Making the Stability Pact More Flexible: Does It Lead to Pro‐Cyclical Fiscal Policies?*

One of the often‐discussed negative aspects of the Stability and Growth Pact is the rigidity of its deficit rule. Several reform proposals aim currently to alleviate the rule in order to allow the automatic stabilisers to operate freely. However, such a reform is likely to cause even further deterioration of fiscal balances in the EMU member countries. The empirical evidence presented in this paper shows that, in the past, increasing the structural deficit had a strong negative impact on the degree of anti‐cyclical fiscal stabilisation. This suggests that the reform of the Pact, through higher structural deficits, could decrease rather than increase the scope of anti‐cyclical fiscal actions in the EMU member countries.     

The fiscal dimension of a common monetary policy: results with a non-Ricardian global model

The paper studies the interaction of fiscal and monetary policy within an Economic and Monetary Union (EMU). Results suggest that, in a model in which bonds and money are counted as net wealth, an important source of cross-country heterogeneity in response to a common monetary shock is the differences in national economies' budgetary positions. In particular, we note that centralising seigniorage revenues may lead, in the long term, to wealth redistribution across countries. Although institutional arrangements such as the Stability Pact might not be necessary to ensure fiscal sustainability, its strict enforcement is shown to be associated with overall ever-lasting benefits. Transition to the new steady state is, however, likely to be remarkably costly for high-debt EMU countries. Finally, different degrees of efficiency characterising European credit markets do not seem to play a major role in explaining asymmetric responses.     

Public Investment in Europe: Evolution and Determinants in perspective*

We describe the evolution of public investment and public capital stocks in Europe over the past three decades. Against this background, we analyse the macroeconomic determinants of public investment, with a special focus on its long‐term trend. We find that public investment has been determined by national income, the stance of budgetary policies and fiscal sustainability considerations. Neither the cost of financing nor the fiscal rules embodied in EMU have had a systemic impact on public investment. The significant downtrend that characterises the evolution of public investment in non‐cohesion countries is chiefly determined by drawn‐out episodes of fiscal consolidation, unrelated to EMU.     

Interaction of Government Tiers and Central Banks in a Federation: An Empirical Test

Fiscal rules are necessary to protect monetary policy from the consequences of unsustainable or active fiscal policy for inflation. Monetary unions, such as the Economic and Monetary Union (EMU), require even stronger fiscal rules to avoid free riding by regional fiscal authorities on the common monetary policy. By contrast, in a fiscal federation, the federal government internalises the effect of active regional policies on the overall price level. Federal fiscal policy contributes to price stability either by enforcing fiscal rules or by adjusting its own stance. Following Canzoneri, Cumby and Diba (2001), we test whether federal and regional governments in Germany behave in an active or passive way. We find evidence of a spillover effect of unsustainable policies on other regions. The German federal government offsets the effect on the price level by running passive policies. The Bundesbank's prime objective of price stability is therefore endorsed by fiscal policy. The results have implications for the regulation of fiscal policies in the EMU.     

A structural decomposition of the U.S. trade balance: Productivity, demographics and fiscal policy

The US external deficits have been the most striking manifestation of global imbalances. This paper investigates the contribution of productivity growth, demographics and fiscal policy in accounting for the evolution of the US external imbalances against industrialized countries during the last three decades. Productivity growth plays a dominant role. Demographics explain a non-negligible and nearly permanent component of the US trade deficit. Furthermore, the international demographic transition is crucial for large US external imbalances to be consistent with the persistent decline of world real interest rates observed in the data. Fiscal policy is of minor importance.     

Macroeconomic imbalances,financial stress and fiscal vulnerability in the euro area before the debt crises: A market view

This paper tries to identify the macro-financial imbalances that exposed the euro area countries to fiscal stress before the outbreak of the European debt crises. Contrary to conventional wisdom that interprets fiscal stress in terms of fiscal sustainability, we focus on short-term fiscal vulnerability as reflected by the conditions of debt refinancing in the sovereign bond markets. We find that market-based indicators capturing risk perceptions of sovereign debts have been influenced by the indicators defined in the European Macroeconomic Imbalance Procedure (MIP) and by variables of financial vulnerability. When pricing the risk of sovereign bonds, the holders of government debts take into account not only the macroeconomic imbalances but also factors such as banking distress, corporate bond risk, liquidity risks in the interbank market or the volatility of stock prices.     

