OCA Theory – Asymmetric shocks in the Euro-Zone, Long Term Structural Problems & the need for EU Fiscal Union

As growth has found its way back on the discourse of the Euro-Zone sovereign debt crisis, I take the opportunity to briefly describe the simple model in the back of most (decent) economists discussing the long term structural problems underlying this crisis.

This post describes the simple two-country application of the Mundel-Flemming model to the specific dynamics of the Euro-Zone when its members are presented with asymmetric shocks. The idea of the post is to give the reader an insight into the graphical shortcut that economists use to think about this issue.  As such, this is a very short and (graphically) descriptive post. I begin by considering the more general AD-SRAS-FE framework before concluding by discussing how a fiscal transfer union could assist with this structural problem.

AD-SRAS-FE: Fixed Exchange rates, Incomplete Monetary Adjustment and Divergence 

There are 3 important things to consider when reading as the figure below (page 355, of Baldwin and Wyplosz):

  1. The two countries (Greece and Germany) have a fixed exchange rate arrangement with each other and a floating exchange rate with the rest of the world.
  2. While Greece is a small country, the ECB has to react if a shock in Greece is large enough or spreads to a significant number of neighbouring economies. This is done by decreasing interest rates and increasing liquidity to compensate for the potential destruction in the monetary base. However, because the shock has only taken place in Greece, rather than also occurring in Germany, the rate fall will not be ideal for either of them. Greece would ideally be at equilibrium “Epg”, where AD’ meets SRAS. However, at E1, output supplied, “Y2S”, is higher than output demanded, “Y2D”. In Germany, because no shock has occurred, aggregate demand, at “Y1D”, is higher than short term aggregate supply, at “Y1S”. Asymmetric shocks in a monetary union creates an incomplete nominal adjustment, described below:
  3. Because of this incomplete nominal adjustment, the onus of is put on the real economy. Once FE has moved, AD and SRAS must react. There are 3 alternatives:
      1. If Purchasing Power Parity does not hold and if prices are flexible but unresponsive to eachother,  “PGre” can fall and “PGer” can rise without leading to an opposite reaction in “PRoW”. There are no other projections of the demand and supply curves and all movements are along the existing ones. In this case the change in prices compensates the incomplete monetary adjustment to the extent necessary to return both economies to their equilibrium, (Y2, EGre) and (Y0,E0). In this case, the fixed exchange rates (FE) between the two members of the monetary union do not bind the movement of the real exchange rate. 
      2. However, if PPP holds, then a change in the price of one country will trigger a similar change in the prices of the RoW complements ensures that real variables must change. In specific, prices and wages must adjust, thus affecting consumption, investment, government spending, as well as employment. In this case, two potentially complementary scenarios can arise:
        1. If  prices and or wages are sticky, the real adjustment cannot be completed or occurs very slowly. In this case the supply cannot adjust in either country and the desequilibrium described above survives longer than under fully flexible conditions. In Greece, excess supply means that unemployment will rise above its “equilibrium level”, while German unemployment will plummet below its own equilibrium level and excess demand will create inflation. This will lead to desiquilibrium divergence. This argument is very important because of rigidities particular to the Euro-Zone. For one, our labour markets are more rigid than those of the USA, due to more widespread collective wage bargaining. Secondly, the language barriers and absence of well oiled migrant networks make it more difficult for unemployed “Greek” workers to move to, and work in, “Germany”.
        2. Alternatively, or with time, aggregate supply may be able to overcome its rigidities and contract in Greece (from SRAS to SRAS’), while expanding in Germany. This could be done through more flexible product and labour markets, where Greek workers would, for example, be able to migrate to Germany. While this solution is often waved as the target in Europe, the truth is that it is a very uncomfortable one. The resulting “equilibrium” will be characterised by a higher level of GDP in Germany and a lower one in Greece, creating equilibrium (“Ed“) of divergence where the rich get richer and the poor get poorer.

Monetary Expansion

In the absence of realistically impossible and likely undesireable flexible labour and product markets, some other adjustment is called for. Because labour markets are rigid, the onus is on demand. This can be done either monetarily or fiscally. In the first case, the common central bank would expand its balance sheet and the monetary base by purchasing the government debt of the troubled country or of its banks. Unfortunately, in national and European institutions are not sophisticated enough to ensure trust among all parties and as a result, moral hazard seems to have stopped the ECB from going “all in” in Greece. Of course the same is not true for Spain and Italy, where the relatively targetted government purchases and the large volumes of the LTRO seem to have exerted the desired effect.

Fiscal Union to the Rescue

Another alternative would be fiscal a common fiscal union. This has the advantage of being transparent and accountable in way that the monetary route discussed above does not. In that case, once the shock hit one country, tax revenues from Germany would be transfered to Greece to allow the country to support banks and to pay unemployment benefits.

Specifically, because of the automatic nature of these transfers, the shock would automatically be smaller for Greece but impact Germany. As a result the aggregate picture would be worse for everyone which would motivate a sharper fall in the MRO and thus a larger fall in nominal exchange rates. Although it is likely that this will only reduce the size of the shock, it is not impossible to consider a scenario where fiscal and monetary authorities coordinate their action so that a new equilibrium (E2,Y3) is achieved. In it Greece is still worse off and Germany is still better off, however the shifts in opposite directions are less accentuated.

Of course, in the absence of trust and proactive monitoring tools, the deployment of such transfers would have to be delegated to a neutral party, i.e.: the European Commission.

Final Comments

Notice that an exclusively demand oriented description can be made using an IS-LM-FE, which would result in similar conclusions. However, because the IS and the LM curves are incorporated into the AD curve, this would only serve to highlight the level of desiquilibrium that monetary unions generate.

Charles Wyplosz and Richard Baldwin have an extremely good book on the economics of the EU, which discusses this at length. DeGrauwe‘s book has a somewhat more superficial dicussion of a similar scenario, focused on the interest rate, while von Hagen and Mundschenk elaborate more thoroughly on a scenario closer to DeGrauwe’s. Finally, Beetsma, Debrun and Klassen also provide some insights. The scenarios discussed above are inspired by Baldwin and Wyplosz’ but I’ve added some details.

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N.B.: This post is a very edited version of another I wrote some years ago.

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One Response to OCA Theory – Asymmetric shocks in the Euro-Zone, Long Term Structural Problems & the need for EU Fiscal Union

  1. Pingback: Effects on Luxembourg: OCA Theory – Asymmetric shocks in the Euro-Zone Long Term | Euro Economy

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