euro-area countries were characterised by the large size of their banksâ?? portfolios of domestic government bonds, which were markedly larger than in the UK or the US. Consequently, concern about sovereign solvency was bound to have major consequences for banks. The structural vulnerability of euro-area countries has increased, reinforcing the sovereign/ banking crisis vicious cycle. All countries for which concerns about state solvency arose in recent years have seen a reversal in the previously steady increase of the share of government debt held by non residents. Germany, by contrast, has seen an increase in the share held by non residents. In the short term, these observations raise a question about the effectiveness of ECB provision of liquidity to banks as a means to alleviate the sovereign crisis. At a point when government bonds are considered risky assets, euro-area banks are faced with both balance sheet and reputational risks compared to their non-euro area counterparts, and may prove reluctant to increase this exposure further. In the longer term, the question is if and how euro-area regulators should set incentives to reduce banksâ?? heavy exposure to sovereigns. This issue should be given more attention in European policy discussions on how to strengthen the euro area.
    Date: 2012–02
  3. By: Alan Ahearne; Guntram B. Wolff
    Abstract: The euro area faces a double challenge: debt overhang and the need for price adjustment. This paper reviews the debt challenges in the household and corporate sectors and maps out some policy options. In particular, we document the increase in private debt prior to the crisis and consider how the corporate and household sectors have adjusted their balance sheets during the crisis. We examine previous experiences with corporate and household deleveraging and draw lessons for policymakers. We show how the macroeconomic effects of balance-sheet adjustments have been in part offset by the use of fiscal deficits, and we discuss the resulting challenges. A key lesson is the importance of maintaining economic growth and avoiding a prolonged doubledip recession in the euro area while facilitating necessary deleveraging in some over-indebted sectors and countries. We also emphasise the need for a growth strategy tailored to southern Europe.
    Date: 2012–01
  4. By: Marcello Pericoli (Bank of Italy)
    Abstract: This paper uses the celebrated no-arbitrage affine Gaussian term structure model applied to index-linked and standard government bonds to derive expected inflation rates and inflation risk premia, in the euro area and in the US. Maximum likelihood estimates show that the model describes the evolution of the nominal and real term structures by using three latent factors which can be interpreted as two real factors and one inflation factor. These provide important information on expected inflation and inflation risk premia. The results highlight some striking differences between the euro area and the US. In the US, forward inflation risk premia become sizable around the start of the late-2000s financial crisis and considerably increase just before the adoption of the first unconventional monetary policy measures in March 2009. By contrast, in the euro area forward inflation risk premia remain unchanged even after the adoption of the unconventional monetary policy measures following the most acute phases of the financial crisis, in October 2008 and in May 2010. However, long-term inflation expectations have been well anchored over the past years.
    Keywords: real and nominal term structure, inflation risk premium, affine term structure, Kalman filter
    JEL: C02 G10 G12
    Date: 2012–01
  5. By: Andini, Corrado (University of Madeira); Cabral, Ricardo (University of Madeira)
    Abstract: This note argues that the solutions to the euro-area crisis proposed by the EU governing institutions in cooperation with the IMF, based on further austerity and wage cuts, will worsen the crisis. They are unlikely to reduce both sovereign and external debt ratios of countries experiencing these problems. Quite in contrary, they are likely to further reduce the real GDP growth of these countries.
    Keywords: euro crisis, austerity, wage cuts
    JEL: E1 E4 E5 E6
    Date: 2012–02
  6. By: Mark Mink; Jakob de Haan
    Abstract: Using an event study approach, we examine the impact of news about Greece and news about a Greek bailout on bank stock prices in 2010 using data for 48 banks included in the European stress tests. We identify the twenty days with extreme returns on Greek sovereign bonds and categorize the news events during those days into news about Greece and news about the prospects of a Greek bailout. We find that news about Greece does not lead to abnormal returns while news about a bailout does, even for banks without any exposure to Greece or other highly indebted euro countries. This finding suggests that markets consider news about the bailout to be a signal of European governments' willingness in general to use public funds to combat the financial crisis. Sovereign bond prices of Portugal, Ireland, and Spain respond to both news about Greece and news about a Greek bailout.
