nep-eec New Economics Papers
on European Economics
Issue of 2012‒08‒23
seventeen papers chosen by
Giuseppe Marotta
University of Modena and Reggio Emilia

  1. On the brink? Intra-euro area imbalances and the sustainability of foreign debt By Körner, Finn Marten; Zemanek, Holger
  2. Public Support for the Single European Currency, the Euro, 1990 to 2011. Does the Financial Crisis Matter? By Roth, Felix; Jonung, Lars; Nowak-Lehmann D., Felicitas
  3. Sovereign Debt Sustainability in Italy and Spain: A Probabilistic Approach By William R. Cline
  4. Paths to Eurobonds By Ashoka Mody; Stijn Claessens; Shahin Vallée
  5. Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups By Anders Aslund
  6. Over-optimistic Official Forecasts in the Eurozone and Fiscal Rules By Jeffrey A. Frankel; Jesse Schreger
  7. On Creditor Seniority and Sovereign Bond Prices in Europe By Sven Steinkamp; Frank Westermann
  8. EMU and the Renaissance of Sovereign Credit Risk Perception By Kai Daniel Schmid; Michael Schmidt
  9. The simple macroeconomics of North and South in EMU By Jean Pisani-Ferry; Silvia Merler
  10. Banks, Sovereign Debt and the International Transmission of Business Cycles By Luca Guerrieri; Matteo Iacoviello; Raoul Minetti
  11. Modifying Taylor Reaction Functions in Presence of the Zero-Lower-Bound – Evidence for the ECB and the Fed By Ansgar Belke; Jens Klose
  12. The Bank Lending Channel and Monetary Policy Rules for European Banks: Further Extensions By Nicholas Apergis; Stephen M. Miller; Effrosyni Alevizopoulou
  13. Fiscal Cyclicality and EMU By Agustín S. Bénétrix; Philip R. Lane
  14. The Crisis Sensitivity of European Countries and Regions: Stylized Facts and Spatial Heterogeneity By Stefan P.T. Groot; Jan L. Mohlmann; Harry Garretsen; Henri L.F. de Groot
  15. Cyclical adjustment in fiscal rules: Some evidence on real-time bias for EU-15 countries By Kempkes, Gerhard
  16. Successful Austerity in the United States, Europe and Japan By Nicoletta Batini; Giovanni Callegari; Giovanni Melina
  17. How are firms’ wages and prices linked: survey evidence in Europe By Martine Druant; Silvia Fabiani; Gábor Kézdi; Ana Lamo; Fernando Martins; Roberto Sabbatini

  1. By: Körner, Finn Marten; Zemanek, Holger
    Abstract: In this paper we study the intra-euro area imbalances based on a dynamic general equilibrium model. We show that European financial integration and the introduction of the euro might have contributed to the development of imbalances. Interest rate convergence following EMU accession led to net foreign debt positions, which prove difficult to reverse. Simulation results for the euro area suggest that current account imbalances and foreign debt positions of today's crisis countries have significantly diverged from a sustainable path. Increasing investment in the EMU core and productivity in crisis countries may permit a return to sustainable foreign debt levels and correct macroeconomic imbalances in the euro area. --
    Keywords: current account imbalances,euro area,foreign debt,sustainability,general equilibrium model
    JEL: E44 F32 F34 G15
    Date: 2012
  2. By: Roth, Felix (Centre for European Policy Studies (CEPS)); Jonung, Lars (Department of Economics, Lund University); Nowak-Lehmann D., Felicitas (University of Göttingen)
    Abstract: This paper analyses the evolution of public support for the single European currency, the euro, from 1990 to 2011, focusing on the most recent period of financial and sovereign debt crisis. Exploring a huge database of more than half a million observations covering the 12 original euro area member countries, we find that the ongoing crisis has only marginally reduced citizens’ support for the euro. This result is in stark contrast to a sharp fall in public trust in the European Central Bank. We conclude that the crisis – at least so far - has hardly dented popular support for the euro while the central bank supplying the single currency has lost sharply in public trust. Thus, the euro appears to have established a credibility of its own – separate from the institutional framework behind the euro.
