With the current European sovereign public debt crisis and current account imbalances difficulties in the EMU, many papers now underline that the problem of the European construction is its lack of institutional framework and common economic governance necessary to make a monetary union viable. According to these papers, the solution would lie in a stronger economic cooperation, with the Northern European countries contributing to lighten the burden of the Southern debtor countries. In this context, our model shows that a symmetric positive demand shock in the EMU could only slightly reduce the external indebtedness of the Southern European countries but would efficiently reduce their public debt levels. To the contrary, an asymmetric positive demand shock in the creditor Northern European countries (e.g., an increase in German wages) could reduce the current account deficits of the Southern European countries, in particular for countries with the highest openness to trade. Nevertheless, it would worsen the indebtedness levels, and it would also increase the recessionary risks in these countries.
In the framework of a monetary union, the member countries loose variations in nominal exchange rates and in interest rates in order to adjust to cyclical economic variations and to stabilize asymmetric shocks. Therefore, real exchange rates can only vary thanks to variations in relative prices. However, at least in the short run, wages and prices are not very flexible. Therefore, budgetary policies must compensate for the price rigidity to allow the adjustment of the output and labor markets. In the absence of any centralized transfer and adjustment mechanism, as in the European Economic and Monetary Union (EMU), the weight of the stabilization can then become too heavy for budgetary policies. So, a growing literature underlines today the problem inherent in the European framework. Monetary unification did not go with a parallel fiscal integration. Thus, an imperfect monetary union without a fiscal union can be at the origin of current account imbalances, which can contribute to accentuate fiscal difficulties and create the conditions of a public debt crisis.
European authorities mostly blamed the fiscal laxity of some European governments for the financial and sovereign public debt crisis since 2008. Nevertheless, many recent economic papers have also stressed the role of current account imbalances for the current European crisis. Indeed, since the 1970s, Northern European countries have accumulated rising and persistent current account surpluses, while Southern countries have accumulated current account deficits and have seen an appreciation of their real exchange rates, because of rising labor costs. (In conformity with empirical observations, we will consider Germany, Austria, Finland, The Netherlands, and Luxembourg as “Northern” or core European countries, whereas Greece, Ireland (despite its geographical situation), Portugal, and Spain are “Southern” or periphery European countries. Cyprus, Malta, and Slovenia could be added to these Southern countries (see [
Southern European countries have a preference for consumption, whereas Northern countries favor sparing and price stability, implying more current account deficits for the Southern countries. Higgins and Klitgaard [
The econometrical study by Arghyrou and Chortareas [
Fiscal policies then reinforced these external divergences. Indeed, the Southern countries were less competitive, which decreased their exports and implied higher current account deficits, depressing their global demand. Therefore, these external imbalances necessitated higher budgetary deficits, which were at the origin of “twin deficits” in the Southern countries. Besides, as EMU member countries had divergent fiscal paths, with Southern countries becoming more indebted with higher budgetary deficits, capital flows had to be directed towards these countries. However, Northern countries were less and less anxious to provide the necessary financial funds to their spendthrift partners. Indeed, after the credit boom, private capital flows suddenly stopped with the financial crisis, after 2009. Indeed, the current account deficits of the Southern countries were then considered by the financial markets as a sign of weak capacity to repay their public debt. So, there were capital outflows from these countries, increasing their interest rates and accentuating their fiscal difficulties, as mentioned by Canale and Marani [
Canale and Marani [
This consideration of external imbalances is very new in the European institutional framework. Indeed, it was fully absent in the Maastricht Treaty. A new surveillance and enforcement mechanism has been set up in December 2011 as part of the so-called Six-Pack legislation, which reinforced economic governance in the EU and the euro area. However, the problem of the new Macroeconomic Imbalances Procedure (MIP) is that the European Commission put pressure on debtor countries to correct their situation, whereas the situation is not symmetric, as no similar pressure is put on creditor countries to reduce their current account surpluses. Countries at risk of running excessive level of private sector indebtedness and current account deficits would be placed in an “Excessive imbalances position.” But countries with surpluses are not clearly compelled to take corrective action [
As mentioned by Merler and Pisani-Ferry [
The first one is to accept an internal devaluation, an increase in their real exchange rates, with a reduction of domestic wages in particular. However, this would probably be costly in terms of economic growth, consumption, and investment spending for the Southern countries. Indeed, Gros [