    Keywords: contagion; euro crisis; event study
    JEL: G14 G15 E44 E63
    Date: 2012–02
  7. By: L. Randall Wray
    Abstract: Euroland is in a crisis that is slowly but surely spreading from one periphery country to another; it will eventually reach the center. The blame is mostly heaped upon supposedly profligate consumption by Mediterraneans. But that surely cannot apply to Ireland and Iceland. In both cases, these nations adopted the neoliberal attitude toward banks that was pushed by policymakers in Europe and America, with disastrous results. The banks blew up in a speculative fever and then expected their governments to absorb all the losses. The situation was similar in the United States, but in our case the debts were in dollars and our sovereign currency issuer simply spent, lent, and guaranteed 29 trillion dollars' worth of bad bank decisions. Even in our case it was a huge mistake—but it was "affordable." Ireland and Iceland were not so lucky, as their bank debts were in "foreign" currencies. By this I mean that even though Irish bank debt was in euros, the Government of Ireland had given up its own currency in favor of what is essentially a foreign currency-the euro, which is issued by the European Central Bank (ECB). Every euro issued in Ireland is ultimately convertible, one to one, to an ECB euro. There is neither the possibility of depreciating the Irish euro nor the possibility of creating ECB euros as necessary to meet demands for clearing. Ireland is in a situation similar to that of Argentina a decade ago, when it adopted a currency board based on the US dollar. And yet the authorities demand more austerity, to further reduce growth rates. As both Ireland and Greece have found out, austerity does not mean reduced budget deficits, because tax revenues fall faster than spending can be cut. Indeed, as I write this, Athens has exploded in riots. Is there an alternative path? In this piece I argue that there is. First, I quickly summarize the financial foibles of Iceland and Ireland. I will then-also quickly-summarize the case for debt relief or default. Then I will present a program of direct job creation that could put Ireland on the path to recovery. Understanding the financial problems and solutions puts the jobs program proposal in the proper perspective: a full implementation of a job guarantee cannot occur within the current financial arrangements. Still, something can be done.
    Keywords: Euro Crisis; Financial Crisis in Ireland; Employer of Last Resort; Job Guarantee; Bank Bailout; Irish Debt Crisis; Government Debt Crisis; Minsky
    JEL: E12 E32 E62 E65 G01 H62 H63
    Date: 2012–02
  8. By: Ingmar Schumacher (Department of Economics, Ecole Polytechnique - CNRS : UMR7176 - Polytechnique - X)
    Abstract: We empirically investigate the dynamic interactions between sovereign ratings and the macroeconomic environment. We use a Panel VAR on annual data for European countries from 1986-2010. Our results provide evidence for a significant two-way interaction between the macroeconomic environment and changes in sovereigns' ratings. Thus, rating changes are able to exacerbate a country's boom-bust cycle.
    Keywords: sovereign ratings; Panel VAR; self-fulfilling prophecy.
    Date: 2012–02–09
  9. By: Marcello Pericoli (Bank of Italy)
    Abstract: Estimates of the real term structure for the euro area implied by French index-linked bonds are obtained by means of a smoothing spline methodology. The real term structure allows computation of the constant-maturity inflation compensation, which is compared with the surveyed inflation expectations in order to obtain a rough measure of the inflation risk premium. The comparison between the inflation compensation and the inflation swap shows that the two variables are closely interlinked but differently affected by illiquidity during periods of stress. The methodology used in this paper is quite effective at capturing the general shape of the real term structure while smoothing through idiosyncratic variations in the yields of index-linked bonds. Real interest rates tend to be quite stable at longer horizons and the average 10-year real rate from 2002 to 2009 is close to 2 per cent. Furthermore, evidence is found that inflation compensation was held down in the period 2008-09 by an increase in the liquidity premium of index-linked bonds.
