Scope of asymmetries in the Euro area

We discuss the scope of asymmetries in growth and inflation developments in the euro area countries, taking the euro area as the natural benchmark since the establishment of EMU. We start with a descriptive analysis of a set of indicators that can give a first idea of the likelihood of or extent to which Member States can show asymmetries with respect to the euro area. This approach typically leads to a division of countries between a core and a periphery, the former consisting over the 1993-2000 sub-period of Belgium, Germany, France, Italy, Spain and Austria and perhaps the Netherlands. However, it is rather difficult to weight the indicators and to draw a firm line between "insiders" and "outsiders" in this way. Moreover the dichotomy does not provide any information on the true extent of the asymmetries inside the core and periphery. Accordingly, we move to a quantitative approach (SVAR models) that makes it possible to assess two forms of asymmetry: asymmetry stemming from country-specific shocks and asymmetry stemming from differences in the way countries react to symmetric euro area shocks. The asymmetries are measured along two dimensions: growth and inflation developments. We find that over the years 1971-2000 growth in many countries is driven by the symmetric shocks while the opposite holds true for inflation where asymmetric (country-specific) shocks dominate. However regarding growth, the responses of the different countries to the symmetric shocks do not really differ and these shocks are not a major source of divergence. As a consequence, for growth as well as for inflation, the asymmetries with respect to the euro area are mainly the result of genuine asymmetric shocks. We notice a marked decrease in the impact of asymmetric shocks on inflation over the years, a phenomenon that is also present for growth, albeit less pronounced. If the years 1993-2000 can be used to evaluate the current situation, it appears that countries are spread along a line going from close similarity to the euro area (France) to extensive asymmetry (Ireland). Asymmetric shocks are not negligible yet with an average annual impact of around 1 percentage point on country growth or inflation. Some countries usually thought to belong to the core, are still exposed to such average shocks, in terms of growth or in terms of inflation.

Deflation, a demon from the distant past or a real danger now ?

During the summer of 2009, Belgium and the euro area, as well as other industrialised countries, recorded negative inflation rates. Although they were the direct result of sharply falling commodity prices in the second half of 2008, policy-makers and the general public wondered whether this would be the start of a deflationary spiral. Indeed, parallels with the Great Depression in the 1930s – which was also characterised by an asset price boom-bust cycle and banking stress – were drawn. The article explains why deflation can have dramatic consequences for the economy, gauges the current deflationary risks and discusses what the policy options are in a deflationary environment. In past centuries, deflation – when defined in a broad sense as a decline in the general price level – was a frequent phenomenon and was not always accompanied by economic hardship. When deflation is defined more narrowly as a sustained decline in the general price level that gives rise to further expected falls, it is no innocent phenomenon since it confronts an economy with a number of nominal rigidities which can trigger a deflationary spiral. One such rigidity is the lower bound on nominal interest rates which can limit the central bank’s potential to stimulate the economy as real interest rates cannot fall any further. Second, the real burden of outstanding debt increases when prices fall, leading to a redistribution of wealth towards lenders who generally have a lower propensity to consume than borrowers. Third, because of money illusion, it is difficult to cut nominal wages, making the adjustment of real wages to a worsened economic situation difficult or even impossible. As shown by available indicators, risk of deflation in the euro area seems limited. The observed negative inflation rates are not a sign of widespread price falls. Inflation expectations remain in check although inflation is expected to return rather slowly to levels consistent with price stability. Taking a broader view, the IMF deflation vulnerability indicator, which combines a range of macroeconomic indicators, shows an increased risk of deflation in all industrialised countries. Having a quantitative definition of price stability that defines the latter as a low, but strictly positive rate of inflation – as the Eurosystem has –, helps to prevent deflation. Yet, when confronted with a deflationary threat, monetary policy has a range of tools to tackle deflationary risks. First, nominal policy rates can be lowered aggressively, until they hit the lower bound. If further stimulus is warranted after rates have been brought close to zero, central banks can resort to unconventional monetary policies, as they have done in previous months. Also fiscal policies can help to contain deflationary risks, especially to tackle banks’ solvency problems if they threaten financial stability, provided that the longer-term sustainability of public finances remains intact. Finally, it must be emphasised that policy-makers have to decide on appropriate policies to deal with deflationary risks in real time.deflation, Great Depression, monetary policy