The second option is to encourage productivity gains in the Southern countries. However, productivity growth depends on capital investment, education, innovation, product market regulation, labor market flexibility, and the business environment. So, the estimates by Jaumotte and Sodsriwiboon [
Horn et al. [
In this framework, the aim of our paper is to study precisely the theoretical implications of symmetric or asymmetric demand shocks, regarding both the external imbalances in the European EMU and the indebtedness problems of the European countries. Indeed, a symmetric demand shock in all the monetary union member countries would be more efficient in order to reduce the indebtedness levels of the Southern European countries; however, current accounts differentials would then hardly be reduced in the EMU. On the contrary, an asymmetric demand shock in the Northern European countries could more efficiently reduce external imbalances in the monetary union. However, it would also increase recessionary risks and public debts in the Southern European countries. Besides, our model shows that the conditions of efficiency of demand shocks also depend on the structural heterogeneity among the member countries of the EMU. The structure of our paper is as follows. Section
We consider a dynamic New-Keynesian model of a monetary union with two distinct kinds of countries: the “North” (N) and the “South” (S). Each subgroup of country is composed of two sectors, households and firms, and of a fiscal authority. We suppose a closed monetary union vis-à-vis the rest of the world, whose countries face symmetric or asymmetric supply or demand shocks. Besides, we suppose that symmetric and asymmetric components of each shock are independently distributed. Anticipations are rational; each economy produces a single perfectly substitutable good. All variables are expressed in deviations from their long run equilibrium values, and the model is therefore in a log-linearized form. Monetary policy is defined by a central bank common to all the monetary union member countries. Budgetary policies are set by the decentralized governments at the national level. Financial markets are supposed to be perfect, whereas goods markets are characterized by nominal price rigidities.
We use a stylized dynamic New-Keynesian model, which is broadly consistent with this literature, even if we do not detail here its underlying microeconomic structure (see, e.g., Lieb [
Traditionally, in New-Keynesian models, aggregate demand is driven by the optimizing behavior of households, which maximize an intertemporal utility function. Thus, output depends on expected future output, because rational agents can maximize their decisions intertemporally and smooth their consumption. Variation in demand is also an increasing function of the variation in public expenditure in a given zone in comparison with what is expected for the following period
The reduced form and linearized supply function is represented by a forward looking New-Keynesian Phillips curve:
Indeed, in New-Keynesian models, aggregate supply results from the behavior of firms that set prices for their products so as to maximize profits in a monopolistic competition setting. Inflation then depends on expectations about future prices, because of learning effects. Besides, the output gap expresses the demand-pull factor and tensions on the utilization of productive capacities. In this framework, (
By combining (
Therefore, we find classical characteristics of these economic variables. Prices and economic activity decrease with the interest rate (restrictive monetary policy), and they increase with positive demand shocks. Positive supply shocks reduce prices, but they have ambiguous consequences on economic activity levels. Indeed, they sustain economic growth in the affected zone to the detriment of the rest of the monetary union.
Beyond economic activity and inflation, let us consider two supplementary variables, which are important in the framework of our study. The first one is the current account position. Let us consider that (
So, in percentage of GDP, we have approximately the following evolution of the net foreign assets position of the zone (
Therefore, the evolution of the current account of the zone (
Therefore, our model can contribute to explain the current dilemma of the European Economic and Monetary Union. The “Southern countries” accumulated growing external indebtedness positions (
The last indicator that we will consider in this paper is the indebtedness level of the member countries of the zone (
So, the evolution of the public debt in terms of deviation from equilibrium value can be given by the following equation:
Moreover, if we consider that the budgetary deficit is the differential between the budgetary expenditure and resources (
We can now turn to the preferences and loss functions of the economic authorities. We suppose that economic policies are endogenous and are the result of a strategic game (Nash equilibrium) between the economic authorities. The preferences of the common central bank are given by the following intertemporal loss function:
Indeed, the central bank stabilizes mostly average inflation but also average output in the monetary union as a whole. Besides, we also suppose that price stability is more important for the central bank than for national governments (
The preferences of the governments of the zone (
The governments of the zone (
In order to calibrate our model, we will retain the following values for our structural parameters. Share of private consumption in GDP ( Openness to trade: ( Price flexibility ( Imported inflation ( Time discount factor ( Debt level in proportion to GDP ( Taxation rates ( Net foreign assets ( Share of the Northern countries in total GDP of the monetary union (
Share of private consumption, openness to trade, indebtedness level, and net foreign assets position of some EMU countries.
