FISCAL AND MONETARY POLICY IN THE EUROZONE

Praise for Fiscal and Monetary Policy in the Eurozone

“Canale and Mirdala guide us through the world of policy and modeling expla-nations concerning developments in the Eurozone…. This well-written book provides coverage of a number of important issues and techniques treated in a refined didactic manner.”

– Julius Horvath, Central European University, Hungary

“This book is useful both for readers interested in the euro area and those inter-ested in the theoretical foundations of economic policies. This double perspective is rarely present in a single book.”– Jean-Pierre Allegret, Full Professor of Economics, Head of GREDEG, CNRS

and University Nice Sophia Antipolis, France

“(This book) addresses the needs of the Eurozone for alternative and pragmatic approaches to theoretical inquiry and policy making in a manner not typically found in other publications.”

– Nikolaos Karagiannis, Winston-Salem State University, USA

“This book is an important contribution to the discussion of the most advances regional integration project on the planet.”

– Martina Metzger, Berlin School of Economics and Law, Germany

“This book will be of much interest to students, scholars, and policy makers interested in understanding the fundamental origins of the euro-area crisis.”

– Sergio Rossi, University of Fribourg, Switzerland

“Fiscal and Monetary Policy in the Eurozone by Rorita Canale and Rajmund Mirdala is an in-depth and useful text…. The book represents a valuable contri-bution to the analysis and the economic policy debate regarding the Eurozone.”

– Daniele Schiliro, University of Messina, Italy

“Fiscal and Monetary Policy in the Eurozone: Theoretical Concepts and Empirical Evidence provides a complete and lucid narrative of the fiscal and monetary policy in the Eurozone.”

– Yaya Sissoko, Indiana University of Pennsylvania, USA

FISCAL AND MONETARY POLICY IN THE EUROZONE: THEORETICAL CONCEPTS AND EMPIRICAL EVIDENCE

BY

ROSARIA RITA CANALEParthenope University of Naples, Italy

and

RAJMUND MIRDALATechnical University of Košice, Slovakia

United Kingdom – North America – Japan – India – Malaysia – China

Emerald Publishing LimitedHoward House, Wagon Lane, Bingley BD16 1WA, UK

First edition 2019

Copyright © 2019 Emerald Publishing Limited

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British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library

ISBN: 978-1-78754-126-9 (Print)ISBN: 978-1-78743-793-7 (Online)ISBN: 978-1-78743-981-8 (Epub)

Contents

List of Figures, Tables ix

Preface xi

Acknowledgements xiii

Introduction 1

Chapter 1 The Policy Framework in the Eurozone 51.1. The European Monetary Union: Historical

Roots and Recent Events 5Box 1.1 The Optimal Currency Area Theory 91.2. Policy Principles from World War II to the

Fall of Bretton Woods 12Box 1.2 Fiscal and Monetary Policy Under

Alternative Exchange Rates Regimes and Perfect Capital Mobility: The Mundell–Fleming Model 17

1.3. From the Exchange Rate Agreements to the Common Currency: The Policy Model of the New Consensus Macroeconomics 22

1.4. The Present Policy Framework of the Eurozone 27

Chapter 2 Fiscal Policy in the Eurozone 312.1. From Keynesian Macroeconomics to

Contemporary Theory 312.2. Fiscal Policy Theory in a Keynesian World 32Box 2.1 Inflation and Output Effects of Expansionary

Fiscal Policies: The Slope of the Supply Curve 35Box.2.2 Fiscal Policy Rules in the Eurozone 372.3. Fiscal Policy and the Intertemporal Approach 402.4 .The Evolution of the Theoretical Debate and the

Case of the Eurozone 44

vi Contents

2.5. The Empirical Literature 492.6. The Issue of Public Debt and the Need to

Implement Structural Public Balance Adjustments 54Box 2.3 The Crowding-out Effect in a Monetary Union 59

Chapter 3 Monetary Policy in the Eurozone 653.1. Theoretical Basis of the Monetary Policy

Conduction 653.1.1. Phillips Curve a NAIRU 653.1.2. The Relationship between Inflation and

Economic Growth 713.1.3. Sources of Inflation 72

Box 3.1 Specific Approaches to Inflation 763.1.4. Effects of Reducing Inflation 793.1.5. Selected Approaches to Deflation 823.1.6. Exchange Rate and Inflation Relationship 843.1.7. Consequences of Exchange Rate

Fluctuations 853.1.8. Real Exchange Rate 86

3.2. Conduction of Monetary Policy and its Macroeconomic Aspects 913.2.1. The Importance of the Nominal Anchor

in the Conduction of Monetary Policy 94Box 3.2 Fixed Versus Flexible Exchange Rate Dilemma

(Evidence from New EU Member Countries) 98Box 3.3 Evolution of Exchange Rate Regimes in the