Fiscal shocks and real exchange rate dynamics: Some evidence for Latin America

This paper analyses the effects of fiscal shocks in selected Latin American countries using a two-country model for output, labour input, government spending and relative prices. Dynamic simulation techniques are then applied, in particular to shed light on the possible effects of fiscal imbalances on the real exchange rate. Using quarterly data over the period 1980-2006, we find that in a majority of cases fiscal shocks are the main driving force of real exchange rate fluctuations.     

Sovereign bond yield spreads: A time-varying coefficient approach

We study the determinants of sovereign bond yield spreads across 10 EMU countries between Q1/1999 and Q1/2010. We apply a semiparametric time-varying coefficient model to identify, to what extent an observed change in the yield spread is due to a shift in macroeconomic fundamentals or due to altering risk pricing. We find that at the beginning of EMU, the government debt level and the general investors’ risk aversion had a significant impact on interest differentials. In the subsequent years, however, financial markets paid less attention to the fiscal position of a country and the safe haven status of Germany diminished in importance. By the end of 2006, two years before the fall of Lehman Brothers, financial markets began to grant Germany safe haven status again. One year later, when financial turmoil began, the market reaction to fiscal loosening increased considerably. The altering in risk pricing over time period confirms the need of time-varying coefficient models in this context.     

German Wage Moderation and European Imbalances: Feeding the Global VAR with Theory

German labor market reforms in the 1990s and 2000s are generally believed to have driven the large increase in the dispersion of current account balances in the Euro Area. We investigate this hypothesis quantitatively. We develop a three‐region open economy New Keynesian model with search and matching frictions from which we derive robust sign restrictions for wage bargaining and matching efficiency shocks which we term wage moderation shocks. We impose these restrictions on a Global VAR consisting of Germany and eight EMU countries to identify a wage moderation shock in Germany. Our results show that, although the German current account was significantly affected by wage moderation shocks, their contribution to European current account imbalances was negligible. We conclude that the German labor market reforms cannot be the lone driver of European imbalances.     

Systemic and Idiosyncratic Risk in EU-15 Sovereign Yield Spreads after Seven Years of Monetary Union

The market capitalisation of international bond markets is much larger than that of international equity markets. However, compared to the large body of literature on international equity market linkages, there are far fewer empirical studies of bond systemic risk or international bond market co-movements. The extent of international bond market linkages merits investigation, as it may have important implications for the cost of financing fiscal deficit, monetary policymaking independence, modelling and forecasting long-term interest rates, and bond portfolio diversification. In this paper, we investigate the relative influence of systemic and idiosyncratic risk factors on yield spreads over 10-year German government securities during the seven years after the beginning of Monetary Integration. We estimate both panel regressions for the two groups of EU-15 countries (EMU and non-EMU) and specific-country regressions for the nine countries in the EMU group and the three countries in the non-EMU group. All estimations include both domestic (differences in market liquidity and credit risk) and international risk factors. The results present clear evidence that it was mostly idiosyncratic rather than systemic risk factors that drove the evolution of 10-year yield spread differentials over Germany in all EMU countries during the seven years after the beginning of Monetary Integration. Conversely, in the case of non-EMU countries, adjusted yield spreads (corrected from the foreign exchange factor) are influenced more by systemic risk factors. The fact that these countries do not share a common Monetary Policy might explain these results, which may show that government bonds from EMU countries have a better safe-haven status that those of non-EMU countries.     