Private consumption/GDP (1) | Openness to trade (2) | Public debt/GDP | Net foreign assets/GDP (3) | |
---|---|---|---|---|
EMU 17 |
|
|
|
|
Austria | 81.0% | 55.6% | 73.4% | 2.9% |
Belgium | 75.1% | 84.2% | 99.6% | 0.8% |
Finland | 74.9% | 41.0% | 53.0% | −1.5% |
France | 75.3% | 28.6% | 90.2% | −1.7% |
Germany | 80.5% | 48.8% | 81.9% | 6.3% |
Greece | 82.2% | 29.5% | 156.9% | −2.9% |
Ireland | 82.5% | 96.0% | 117.6% | 3.7% |
Italy | 79.9% | 29.7% | 127.0% | −0.4% |
The Netherlands | 71.5% | 83.8% | 71.2% | 8.0% |
Portugal | 81.7% | 39.1% | 123.6% | 0.4% |
Spain | 79.9% | 31.7% | 84.2% | −0.2% |
Source:
(1) 1 − (Final consumption expenditure of general government/GDP), in 2012.
(2) (Exportations + Importations of goods and services)/(2 * GDP), in 2012.
(3) Net borrowing (−) or net lending (+), total economy, in % of GDP, in 2012.
Finally, regarding the preferences of the economic authorities, we will suppose:
We can now define the Nash equilibrium of our model. By combining (
Let us first study the implications of a symmetric demand shock:
After a positive symmetric demand shock (
Besides, according to (
Therefore, prices, economic activity levels, or current accounts could perfectly be stabilized in all countries if there was no constraint on the use of the budgetary instrument (
However, the expansionary tensions and variations in the current accounts do not depend on the importance of external imbalances and on the weight of stabilizing current accounts (
Therefore, the first results of our model would tend to show that, in case of structural homogeneity, a symmetric expansionary demand shock in all European countries could not be useful in order to solve the problem of external imbalances and of deficits in the current accounts of the Southern European countries. Indeed, as economic activity and prices would tend to grow in parallel in all countries, the insufficient price competitiveness of the Southern European countries would remain unchanged. Nevertheless, our model can provide some supplementary teachings regarding symmetric demand shocks, in case of structural heterogeneity among the member countries of a monetary union.
Regarding variations in current accounts, the common central bank could perfectly stabilize them if it was not constrained in the variations of its interest rate (
We can also mention that if price flexibility (
Furthermore, in case of structural homogeneity in the demand and supply functions among the member countries of the monetary union, variations in current accounts only depend on the previously accumulated foreign assets (
For example, with the basic calibration of our model, if foreign assets represent 6% of GDP of the Northern zone (
In this framework, according to our model, even a symmetric positive demand shock could contribute to reduce the external imbalances in the EMU. Indeed, it would automatically reduce the value of the current account surpluses of the creditor Northern European countries, whereas it would also reduce the current account deficits of the debtor Southern European countries. Moreover, a positive symmetric demand shock could reduce budgetary deficits and indebtedness levels in the Southern European countries, and all the more as price flexibility and imported inflation are weak in these countries. Nevertheless, our simulations show that the size of the variations in current accounts would remain quite limited in case of a positive symmetric demand shock. Our model also shows the limits of joint and parallel austerity measures in all EMU member countries, which could tend to accentuate external imbalances and debt problems in all the monetary union member countries.
Now, let us study the implications of an asymmetric demand shock increasing demand in the zone (
After an asymmetric demand shock, monetary policy would not vary in case of structural homogeneity between the member countries of the monetary union and if they had the same size (
Besides, according to (
Therefore, prices, economic activity levels, or current accounts could perfectly be stabilized in all countries if there was no constraint on the use of the budgetary instrument (
In these conditions, the weaker price competitiveness and growing net imports create a current account deficit in the zone (
Therefore, our model would tend to show that, even in case of structural homogeneity among the member countries of the EMU, an asymmetric positive demand shock in the Northern European countries could contribute to limit external imbalances and deficits in the current accounts of the Southern European countries. Indeed, such a shock would create inflationary tensions and reduce the price competitiveness of the Northern countries, as well as their current account surpluses. Thus, it would reduce external imbalances and current account deficits in the Southern countries, which would benefit from a relatively smaller inflation rate and from a better price competitiveness in comparison with their Northern partners. Nevertheless, an asymmetric negative demand shock would increase budgetary deficits and public debts, and it would create recessionary tensions in the Southern European countries. Furthermore, our model can provide some supplementary teachings regarding asymmetric demand shocks, in case of structural heterogeneity among the member countries of a monetary union.