European Transition Economies 101Box 3.4 Monetary Policy and the Exchange Rate

System 1123.2.2. Transmission Mechanism of Monetary

Policy 1143.2.3. The Importance of the Operational

Criterion in the Transmission Mechanism of Monetary Policy 117

Box 3.5 Impact of Quantitative and Qualitative Approach to the Monetary Policy Conduction on Central Bank’s Balance Sheet 1223.2.4. Choice between Inflation and Price

Targeting 1253.3. Evolution of the ECB’s Monetary Policy 126

3.3.1. First Phase: Monetary Policy Beginning and Adjustment (1999–2003) 128

Contents vii

3.3.2. Second Phase: Monetary Policy Until the Financial Crisis (2003–2007) 131

3.3.3. Third Phase: Global Financial Crisis and Great Recession (2008–2013) 132

3.3.4. Fourth Phase: Ultra-low Inflation and QE (2014 to the Present) 134

Box 3.6 Overview of the Instruments Employed via a Broad Policy of Liquidity Provision to the Banking Sector Employed by ECB (2018) 135

3.4. Monetary Policy Controversies 1373.4.1. Qualitative and Quantitative Approach

to the Monetary Policy Conduction 1373.4.2. Rules Versus Discretion 1403.4.3. Taylor Rule 143

3.5. Monetary Policy in DSGE Model 146

Chapter 4 Policy Coordination in the Eurozone 1534.1. Policy Coordination in the Eurozone:

A General Framework 153Box 4.1. International Spillover Effects under

Floating Exchange Rate Regimes 1554.2. Fiscal Policy, Monetary Policy, and Financial

Markets: A Stylized Model for A Country Belonging to The Eurozone 1584.2.1. National Government Behavior 1594.2.2. Financial Market Behavior 1614.2.3. A Graphical Representation 1614.2.4. Case 1. Sustainable Shocks 1624.2.5. Case 2. Unsustainable Shocks 162

4.3. Policy Coordination and External Equilibrium 1654.4. Policy Coordination and the Future of the

Eurozone 170Box 4.2 Unpleasant Effects of Restrictive Fiscal

Measures in the Eurozone 172

Conclusions 177

References 181

Index 195

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List of Figures, Tables

FiguresFig. 1.1 Effects of an Asymmetric Shock in Two Different

Countries Belonging to a Monetary Union. 10Fig. 1.2 Automatic Rebalancing through Wage Flexibility or

Labor Mobility of an Asymmetric Shock 11Fig. 1.3 Policy Instruments and Objectives Under the Principle

of “Effective Market Classification.” 16Fig. 1.4 Monetary Expansion Under a Flexible Exchange

Rate Regime. 18Fig. 1.5 Fiscal Expansion Under a Flexible Exchange

Rate Regime. 19Fig. 1.6 Changes in Money Supply Under Fixed Exchange

Rates. 20Fig. 1.7 Changes in Government Expenditure Under Fixed

Exchange Rates. 21Fig. 1.8 A Stylized Illustration of the Transmission Mechanism

from Interest Rates to Prices. 26Fig. 2.1 Inflationary Effects of Demand Changes Under

Alternative Hypotheses on the Slope of the Supply Curve. 35

Fig. 2.2 Debt Dynamics in the Case of g>r. 55Fig. 2.3a Debt Dynamics in the Case of g0. 56Fig. 2.3b Debt Dynamics in the Case of g

x List of Figures, Tables

Fig. 3.4 Phillips Curve, Eurozone (1997–2017). 70Fig. 3.5 Transmission Mechanism of Monetary Policy. 114Fig. 3.6 Quantitative and Qualitative Approach to the

Monetary Policy Conduction. 137Fig. 3.7 Structure of the New Keynesian Model 149Fig. 4.1 Monetary Policy Spillover Effects Under Floating

Exchange Rates. 156Fig. 4.2 Fiscal Policy Spillover Effects Under Floating

Exchange Rates. 157Fig. 4.3 Sound Fiscal Dynamics. 162Fig. 4.4 Unsound Fiscal Dynamics. 163Fig. 4.5 Solution to Unsound Fiscal Dynamics. 164Fig. 4.6 Long-term Interest Rates on Government Bonds

and Current Account as a Percentage of GDP in Selected Eurozone Countries 2004–2007. 167

Fig. 4.7 Long-term Interest Rates on Government Bonds and Current Account as a Percentage of GDP in Selected Eurozone Countries (2008–2011). 168

Fig. 4.8 Eurozone Trilemma Triangle. 170Fig. 4.9 Material Deprivation and Cumulative Structural

Adjustment: Yearly Means. 173Fig. 4.10 Change in Material Deprivation and Cumulative

Structural Adjustment from 2005-2015 in Single EZ Countries. 174

TablesTable 2.1 Competing Schools of Thought and Fiscal Policy:

Hypotheses and Outcomes. 47Table 3.1 Exchange Rate Regimes in New EU Member

Countries. 104Table 3.2 Operational and Intermediate Criteria of Monetary

Policy. 120

Preface

This book was born from the intention to present in a different light and in a systematic way the institutional structure that regulates economic policy in the European Monetary Union.