    Keywords: Support for the euro; European Monetary Union; euro area crisis
    JEL: C23 E31 E42 E65
    Date: 2012–07–18
  3. By: William R. Cline (Peterson Institute for International Economics)
    Abstract: This paper introduces a new probabilistic approach to sovereign debt projections and presents new estimates of debt ratios through 2020 for Italy and Spain. The new approach takes account of likely correlations across 243 alternative scenarios with three states (good, baseline, bad) for five key variables (growth, interest rate, primary surplus, bank recapitalization, and privatization). The 25th and 75th percentile scenarios are reported, as are the baseline and probability-weighted outcomes. The results suggest sovereign debt is sustainable in both Italy (where debt ratios are likely to decline because of a high primary surplus) and Spain (where the ratios rise but at a decelerating pace and from relatively low levels).
    Keywords: sovereign debt, Italy, Spain, euro area crisis
    JEL: E62 H63 H68
    Date: 2012–08
  4. By: Ashoka Mody; Stijn Claessens; Shahin Vallée
    Abstract: This paper discusses proposals for common euro area sovereign securities. Such instruments can potentially serve two functions: in the short-term, stabilize financial markets and banks and, in the medium-term, help improve the euro area economic governance framework through enhanced fiscal discipline and risk-sharing. Many questions remain on whether financial instruments can ever accomplish such goals without bold institutional and political decisions, and, whether, in the absence of such decisions, they can create new distortions. The proposals discussed are also not necessarily competing substitutes; rather, they can be complements to be sequenced along alternative paths that possibly culminate in a fully-fledged Eurobond. The specific path chosen by policymakers should allow for learning and secure the necessary evolution of institutional infrastructures and political safeguards.
    Keywords: Bonds , Capital markets , Euro Area , Europe , Financial stability , Fiscal policy , Fiscal risk , Monetary transmission mechanism , Sovereign debt ,
    Date: 2012–07–02
  5. By: Anders Aslund (Peterson Institute for International Economics)
    Abstract: One of the big questions of our time is whether the Economic and Monetary Union (EMU) will survive. Too often, analysts discuss a possible departure of one or several countries from the euro area as little more than a devaluation, but Åslund argues that any country’s exit from the euro area would be a far greater event with potentially odious consequences. A Greek exit would not be merely a devaluation for Greece but would unleash a domino effect of international bank runs and disrupt the EMU payments mechanism, which would lead to a serious, presumably mortal, disintegration of the EMU. It would inflict immense harm not only on Greece but also on other countries in the European Union and the world at large. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction. Åslund’s critical argument for a domino effect is that the EMU already has large uncleared interbank balances in its so-called Target2 system. Exit of any country is likely to break this centralized EMU payments mechanism. These rising uncleared balances are a serious concern because nobody can know how they will be treated if the EMU broke up. Any attempt to cap them would risk disruption of the EMU. These balances need to be resolved but in a fashion that safeguards the integrity of the EMU. However, this can hardly be done by anything less than fully securing the sustainability of the EMU. If the euro area does break up, Åslund says, the damage will vary greatly depending on the policies pursued. On the basis of prior dissolutions of currency zones, such as the ruble zone in 1992/1993, he suggests that an amicable, fast, and coordinated end of the EMU would minimize the harm.
    Date: 2012–08
  6. By: Jeffrey A. Frankel; Jesse Schreger
    Abstract: Why do countries find it so hard to get their budget deficits under control? Systematic patterns in the errors that official budget agencies make in their forecasts may play an important role. Although many observers have suggested that fiscal discipline can be restored via fiscal rules such as a legal cap on the budget deficit, forecasting bias can defeat such rules. The members of the eurozone are supposedly constrained by the fiscal caps of the Stability and Growth Pact. Yet ever since the birth of the euro in 1999, members have postponed painful adjustment by making overly optimistic forecasts of future growth and budget positions and arguing that the deficits will fall below the cap within a year or two. The new fiscal compact among the euro countries is supposed to make budget rules more binding by putting them into laws and constitutions at the national level. But what is the record with such national rules? Our econometric findings are summarized as follows: • Governments’ budget forecasts are biased in the optimistic direction, especially among the Eurozone countries, especially when they have large contemporaneous budget deficits, and especially during booms. • Governments’ real GDP forecasts are similarly over-optimistic during booms. • Despite the well-known tendency of eurozone members to exceed the 3% cap on budget deficits, often in consecutive years, they almost never forecast that they will violate the cap in the coming years. This is the source of the extra bias among eurozone forecasts. If euro area governments are not in violation of the 3% cap at the time forecasts are made, forecasts are no more biased than other countries. • Although euro members without national budget balance rules have a larger over-optimism bias than non-member countries, national fiscal rules help counteract the wishful thinking that seems to come with euro membership. The reason is that when governments are in violation of the 3% cap the national rules apparently constrain them from making such unrealistic forecasts. • Similarly, the existence of an independent fiscal institution producing budget forecasts at the national level reduces the over-optimism bias of forecasts made when the countries are in violation of the 3% cap.