Cyclically‐Neutral Generational Accounting

This paper introduces a key methodological innovation into generational accounting. By incorporating cyclically‐adjusted balances into the forward‐looking budget projections underlying the concept, we isolate pure policy effects, which render comparisons of the fiscal sustainability indicators obtained across time and countries truly meaningful. We also show that a demographic effect and a debt effect may drive fiscal sustainability measures over time, and establish a routine to control for these effects in the generational accounting framework. An empirical application for Spain illustrates that our proposed decomposition of indicators is empirically relevant. Standard generational accounting suggests that fiscal sustainability in Spain improved substantially in preparing for EMU. However, calculation of the pure policy effects reveals that this has not been the case.     

Generational Accounting in New Zealand: Is There Generational Balance?

This paper uses a recently-developed technique, calledgenerational accounting, to assess New Zealand's long-term fiscalposition. Generational accounting has become a popular alternativeto traditional deficit accounting, because it provides a moreaccurate picture of the intergenerational distribution of fiscalburdens and the associated macroeconomic effects, particularlyin the presence of demographic transitions and large unfundedpublic transfer programs. Past studies have suggested the existenceof significant generational imbalances in several countries.We find that behind New Zealand's projectedbudget surpluses, there is indeed a sound fiscal picture. Evenunder the base case scenario, which entails substantial short-runtax reductions, the burden on future generations (relative toincome) is projected to fall slightly below that on current newborns.New Zealand appears to have avoided the large fiscal imbalancesplaguing the United States and other OECD countries not by placinglarge tax burdens on young current generations, but by limitingthe size of its commitments.     

A Model for Studying the Effect of EMU on European Yield Curves

In January 1999, the European monetary union (EMU) was formally launched with 11 member countries. However, before May 1998 there was considerable uncertainty about who would join EMU, and whether the project would start on time. When a monetary union is formed, exchange rates between the member countries are irrevocably fixed, and yield spreads stemming from exchange-rate risk are eliminated. As a direct consequence, EMU affected the prices of long-term bonds well before 1999, but quantifying this effect can be difficult when there is uncertainty about the monetary union. We address these issues and develop a bond-pricing model which explicitly takes into account that a country may join a monetary union at a future, unspecified date. The empirical results show that a narrow EMU, consisting of Germany, France and the Benelux countries, has been priced with almost 100% probability throughout the period 1995–1998, whereas, on average, the implied probability of joining EMU has been somewhat lower for the other EU countries. However, in the period leading up to May 1998, the estimated probabilities have increased considerably for the countries that joined EMU in January 1999.     

Is there an alternative way to avoid another eurozone crisis to the Five Presidents' Report?

The EU Commission's Five Presidents' Report proposes new rules for the eurozone covering fiscal policy, banking and financial markets designed to avert another eurozone crisis. This paper examines the causes of the current eurozone crisis and discusses whether the Report's proposals are likely to succeed. It is argued that the main causes of the crisis were EMU and the failure of financial markets to price risk correctly. It is claimed that the Report may not solve these problems. Having already lost their monetary policy instrument, the Report's fiscal proposals would remove countries' fiscal policy instrument too and deprive countries of the means of economic stabilisation. The proposals would also transfer to an undemocratic and unaccountable Commission important national competences.     

The EMU effects on asset market holdings and the recent financial crisis

This paper examines if there are significant integration effects from the establishment of European Monetary Union (EMU) and the introduction of euro on EMU and non-EMU equity and bond markets. This is done by looking at the holdings of these markets. We investigate to what extent these effects have been affected by the recent global financial crisis. This is done based on gravity model determining bilateral asset holding among the EMU countries, non-EMU European countries and the rest of world. This model can control for the effects of other economic (gravity-type) variables on the effects of the EMU on financial markets, like the size of the capital markets across countries, the geographical distance, information asymmetries etc. Ignoring these effects may exaggerate the actual EMU integration effects. The paper provides clear cut evidence that the establishment of the EMU had significant integration effects on equity and bond markets. It significantly increased the EMU bond and equity holdings by the EMU and non-EMU investors. These effects have become important since year 2001. However, they have considerably reduced after year 2007, due to the recent global financial crisis. Across the EMU countries, we have found that the strongest disintegration effects of the above crisis were observed for the peripheral countries of the EMU. These effects became evident before the start of the European debt crisis in early 2010.     

