Does the Eurozone need a fiscal capacity? E-Book

Alexander Kuchta

• Herausgeber: GRIN Verlag
• Sprache: Englisch

Veröffentlichungsjahr: 2015

Beschreibung

Master's Thesis from the year 2015 in the subject Economics - Other, grade: 1,3, University of Frankfurt (Main), language: English, abstract: 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. 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. As readjustment takes longer than expected, the political, economic and social costs have since then 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 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. 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. In Chapter 4.2. the efficacy of the enacted changes in the EMU financial, fiscal and eco-nomic framework to cope with the existing weaknesses of the EMU structure is determined. , 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 conver-gence, countercyclical properties and their potential problems.

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Table of content

List of Figures

List of Tables

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 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 equalisationDelors(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 exemplarilySinn(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 byGrauwe(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.

Figure1Idiosyncratic shock and adjustment process in a two country case

Source: Grauwe (2009).

According toRose 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