europe’s stability and growth pact in the context of a global economic slowdown warwick j mckibbin...
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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 SatchiOxford
David VinesOxford, 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)
Sectors:EnergyNon – EnergyCapital goods producing sectorHousehold capital sector
The MSG3 Model
Countries: Exchange rate Regime:United States floatJapan floatAustralia floatCanada floatUnited Kingdom floatGermany Euro (floating)Austria Euro (floating)France Euro (floating)Italy Euro (floating)Rest of Euro Zone Euro (floating)Rest of OECD floatChina peg to $USnon Oil Developing countries peg to $USEastern Europe and Russia floatOPEC peg to $US
The MSG3 Model
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.
Stylized Risk Premium Shock
0
1
2
3
4
5
6
7
8
9
Baseline 1
Baseline 2
Baseline 3
Baseline 4
Rise in OECD wide Equity Risk: Germany
National Acounts(%GDP deviation)
-5
-4
-3
-2
-1
0
1
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
GDP Consumption
Investment Exports
Employment and Inflation(% deviation)
-3
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
Employment CPI Inflation PPI Inflation
Rise in OECD wide Equity Risk: Germany
Wages and Prices(%GDP deviation)
-4
-2
0
2
4
6
8
10
12
14
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
Wage CPI PPI
Asset Prices(%GDP deviation)
-20
-15
-10
-5
0
5
10
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
Nominal r Real r
Tobin q (nonenergy) Tobin Q Housing
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
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
No Fiscal Only Europe fiscal global fiscal global fiscal - no Euro
German Fiscal Deficit% GDP deviation
-2
-1
0
1
2
3
4
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
No Fiscal Only Europe fiscal global fiscal global fiscal - no Euro
German Employment% deviation
-3
-2
-1
0
1
2
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
No Fiscal Only Europe fiscal global fiscal global fiscal - no Euro
German Inflation% point deviation
-1.5
-1
-0.5
0
0.5
1
1.5
2
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89
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