Download Europe`s Stability and Growth Pact in the Context

Europe’s Stability and Growth Pact in the
Context of a Global Economic Slowdown
Warwick J McKibbin
ANU Centre for Applied Macroeconomic
Analysis (CAMA)
Presented at the ANU Conference on Fiscal Policy and Financial Markets, ANU, October 2003
Stability and Growth Pact
 Agreed in July 1997 based on Maastricht convergence
criteria for a single currency in Europe.
 Member states commit to a medium term objective of
budgetary balance.
 Will take action no later than the year following the
identification of “excessive fiscal deficit” which is in excess
of 3% of GDP
 The European council is “always invited” to impose
sanctions if the member state fails to take necessary steps
to bring deficits under control
Results Based on:
“Optimal Fiscal and Monetary Policy Responses to Global Risk
Shocks”
by
Warwick J McKibbin
Centre for Applied Macroeconomic Analysis (CAMA) at ANU
Mathan Satchi
Oxford
David Vines
Oxford, ANU and CEPR
Background
 Two broad views of the current global economic
slowdown
• The result of weak aggregate demand that can be offset
through appropriate adjustments to monetary policies
• The results of a reduction in aggregate supply resulting
from
 A downward revision in productivity growth in the OECD
 The collapse of the “new economy” bubble
 An increase in risk since September 11 and the war on terrorism
Goals of the Paper
 In a previous paper we explored the global
adjustment to Changes in Equity Risk premia and
the role for monetary policy
 In this paper we extend the analysis to explore the
optimal response of fiscal and monetary policy to
equity risk shocks
Questions to be addressed
 What is the optimal response of fiscal and monetary
policies in countries experiencing a rise in equity
risk?
 How does the existence of the European Central
Bank (ECB) affect the response of European fiscal
authorities relative to countries with floating
exchange rates?
 How does the existence of the Stability and Growth
Pact affect the optimal fiscal policy response?
Some Answers
 The optimal response to a rise in equity risk is a loosening
of monetary policy and a fiscal expansion in the short run to
manage demand but a long term fiscal consolidation to
manage supply;
 The smaller the country, the more reliance on fiscal policy
for a demand stimulus;
 The existence of a single currency in Europe causes
individual countries within Europe to expand fiscal policy
more than if they were floating
 The Stability and Growth Pact inhibits the optimal European
response – indeed it works in reverse in the medium run.
Attempt to Quantify the Key Issues using
a global model
Use the MSG3 model version 50o
www.gcubed.com
The G-Cubed Model
 Key features
• Based on explicit intertemporal optimization by
households and firms in each economy in a dynamic
setting
• Substantial sectoral dis-aggregation with
macroeconomic structure
• Explicit treatment of financial assets with stickiness in
physical capital differentiated from flexibility of financial
capital
• Short run deviation from optimizing behavior due to
stickiness in labor markets, myopia
• Short run “New Keynesian” Model with Neoclassical
steady state
G-Cubed Model
 12 sectors production in each economy
• Plus a capital good producing sector
• Plus a household durable production sector (I.e. housing)
 Estimation of KLEM technology in production and
consumption
 Tracks flows of international trade at the sectoral level
 Tracks flows of international capital
 Distinguishes between relatively traded and non trade goods
(all goods are potentially tradeable)
Derivative Models
We aggregate the full G-Cubed model by sectors and
countries to create models suitable for particular purposes:
G-Cubed (Asia Pacific)
G-Cubed (Agriculture)
G-Cubed (Environment)
MSG3 (macro)
The MSG3 Model
Sectors:
Energy
Non – Energy
Capital goods producing sector
Household capital sector
The MSG3 Model
Countries:
United States
Japan
Australia
Canada
United Kingdom
Germany
Austria
France
Italy
Rest of Euro Zone
Rest of OECD
China
non Oil Developing countries
Eastern Europe and Russia
OPEC
Exchange rate Regime:
float
float
float
float
float
Euro (floating)
Euro (floating)
Euro (floating)
Euro (floating)
Euro (floating)
float
peg to $US
peg to $US
float
peg to $US
The Results
The Simulations
 1) Baseline 2000
• Assumptions about
 population growth by country
 Productivity growth by sector catching up by 2% per year to US leading
sector
 Given tax rates, monetary growth rates etc in all countries
• Solve for rational expectations equilibrium for the global
economy
 2) apply the change in equity risk premium
• Equity risk increase across the OECD
The Equity Risk Premium (μ)
Excess return on equities relative to the return on
government bonds
How to think about the
Temporary Shock?