The IMF and precautionary lending: An empirical evaluation of the selectivity and effectiveness of the flexible credit line. National Bank of Belgium Working Paper No. 323

This paper provides an empirical evaluation of the Flexible Credit Line (FCL), the IMF's prime precautionary lending instrument since 2009 to which so far only three emerging market economies have subscribed: Mexico, Colombia and Poland. We consider both questions of selectivity and effectiveness: first, which factors explain the three FCL countries' participation in such arrangements? And second, to which extent have the FCL arrangements delivered on their promise of boosting market confidence in their respective users? Based on a probit analysis we show that FCL selectivity can be explained by both demand- and supply-side factors. The probability of participation in the FCL was greater in countries that experienced larger exchange market pressures prior to the creation of the instrument, that had lower bond spreads and inflation, that accounted for higher shares in US exports, and that exhibited a higher propensity of making political concessions to the US. Our estimation of the effects of the FCL employs the ‘synthetic control’ methodology, a novel counterfactual approach. We find evidence for some but not spectacular beneficial effects on sovereign bond spreads and gross capital inflows in FCL countries. Overall, our results suggest that any economic stigma eligible countries still attach to entry into an FCL arrangement is unwarranted. Conversely, the apparent link of FCL participation with US interests may not be conducive to overcoming political stigma

Asymmetric Growth and Inflation Developments in the Acceding Countries: A New Assessment. NBB Working Paper Nr. 63, November 2004

In this paper, we use a SVAR model in order to study the asymmetry of growth and inflation developments in the acceding countries vis-à-vis the euro area over the years 1995-2003. The model combines two strands of the literature, the explanation in terms of country-specific and euro area shocks, and a further split between supply and demand shocks. The four structural shocks may all create asymmetries vis-à-vis the euro area. It appears that country-specific shocks are the main source of growth or inflation divergence, rather than the distinct way in which acceding countries react to euro area shocks. But whereas country-specific supply shocks are mainly responsible for growth divergence, country-specific demand shocks are mainly responsible for inflation asymmetry. Hence, a low asymmetry in terms of growth does not necessarily imply a low asymmetry in terms of inflation, although the latter is particularly important for countries aiming to join the euro area. There is some evidence that both asymmetries were on the fall over the last years of the sample

The European Union and the euro: how to deal with a currency built on dreams?

The least that can be said is that since 2007 the European Union and the currency of most of its members, the euro, are not doing well. The old continent seems to have lost its competitiveness against the United States and the emerging countries. The euro crisis has turned into a succession of country crises coming up and receding like flood and ebb and threatening to intoxicate the entire Eurosystem. In this book we deal with this period of turmoil, putting it into a larger historical, institutional and economic context and sketching the efforts of the EU and its member states to escape economic and financial breakdown. The book covers the fundamental elements of the economic and monetary union (emu) that the EU has been building for more than half a century, going from a customs union, over the single market to the euro. It not only deals with the institutional architecture of the emu but also pinpoints at the weaknesses that endangered it and describes the conversion of this system into a truly EU system of economic governance. The many facets of this emerging system are sketched. The reasons why a fiscal union is needed are explained as well as how this fiscal union looks after the sixpack, the twopack, the fiscal compact and the European semester. The same is done for banking union with a European supervision of financial institutions and a Europe wide resolution deposit guarantee scheme. Also the new face of monetary policy with unconventional tools such as outright monetary transactions and long term funding of financial institutions is analyzed. This book is an indispensable guide to understand what is happening with the European union and the euro in these turbulent times