    Keywords: index-linked bond, real term structure, inflation compensation, inflation risk premium, smoothing spline
    JEL: C02 G10 G12
    Date: 2012–01
  10. By: David Matesanz Gomez; Guillermo J. Ortega; Benno Torgler
    Abstract: This paper analyses synchronization in business cycles across the European Union (EU) since 1989. We include both old and new European Union members and countries which are currently negotiating accession, as well as potential European Union members. Our methodological approach is based on the correlation matrix and the networks within, which allows us to summarize the individual interaction and co-movement, while also capturing the existing heterogeneity of connectivity within the European economic system. The results indicate that the synchronization of the old EU countries remained stable until the current financial crisis. Additionally, the synchronization of the new and potential members has approached to the old EU members although we observe the existence of different synchronization levels and dynamics in output growth in single countries as well as in groups of countries. Some countries have achieved an important degree of co-movement (such as the Baltic Republics, Hungary, Slovenia and Iceland), while others have experienced reduced synchronization, or even desynchronization (such as Romania, Bulgaria and even Greece and Ireland).
    Keywords: Business cycle synchronization; European Union countries; EU candidates; complex systems; network topology
    JEL: E32 C45 O47
    Date: 2012–01
  11. By: van Aarle, Bas; Kappler, Marcus
    Abstract: This paper analyses Greek fiscal sustainability from a retrospective and a prospective view. Implications of Greek fiscal (un)sustainability are discussed. In the empirical analysis econometric testing of Greek government solvency during the period 1985-2008 is combined with a scenario analysis of budgetary adjustments during the period 2011-2030 under alternative hypotheses. --
    Keywords: Greece,euro area,fiscal policy,policy rules,fiscal sustainability
    JEL: F31 F41 G15
    Date: 2011
  12. By: Aleksejs Melihovs; Igors Kasjanovs
    Abstract: This paper, attempting to tackle separately real and structural convergence, is an in-depth study of the convergence processes in Latvia and Europe. Latvia's structural convergence towards both the EU and other neighbouring (Baltic) countries is estimated using the Krugman index. Real convergence processes in the EU, distinguishing between ? convergence and beta convergence, are likewise studied. In addition, cluster analysis with grouping European countries by their structural features is conducted. In this study, the current beta convergence and sigma convergence processes within the EU are identified, yet an in-depth study disclosed that it was mostly the EU12 countries that were the convergence process drivers, with convergence at the regional level well behind that at the national level. The convergence among the EU Member States primarily depended on the wealthier regions of countries becoming richer (characteristic of EU12 in particular), with the process proceeding at a faster pace in relatively poorer countries. This suggests that within a country the discrepancies between rich and poor regions intensify over time. That leads to a conclusion that the European regional policy aimed at decreasing regional income heterogeneity did not prove efficient in the reference period. Structural convergence in Latvia was mainly observed in 2008 and 2009, i.e. the years of real divergence enhanced by the onset of the crisis. Structural convergence in the breakdown of gross value added was mainly driven by the fluctuations of the value added ratio of trade, tourism and transport, manufacturing and construction sector. The conducted cluster analysis demonstrates that over time European countries have become more homogenous or mutually similar in terms of economic structure. A particular focus on the specific economic characteristics of countries leads to a different conclusion: the countries in Europe agglomerated into several specific groups, thus clearly outlining the different drivers of growth in the post-crisis period.
    Keywords: Latvia, the EU, structural convergence, real convergence, specialisation, cluster analysis
    JEL: C20 C50 F15 E13 E60
    Date: 2011–12–31
  13. By: Philip Vermeulen (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany and CEPR.)
    Abstract: The survey based monthly US ISM production index and Eurozone manufacturing PMI output index provide early information on industrial output growth before the release of the official industrial production index. I use the Carlson and Parkin probability method to construct monthly growth estimates from the qualitative responses of the US ISM production index and the Eurozone manufacturing PMI output index. I apply the method under different assumptions on the cross-sectional distribution of output growth using the uniform, logistic and Laplace distribution. I show that alternative distribution assumptions lead to very similar estimates. I also test the performance of the different growth estimates in an out of sample forecasting exercise of actual industrial production growth. All growth estimates beat a simple autoregressive model of output growth. Distribution assumptions again matter little most of the time except during the financial crisis when the estimates constructed using the Laplace distributional assumption perform the best. My findings are consistent with recent findings of Bottazzi and Sechi (2006) that the distribution of firm growth rates has a Laplace distribution. JEL Classification: C18, E27.