    JEL: F3
    Date: 2012–08
  7. By: Sven Steinkamp (Universitaet Osnabrueck); Frank Westermann (Universitaet Osnabrueck)
    Abstract: The recent increase of interest rate spreads in Europe and their apparent detachment from underlying fundamental variables has generated a debate on multiple equilibria in the sovereign bond market (see Grauwe and Ji (2012)). We critically evaluate this hypothesis, by pointing towards an alternative explanation: the increasing share of senior lenders (IMF, ECB, EFSF, etc.) in the total outstanding government debt of countries in crisis. We illustrate the close relationship between senior tranche lending – including Target2 balances – and recent developments in the sovereign bond market, both graphically and in a formal regression analysis.
    Keywords: Government bond spreads, Eurozone, senior tranche lending
    JEL: F34 G12 H81
    Date: 2012–08–10
  8. By: Kai Daniel Schmid; Michael Schmidt
    Abstract: What is the role of fiscal variables for the assessment of sovereign credit risk? Has this role changed over time? In the face of the financial crisis many OECD countries have experienced large increases of government debt relative to GDP. This has triggered a distinct response of financial markets reflected by a sharp rise of longterm interest on government bonds. We show that, in particular, within some member countries of the European Monetary Union the explanation of investors’ recent reactions to these fiscal imbalances is twofold: first, it is the worsening of fiscal positions due to the financial crisis that has been taken into account. Second, and more striking, it is financial markets’ reconsideration of the role of these fiscal fundamentals for the pricing of sovereign credit risk. We argue that, from a historical perspective, this recent re-evaluation of fiscal positions seems little surprising. It is rather the re-establishment of the temporarily interrupted pricing of fiscal imbalances as a central factor of sovereign credit risk than the aggravation of fiscal imbalances. In our study we provide cross-country evidence for the impact of fiscal imbalances upon long-term interest rates. We use macroeconomic data from 1980 to 2012 and contrast a panel of 22 OECD countries with 11 EMU member countries and the so called GIIPS countries. This comparably long time span allows us to evaluate the changes in sovereign risk pricing that set in with the start of the EMU. In particular, we find that the relationship between the perceived default risk reflected by long-term interest rates and the public debt to GDP ratio as an indicator of fiscal sustainability is time regime as well as regional cluster specific. Our findings suggest that there is a strong connection of institutional aspects of EMU and the relationship between fiscal imbalances and changes in the pricing of sovereign credit risk.
    Keywords: default risk, EMU, GIIPS, long-term interest rate, sovereign debt crisis
    JEL: E43 E44 E62
    Date: 2012–06
  9. By: Jean Pisani-Ferry; Silvia Merler
    Abstract: The euro area today consists of a competitive, moderately leveraged North and an uncompetitive, over-indebted South. Its main macroeconomic challenge is to carry out the adjustment required to restore the competitiveness of its southern part and eliminate its excessive public and private debt burden. This paper investigates the relationship between fiscal and competitiveness adjustment in a stylised model with two countries in a monetary union, North and South. To restore competitiveness, South implements a more restrictive fiscal policy than North. We consider two scenarios. In the first, monetary policy aims at keeping inflation constant in the North. The South therefore needs to deflate to regain competitiveness, which worsens the debt dynamics. In the second, monetary policy aims at keeping inflation constant in the monetary union as a whole. This results in more monetary stimulus, inflation in the North is higher, and this in turn helps the debt dynamics in the South. Our main findings are: The differential fiscal stance between North and South is what determines real exchange rate changes. South therefore needs to tighten more. There is no escape from relative austerity.If monetary policy aims at keeping inflation stable in the North and the initial debt is above a certain threshold, debt dynamics are perverse: fiscal retrenchment is self-defeating;If monetary policy targets average inflation instead, which implies higher inflation in the North, the initial debt threshold above which the debt dynamics become perverse is higher. Accepting more inflation at home is therefore a way for the North to contribute to restoring debt sustainability in the South.Structural reforms in the South improve the debt dynamics if the initial debt is not too high. Again, targeting average inflation rather than inflation in the North helps strengthen the favourable effects of structural reforms.