First, in case of an asymmetric demand shock, if the monetary policy transmission parameters are weaker in the zone (
Regarding openness to trade, if openness of the zone (
Furthermore, the previously accumulated foreign assets have only minor consequences on inflation and economic activity levels, according to our model. Even in case of structural homogeneity in the demand and supply functions among the member countries of the monetary union, accumulated foreign assets (
For example, with the basic calibration of our model, if foreign assets represent 6% of GDP of the Northern zone (
In conclusion, in case of asymmetric demand shocks, in order to reduce external imbalances in the monetary union, it is obviously necessary that the shock positively affects the creditor countries in the monetary union. In this framework, according to our model, an asymmetric positive demand shock affecting the creditor Northern countries of the EMU could reduce external imbalances in the monetary union. Indeed, such a shock would reduce the current account surpluses of the creditor Northern European countries, whereas it would also reduce the current account deficits of the debtor Southern European countries. In order to reduce the current account deficits of these debtor countries at a smaller cost for their indebtedness levels, it would also be better if the debtor countries negatively affected had stronger monetary policy transmission parameters (
With the current European sovereign public debt crisis and current account imbalances difficulties in the EMU, many papers now underline that the problem of the European construction is its lack of institutional framework and common economic governance necessary to make a monetary union viable. For example, Tilford and Whyte [
Our model shows that in case of a positive symmetric demand shock, both monetary and budgetary policies are more recessionary in order to compensate for the consequences of the shock. Economic policies are then complementary, and the relative preferences of the authorities only contribute to determine their respective weights in the stabilization effort of these demand shocks. Whereas austerity measures have detrimental consequences, positive demand shocks would be beneficial to the reduction in budgetary deficits and indebtedness levels for the debtor Southern European countries. However, if the economic authorities are constrained in the use of their instruments, prices and economic activity levels then increase in parallel in all member countries of the monetary union. The consequences are therefore limited for the relative price competitiveness and the current accounts of the member countries of the monetary union. Indeed, positive demand shocks could contribute to reduce the differential in net foreign assets detained by the member countries of a monetary union, in particular if the stabilization effort mainly relies on the governments and not on the common central bank, but these variations would remain very limited. Moreover, external imbalances and indebtedness levels in a monetary union are more easily reduced by a positive symmetric demand shock if the debtor countries have a weaker price flexibility and imported inflation.
In case of an asymmetric demand shock, if the budgetary authorities are constrained in the use of their budgetary expenditure, the more restrictive budgetary policies cannot avoid the expansionary tensions in the countries positively affected whereas the more expansionary budgetary policies cannot avoid the recessionary tensions in the countries negatively affected by the shock. In these conditions, such a shock creates current account deficits in the countries affected by a positive demand shock and current account surpluses in the partner countries. So, according to our model, an asymmetric positive demand shock in the creditor Northern European countries (Germany or The Netherlands) would reduce the current account deficits and the external imbalances for the debtor Southern European countries. However, this would also increase the budgetary deficits and public debts and would create recessionary risks in these Southern European countries. Therefore, the main argument against an asymmetric (in comparison with a symmetric) demand shock in Europe is that it would increase the debt problems of the debtor Southern countries, instead of lightening their difficulties. Nevertheless, external imbalances would be reduced at a smaller cost for the indebtedness level if the countries negatively affected by the shock have the strongest monetary policy transmission parameters and the highest openness to trade. Therefore, a positive demand shock in Germany would be more beneficial in order to reduce the current account deficit of an open country like Ireland than for more closed countries like Spain or Greece. It would also be more beneficial if price flexibility was high in the EMU, whereas rigidities are still quite important in Europe today, in particular in labour markets.
Solving (
Then, by combining (
(
The central bank minimizes its loss function. Therefore, with
The government (
So, by combining (
Then, by combining the economic policies (
There is no conflict of interests regarding the publication of this paper.