Challenges for the euro area and implications for Latvia

This Policy Contribution reviews the major challenges faced by the euro area, and discusses recent initiatives and the way forward. Some implications are drawn out for Latviaâ??s euro accession, which is likely to be beneficial on balance. The euro area faces three major challenges: (1) high private and public debt in some of its parts together with a requirement for competitiveness adjustment that in some countries has barely started; (2) weak growth outlook; (3) continued banking-sector fragility that, with sovereign stress, feeds a negative feedback loop. The euro area has agreed many significant measures to overcome these problems, including the European Stability Mechanism and the fiscal compact. The 21 February agreement on Greece removes a major source of financial instability even though it is likely that further debt reductions will be needed. Significant concerns remain, the most important of which are the slow real economic adjustment and the largely unaddressed banking-sovereign fragility. The fiscal compact raises the issue of appropriate fiscal stabilisation tools at the euro-area level. Countries that will soon join the euro should actively shape the debate about the further development of the overall set-up. For Latvia, joining the euro makes sense because Latvia has kept its exchange rate fixed and has undergone internal adjustment. In its euro-area accession negotiations, Latvia should ensure that it does not participate in any of the currently ongoing financial assistance programmes. This Policy Contribution reproduces evidence given by Guntram B. Wolff to the Latvian parliamentâ??s European affairs committee, 22 February 2012.

Should non-euro area countries join the single supervisory mechanism?

Irrespective of the euro crisis, a European banking union makes sense, including for non-euro area countries, because of the extent of European Union financial integration. The Single Supervisory Mechanism (SSM) is the first element of the banking union. From the point of view of non-euro countries, the draft SSM regulation as amended by the EU Council includes strong safeguards relating to decision-making, accountability, attention to financial stability in small countries and the applicability of national macroprudential measures. Non-euro countries will also have the right to leave the SSM and thereby exempt themselves from a supervisory decision. The SSM by itself cannot bring the full benefits of the banking union, but would foster financial integration, improve the supervision of cross-border banks, ensure greater consistency of supervisory practices, increase the quality of supervision, avoid competitive distortions and provide ample supervisory information. While the decision to join the SSM is made difficult by uncertainty surrounding other elements of the banking union, including possible burden sharing, we conclude that non-euro EU members should stand ready to join the SSM and be prepared for negotiations on the other elements of the banking union

Does anticipation of government spending matter? The role of (non-)defense spending

We investigate the effects of government expenditure on private consumption when the private sector anticipates the fiscal shocks. In order to capture anticipation of fiscal policy, we develop a new method based on a structural vector autoregression (SVAR). By simulating data from a theoretical model featuring (imperfect) fiscal foresight, we demonstrate the ability of our new approach to correctly capture macroeconomic dynamics. We take advantage of the flexibility of our econometric approach and study those subcomponents of total government spending, which have different macroeconomic effects according to economic theory. Using post-WWII US data, we find that when taking into account anticipation, private consumption significantly decreases in response to a defense expenditure shock, whereas when considering shocks to non-defense spending, consumption increases significantly. A standard SVAR does not produce clear consumption responses, highlighting the importance of anticipation. Our results thus reconcile the different findings of the narrative and SVAR approaches to the study of fiscal policy effects.fiscal policy anticipation, SVAR, consumption response, government spending

Does anticipation of government spending matter? Evidence from an expectation augmented VAR

How does private consumption react to an exogenous increase in government expenditure? Standard structural vector autoregressions (SVARs) usually report a positive GDP as well as consumption response, while event studies report a negative consumption response. We investigate in a SVAR whether anticipation of the fiscal shock reverses the sign of this dynamic response to a negative one. As a methodological contribution, we model expectation formation within a SVAR framework. We show for the US that consumption falls in reaction to an expenditure shock once the model allows for one-period-ahead anticipation of this shock. Modelling anticipation of fiscal shocks is thus crucial to correctly capture their macroeconomic effects. Differences in results between event studies and VARs can be explained by missing anticipation in VARs. When re-estimating the two models (with and without anticipation) for non-defense related expenditures, we find a positive consumption response for both models. The implications of our results for macroeconomic theory are briefly discussed. --Fiscal policy,government spending,net revenue,policy anticipation,structural vector autoregression

Rules and risk in the euro area: does rules-based national fiscal governance contain sovereign bond spreads?