    Keywords: Diffusion index, forecasting, purchasing managers’ surveys, ISM, PMI, qualitative response data, Carlson-Parkin method
    Date: 2012–02
  14. By: Andrzej Torój (Ministry of Finance, Poland)
    Abstract: We develop a framework for assessing the welfare implications of the new EU's Excessive Imbalance Procedure (EIP) to be implemented in 2012, with a special focus on the current account (CA) constraint. For this purpose, we apply a New Keynesian 2-region, 2-sector DSGE model, using the second order Taylor approximation of the households' utility around the steady state as a standard measure of welfare. The compliance with the CA criterion is ensured by modifying the policymakers' loss function in line with Woodford's (2003) treatment of the zero lower bound of nominal interest rates. The introduction of EIP threshold on CA balance results in a welfare loss equivalent to steady-state decrease in consumption of 0.105% after the euro adoption or 0.033% before that. If we consider the 4% threshold on current plus capital account (rather than current account alone), this cost decreases to 0.019 under the euro and approximately a half of that without the euro. EIP can be seen as a factor augmenting the cost of euro adoption.
    Keywords: Excessive Imbalance Procedure, EMU, DSGE, welfare, constrained optimum policy
    JEL: C54 D60 E42 F32
    Date: 2012–02–03
  15. By: Jerome Creel (Observatoire Francais des Conjonctures Economiques); Paul Hubert (Observatoire Francais des Conjonctures Economiques); Francesco Saraceno (Observatoire Francais des Conjonctures Economiques)
    Abstract: This paper contributes to the debate on fiscal governance for the European Monetary Union, assessing the different fiscal rules currently discussed. We simulate a small scale macroeconomic model with forward looking agents, augmented with a public finances block. We account for both the positive (output stabilization) and negative (via risk premia) effects of debt and deficit. By the appropriate choice of the exogenous fiscal variables, in the fiscal block, we replicate the working of the rules embedded in the so-called "fiscal compact": a balanced budget rule (the "new golden rule"), and the debt reduction rule (to reach 60% of GDP in 20 years). We compare these rules with the Maastricht 3% deficit limit (status quo), and with an "investment" rule leaving room for public investment. We evaluate the performance in terms of output loss during a fiscal consolidation, as well as following demand and supply shocks in steady state. All rules guarantee long run sustainability. The investment rule emerges robustly as the one guaranteeing the lower output loss, followed by the status quo. The "fiscal compact" rules appear to be recessionary
    Keywords: Fiscal Rules, Small scale Macroeconomic Models, golden rule, fiscal consolidation, EMU economic governance, fiscal compact, Dynare
    JEL: C63 E62 E63 H61
    Date: 2012–02
  16. By: Alexander Chudik (Federal Reserve Bank of Dallas, 2200 N. Pearl Street, Dallas, Texas 75201, USA and CIMF.); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany and CEPR.)
    Abstract: The paper analyses the transmission of liquidity shocks and risk shocks to global financial markets. Using a Global VAR methodology, the findings reveal fundamental di¤erences in the transmission strength and pattern between the 2007-08 financial crisis and the 2010-11 sovereign debt crisis. Unlike in the former crisis, emerging market economies have become much more resilient to adverse shocks in 2010-11. Moreover, a flight-to-safety phenomenon across asset classes has become particularly strong during the 2010-11 sovereign debt crisis, with risk shocks driving down bond yields in key advanced economies. The paper relates this evolving transmission pattern to portfolio choice decisions by investors and finds that countries' sovereign rating, quality of institutions and their financial exposure are determinants of cross-country differences in the transmission. JEL Classification: E44, F3, C5.
    Keywords: Global financial crisis, sovereign debt crisis, liquidity, risk, capital flows, transmission, high dimensional VARs, advanced economies, emerging market economies.
    Date: 2012–02
  17. By: Andre C. Silva
    Abstract: I relate hours worked with taxes on consumption and labor. I propose a model and compare its predictions for Portugal, France, Spain, United Kingdom and United States. Hours per worker in Portugal decreased from 35.1 in 1986 to 32.6 in 2001. With only the parameters and the taxes for Portugal, the model predicts the hours worked in 2001 with an error of only 12 minutes from the actual hours. Across countries, most predictions differ from the data by one hour or less. The model is able to explain the trend in hours with only the changes in taxes. JEL codes:
    Keywords: labor supply, consumption tax, labor income tax
    Date: 2012

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