 The way to interpret the shock depends crucially on
the nature of the baseline.
 The equity risk premium fell sharply to 1999 and
suppose it was expected to gradually rise back
towards 5% over a decade.
 The temporary risk shock can be interpreted as a
return to long term 5% more quickly than was
expected in 2000 so that the steady state is the
same but the path towards it is shifted.
Rise in OECD wide Equity Risk: Germany
National Acounts
Employment and Inflation
(%GDP deviation)
(% deviation)
1
2
1.5
0
1
-1
0.5
0
-2
-0.5
-3
-1
-1.5
-4
-2
Employment
CPI Inflation
2024
2022
2020
2018
2016
2014
2012
2010
2008
2006
Exports
2004
Investment
-3
2002
Consumption
-2.5
2000
GDP
2024
2022
2020
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
-5
PPI Inflation
Rise in OECD wide Equity Risk: Germany
Wages and Prices
Asset Prices
(%GDP deviation)
(%GDP deviation)
10
14
12
5
10
0
8
6
-5
4
-10
2
-15
0
-2
Wage
CPI
PPI
Nominal r
Real r
Tobin q (nonenergy)
Tobin Q Housing
2024
2022
2020
2018
2016
2014
2012
2010
2008
2006
2004
2002
2024
2022
2020
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
-4
2000
-20
Risk Shock without a policy response
 The desired capital stock falls, real wages need to
fall, potential output falls, real interest rates fall.
 Capital tends to flow into the large country away
from small countries
 Employment falls by more in a small country and
prices rise by more in a small country relative to a
large country
Optimal Policy Response
Policy makers choose a vector of instrument
(monetary policy and fiscal spending) to minimize
the discounted expected future squared deviation of
targets from desired values
Policy optimization
 Countries have weights of:
• 2 on output price inflation;
• 1 on employment (log);
• 1 on fiscal deficits.
 Instruments are:
• Monetary policy
• Fiscal spending on workers
Fiscal Policy Lessons
 A fiscal stimulus in a large country
• Raises world interest rates permanently
• Crowds out home and foreign investment
• Crowds out net exports through an appreciation
 A fiscal stimulus in a small country
• Raises home interest rates (temporarily)
• Crowds out home investment
• Crowds out net exports through an appreciation
 Relatively more crowding out of investment in a large
country and net exports in a small country
Putting the shock and the policy Response together
European Interest Rates
% point deviation
1.5
1
0.5
0
-0.5 1
-1
5
9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
-1.5
-2
-2.5
No Fiscal
Only Europe fiscal
global fiscal
global fiscal - no Euro
German Fiscal Deficit
% GDP deviation
4
3
2
1
0
-1 1
5
9
13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
-2
No Fiscal
Only Europe fiscal
global fiscal
global fiscal - no Euro
German Employment
% deviation
2
1
0
-1
1
5
9
13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
-2
-3
No Fiscal
Only Europe fiscal
global fiscal
global fiscal - no Euro
German Inflation
% point deviation
2
1.5
1
0.5
0
-0.5 1
5
9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
-1
-1.5
No Fiscal
Only Europe fiscal
global fiscal
global fiscal - no Euro
Conclusion
 Shocks to equity risk premia have significant effects on the
real economy
 Both aggregate demand and supply are affected.
 Monetary and fiscal policy can help in the short run to
smooth the adjustment but it can do little to completely
offset the underlying shock
 The optimal fiscal response is a fiscal expansion followed
by a long term fiscal consolidation
 The existence of the Euro implies more fiscal activism in
Europe would be optimal given a global risk shock
 The Stability and Growth Pact constrains the optimal
response
Background Papers
www.gcubed.com
www.sensiblepolicy.com