    Date: 2012–07
  10. By: Luca Guerrieri; Matteo Iacoviello; Raoul Minetti
    Abstract: This paper studies the international propagation of sovereign debt default. We posit a two-country economy where capital constrained banks grant loans to firms and invest in bonds issued by the domestic and the foreign government. The model economy is calibrated to data from Europe, with the two countries representing the Periphery (Greece, Italy, Portugal and Spain) and the Core, respectively. Large contractionary shocks in the Periphery trigger sovereign default. We find sizable spillover effects of default from Periphery to the Core through a drop in the volume of credit extended by the banking sector.
    JEL: F4 G21 H63
    Date: 2012–08
  11. By: Ansgar Belke; Jens Klose
    Abstract: We propose an alternative way of estimating Taylor reaction functions if the zero-lower-bound on nominal interest rates is binding. This approach relies on tackling the real rather than the nominal interest rate. So if the nominal rate is (close to) zero central banks can influence the inflation expectations via quantitative easing. The unobservable inflation expectations are estimated with a state-space model that additionally generates a time-varying series for the equilibrium real interest rate and the potential output - both needed for estimations of Taylor reaction functions. We test our approach for the ECB and the Fed within the recent crisis. We add other explanatory variables to this modified Taylor reaction function and show that there are substantial differences between the estimated reaction coefficients in the pre- and crisis era for both central banks. While the central banks on both sides of the Atlantic act less inertially, put a smaller weight on the inflation gap, money growth and the risk spread, the response to asset price inflation becomes more pronounced during the crisis. However, the central banks diverge in their response to the output gap and credit growth.
    Keywords: Zero-lower-bound; Federal Reserve; European Central Bank; equilibrium real interest rate; Taylor rule
    JEL: E43 E52 E58
    Date: 2012–07
  12. By: Nicholas Apergis (University of Piraeus); Stephen M. Miller (University of Nevada, Las Vegas and University of Connecticut); Effrosyni Alevizopoulou (University of Piraeus)
    Abstract: The monetary authorities affect the macroeconomic activity through various channels of influence. This paper examines the bank lending channel, which considers how central bank actions affect deposits, loan supply, and real spending. The monetary authorities influence deposits and loan supplies through its main indicator of policy, the real short-term interest rate. This paper employs the endogenously determined target interest rate emanating from the central bank’s monetary policy rule to examine the operation of the bank lending channel. Furthermore, it examines whether different bank-specific characteristics affect how European banks react to monetary shocks. That is, do sounder banks react more to the monetary policy rule than less-sound banks. In addition, inflation and output expectations alter the central bank’s decision for its target interest rate, which, in turn, affect the banking system’s deposits and loan supply. Robustness tests, using additional control variables, (i.e., the growth rate of consumption, the ratio loans to total deposits, and the growth rate of total deposits) support the previous results.
    Keywords: Monetary policy rules, bank lending channel, European banks, GMM methodology
    JEL: G21 E52 C33
    Date: 2012–07
  13. By: Agustín S. Bénétrix (IIIS, Trinity College Dublin); Philip R. Lane (IIIS, Trinity College Dublin and CEPR)
    Abstract: For the set of EMU member countries, we examine cyclical patterns in fiscal outcomes. We find that there is significant time variation in fiscal cyclicality, with an improvement in the wake of the Maastricht Treaty but a deterioration after the creation of EMU. Furthermore, we show that the fiscal cycle is affected by the financial cycle in addition to the output cycle. The lessons for the current reforms of European economic and fiscal governance are manifest.