The strengthening of national fiscal frameworks, including numerical fiscal rules, has recently been proposed as an important part of the economic governance reform package for the EU. The strength of numerical fiscal rules can be described along the dimensions of their statutory base, the room to revise budgetary objectives, provisions for their monitoring and enforcement, and their media visibility. With a unique data set summarizing the quality of national fiscal rules along these dimensions, we show that stronger fiscal rules in euro area member states reduce sovereign risk. According to our estimates, yield spreads against Germany of countries with relatively weak fiscal rules could be up to 100 basis points lower if they upgraded their numerical fiscal rules. The legal base turns out to be the most important dimension for the perceived effectiveness of the rules. The effectiveness of the correction and enforcement mechanisms turns out to be very important as well, while the role of the bodies in charge of monitoring and enforcing compliance is somewhat smaller. Overall, national fiscal rules are found to be beneficial for market assessments of governments' ability and willingness to timely service debt: they could thus provide an effective way to implement fiscal discipline.

The German sub-national government bond market: evolution, yields and liquidity

The paper presents a comprehensive data set of all bonds issued by the sixteen German states (L¨ander) since 1992. It thus provides a complete picture of a capital market comparable in size to funds raised in the German fixed income market for corporations. The quantitative analysis reveals that L¨ander follow different issuing strategies: while some concentrate to a greater extend on large issues or issue joint bonds with other L¨ander (Jumbos), others rely more on comparatively small but frequent issues. Moreover, some L¨ander issue a significant volume-share of their bonds in foreign currencies. Suitable bonds are used to compute yields for the respective L¨ander at a daily frequency. In addition, we construct a measure of liquidity based on the standard deviation of yields of those bonds that are used to compute the average yield. --sovereign bond market,yields,liquidity,fiscal federalism,Germany

The Euro area's macroeconomic balancing act

The European Systemic Risk Board (ESRB) and the proposed prevention and correction of macroeconomic imbalances regulation (EIP) are designed to avoid imbalances. However, these instruments overlap, and need clarification. Both the ESRB and the Commission, which is given certain powers by the EIP, must identify and act early on risks. Acting in the face of strong economic and political pressure is difficult. Complementing the current approach with transparent and rules-based mechanisms will reduce this problem. The EIP and ESRB can complement each other in terms of analysis and policy, and close collaboration will be vital. The EIP regulation can be used to ensure that ESRB recommendations are followed up. In the area of financial recommendations relevent to macroeconomic imbalances, the Commission should have a more formal requirement to act on ESRB recommendations. The EIP regulation would benefit from a clause allowing recommendations to be addressed not only to member states. Conflicts between the ESRB and Commission could arise. In this case, the Treaty requires the Commission to issue a recommendation even if the ESRB issues a negative finding. Legally, it might not be possible to exclude the use by the Commission of confidential information obtained in the ESRB.

What do deficits tell us about debt? Empirical evidence on creative accounting with fiscal rules in the EU

Fiscal rules, such as the Excessive Deficit Procedure and the Stability and Growth Pact (SGP), aim at constraining government behavior. Milesi-Ferretti (2003) develops a model in which governments circumvent such rules by reverting to creative accounting. The amount of this depends on the reputation cost for the government and the economic cost of sticking to the rule. We provide empirical evidence of creative accounting in the European Union. We find that the SGP rules have induced governments to use stock-flow adjustments, a form of creative accounting, to hide deficits. The tendency to substitute stock-flow adjustments for budget deficits is especially strong for the cyclical component of the deficit, as in times of recession the cost of reducing the deficit is particularly large.Fiscal rules; stock-flow adjustments; debt-deficit adjustments; stability and growth pact; excessive deficit procedure; ESA 95