Sovereign risk premiums in the European government bond market

This paper provides a study of bond yield differentials among EU government bonds on the basis of a unique data set of issue spreads in the US and DM (Euro) bond market between 1993 and 2009. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premiums which increase with fiscal imbalances and depend negatively on the issuer’s relative bond market size. The start of the European Monetary Union has shifted market attention to deficit and debt service payments as key measures of fiscal soundness and eliminated liquidity premiums in the euro area. With the financial crisis, the cost of loose fiscal policy has increased considerably.     

资金流动、国际金融整合与经济增长——基于新兴市场国家面板数据

本文尝试检验东欧、东亚和拉丁美洲三大主要新兴市场国家或地区的资金流动方向及其对经济增长的影响,以及近来众所关切的全球经常账户失衡问题。实证结果显示:东欧国家收入水平与金融深化程度仍然偏低,但随着发展程度提高,未来将由资金流入转为流出。东亚国家或地区的超额外汇储备、贸易顺差与资金流出,被指控为造成美国巨额经常账户赤字与全球经常账户失衡的主要原因之一,但若能够持续金融深化的努力,资金可能回流并使全球经常账户失衡现象得以缓解。至于拉丁美洲国家的宏观经济、金融和政策变量,对于资金流动方向并无决定性影响,但宏观经济政策仍是决定资金流入能否有助于经济增长的关键因素。     

Economic interdependence and common stochastic trends: A comparative analysis between EMU and non-EMU stock markets

Whether economic interdependence among countries is a contributing factor to cointegration and common stochastic trends in international stock markets is indiscernible due to contradictory results from prior empirical work. This study aims to add clarity to this issue through a more distinct grouping of countries and methodological enhancements. A comparative analysis of cointegration is conducted between stock market price indices of major Economic and Monetary Union (EMU) and non-EMU countries. The conventional Johansen methodology is augmented with several diagnostic techniques (that have not been all inclusive in previous studies) to ensure the robustness of test results. Major findings pertinent to investors and policymakers are that economic interdependence appears to be the important contributing factor and that the U.S. stock market does not exert influences on long-run performances of other included stock markets. Furthermore, while the UK is not an EMU member, it may be viewed as a quasi EMU participant due to its stock market being cointegrated with and yet one of the common stochastic trends (besides those of Germany, Italy, and the Netherlands) within the EMU stock markets under investigation.     

Effects of Economic Convergence on Stock Market Returns in Major EMU Member Countries

This study updates and extends existing literature by investigating the effects of economic convergence among major European Economic and Monetary Union (EMU) member countries on stock market returns in each respective nation. Main findings include: (1) long-term stability in the EMU appears to be attainable, but further integration of product and factor markets is needed to reinforce convergence of real sectors; (2) the UK can be considered a quasi EMU participant due to convergence of its key economic variables with those of formal EMU members; and (3) economic convergence appears to be an important contributing factor to returns from stock markets in the included EMU countries except Germany.     

Sovereign debt spreads in EMU: The time-varying role of fundamentals and market distrust

This paper provides further analysis on the determinants of sovereign debt spreads for peripheral Eurozone countries since the start of EMU, paying special attention to episodes that characterized the global financial crisis aftermath starting in 2007. More specifically, the purpose of our research is to disentangle the role of fundamental variables and market perception about variations on risk in order to explain the evolution of sovereign spreads in EMU during the recent crisis. Our results, in line with previous literature, show the importance of three groups of observable variables, namely, changes in risk-aversion of creditors, fiscal indebtedness and liquidity variables. In addition, our model includes unobserved components that are estimated through the Kalman filter as time-varying deviation from fixed-mean parameters of spread determinants. This shows the importance of expectations (market sentiments), amplifying (or reducing) the relative importance of the spread determinants over time through the time-varying behavior of the parameters around their steady-state estimates.