    Keywords: Cyclicality, EMU
    JEL: E62
    Date: 2012–07
  14. By: Stefan P.T. Groot (VU University Amsterdam); Jan L. Mohlmann (VU University Amsterdam); Harry Garretsen (University of Groningen); Henri L.F. de Groot (VU University Amsterdam)
    Abstract: This paper investigates the impact of the recent global recession on European countries and regions. We first present several stylized facts as to the heterogeneous impact of the global recession on individual European countries and regions. We then offer an investigation of three main classes of explanations for spatial heterogeneity in the severity of the crisis. The first is the extent to which countries are integrated in the global economy via financial and trade linkages. A second class of potential explanations is found in differences in the institutional framework of countries. A third possible cause why some countries and notably also regions are more affected than others is differences in their sectoral composition. We show that especially variation in the sectoral composition contributes to the variation in the effects of the current crisis, both at the country level and at the detailed regional level across the EU.
    Keywords: recession; austerity; Europe; spatial heterogeneity
    JEL: E02 E32 E63 F44 O52 R11
    Date: 2011–04–21
  15. By: Kempkes, Gerhard
    Abstract: Most EU member states will adopt fiscal rules that refer to cyclically-adjusted borrowing limits. Under the standard cyclical adjustment procedure, trend increases in public debt based on cyclical components are prevented if the real-time output gaps used to calculate cyclical components balance over time. We analyse real-time output gaps for EU-15 countries over the 1996-2011 period as estimated by the EU, the IMF and the OECD. Compared to each institution's final estimate, we find that real-time output gaps in our sample period are negatively biased. This bias is observed (i) irrespective of the source of the data, (ii) in all real-time vintages, (iii) basically across the entire cross-section of countries. The magnitude of the bias is considerable: on average, real-time cyclical components as a percentage of GDP are biased downwards by about 0.5 percentage point per year. Our results suggest that fiscal rules should incorporate ex-post checks of the unbiasedness of the cyclical components used within the rule. Potential biases would then decrease or increase future borrowing limits. --
    Keywords: public finance,fiscal rules,cyclical adjustment
    JEL: H61 H68 E32
    Date: 2012
  16. By: Nicoletta Batini; Giovanni Callegari; Giovanni Melina
    Abstract: The output effects of 2009 fiscal expansions have been hotly debated. But the discussion of fiscal multipliers is even more relevant now that several European countries have had to quickly retract their stimulus measures in an effort to regain market confidence. Using regime-switching VARs we estimate the impact of fiscal adjustment on the United States, Europe and Japan allowing for fiscal multipliers to vary across recessions and booms. We also estimate ex ante probabilities of recessions derived in association with different-sized and different types of consolidation shocks (expenditure- versus tax-based). We use these estimates to understand how consolidations should be designed to be most effective in terms of permanently and rapidly reducing a country’s debt-to-GDP ratio. The main finding is that smooth and gradual consolidations are to be preferred to frontloaded or aggressive consolidations, especially for economies in recession facing high risk premia on public debt, because sheltering growth is key to the success of fiscal consolidation in these cases.
    Keywords: Fiscal consolidation , Fiscal policy , Adjustment process , External shocks , Business cycles , Government expenditures , Public debt , Risk management ,
    Date: 2012–07–26
  17. By: Martine Druant (National Bank of Belgium); Silvia Fabiani (Bank of Italy); Gábor Kézdi (Magyar Nemzeti Bank (central bank of Hungary), Central European University, Institute of Economics of the Hungarian Academy of Sciences); Ana Lamo (European Central Bank); Fernando Martins (Bank of Portugal, ISEG (Technical University of Lisbon), Universidade Lusíada of Lisbon); Roberto Sabbatini (Bank of Italy)
    Abstract: This paper presents new evidence on the patterns of price and wage adjustment in European firms and on the extent of nominal rigidities. It uses a unique dataset collected through a firm-level survey conducted in a broad range of countries and covering various sectors. Several conclusions are drawn from this evidence. Firms adjust wages less frequently than prices: the former tend to remain unchanged for about 15 months on average, the latter for around 10 months. The degree of price rigidity varies substantially across sectors and depends strongly on economic features, such as the intensity of competition, the exposure to foreign markets and the share of labour costs in total cost. Instead, country specificities, mostly related to the labour market institutional setting, are more relevant in characterising the pattern of wage adjustment. The latter exhibits also a substantial degree of time-dependence, as firms tend to concentrate wage changes in a specific month, mostly January in the majority of countries. Wage and price changes feed into each other at the micro level and there is a relationship between wage and price rigidity.
    Keywords: survey, wage rigidity, price rigidity, indexation, institutions, time dependent
    JEL: D21 E30 J31
    Date: 2012

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