The view is shared by both authors, which, despite belonging to different coun-tries and with different personal experiences in respect to the Eurozone institu-tional consolidation process, found themselves convinced that it was necessary to make explicit the connection between the evolution of the economic theory and the path of construction of the European Monetary Union. The underlying idea is that the rules that determine its functioning are the result of the evolution of economic theory in light of historical facts and that it is essential to understand their meaning in terms of policy proposals. As the Keynesian approach revealed to be inadequate to interpret the facts after the 1970s, now the consolidated new neoclassical synthesis approach appears to be unable to solve the asymmetries inside the Eurozone without questioning the existence of the whole currency area. This approach provides a new perspective from which to examine the cur-rent Eurozone policy equilibria and, in the light of current crisis, calls for new answers in terms of policy prescriptions.

The authors would like to thank their families: someone would think that without their presence the book would have been written more quickly. However, they know that in the absence of those affections, they would not have had the necessary strength to carry out the project.

This book is dedicated to Rorita’s family – Francesco, Anna, and Benedetta and Rajmund’s family – Paulina and Ivana.

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Acknowledgements

This book benefited from the financial support of the University of Naples “Par-thenope”, assigned on an award basis to Rosaria Rita Canale.

This book was written in connection with scientific project VEGA No. 1/0793/19. Financial support from this Slovak Ministry of Education scheme is also gratefully acknowledged.

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Introduction

Subject and ApproachThis book provides a theoretical and empirical reconstruction of economic para-digms that led to the present institutional framework of the Eurozone. Its attempts to merge the evolution of the theory with the changes in facts and presents the competing economic paradigms in the awareness that economic policy theory cannot be evaluated separately from the historical context. Special attention is devoted to the policy framework of the so-called “macroeconomic consensus,” which in the light of the events occurred after the crisis, appear to be unable to incorporate in their analysis the real and financial fragility of modern economies.

The 2007–2008 economic and financial crisis highlighted the flaws in both operational and institutional design of economic policy in the Eurozone. Severe recession and reduced macroeconomic performance followed by increasing defla-tionary pressures represented a reasonable challenge for both monetary authority (ECB) and fiscal authorities (national governments). However, reduced maneu-verability of fiscal authorities (in some cases consequences of fiscal irresponsibil-ity during “good times,” unstable size of fiscal multipliers during the crisis period), as well as monetary authority (liquidity trap, ineffective transmission mechanism of monetary policy) together with reduced predictability of macroeconomic development (another wave of recession during 2012–2013) clearly raised doubts and uncertainty about suitability of ad hoc discretionary policies based on tra-ditional theoretical or even empirically verified concepts or models heavily used in good times. Moreover, still persistent heterogeneity across Eurozone member countries recalled emphasis on policy coordination. Finally, considering that the single monetary policy cannot cater for heterogeneity across member countries of the monetary union, even more, in the low interest rate environment, increased role of fiscal policies in reducing negative effects of external and internal shocks on macroeconomic performance of the Eurozone was just generally expected. However, many empirical studies emphasize the existence of asynchronous fea-tures strongly embedded in the mix represented by uncoordinated national fiscal policies combined with single monetary policy that even increases heterogeneity among the Eurozone member countries and thus reduces the overall benefits of deeper economic integration. The book Fiscal and Monetary Policy in the Euro-zone provides rigorous insights into the theoretical and empirical dimensions of

Fiscal and Monetary Policy in the Eurozone:Theoretical Concepts and Empirical Evidence, 1–3Copyright © 2019 by Emerald Publishing LimitedAll rights of reproduction in any form reserveddoi:10.1108/978-1-78743-793-720191001

http://dxi.doi.org/1397781622

2 Fiscal and Monetary Policy in the Eurozone

fiscal and monetary policy in the Eurozone that contributed to the rise and deep-ening of the external and internal imbalances within the monetary union.

The Policy Framework in the EurozoneIn this chapter, the historical and theoretical evolution of the policy framework in Europe and Eurozone is presented chronologically starting from the abandon-ment of the Bretton Woods, via reviewing the crucial milestones of economic and monetary integration in Europe, and until the creation of the common cur-rency area with its key institutional and policy framework. It starts from the early steps guided by the general principles of the Keynesian theory in open economies, goes through its revision that occurred after the 1970s and the fall of the Bret-ton Woods agreements, the creation of the European monetary system, and ends with a presentation of the theoretical underpinning that brought to the model on which the European monetary union was built on. The evolution of the eco-nomic theory is pieced together (from Keynesian economics through neoclassical synthesis until New Keynesian economics), in the light of the main historical and political facts occurred. A first insight about the flaws of the Eurozone policy framework is provided.

Fiscal Policy in the EurozoneThe second chapter presents the fiscal policy content and associated theoretical background considering its evolution that influenced the policy principles imple-mented from the end of World War II to the present. It shows how the theoreti-cal foundations evolved, from the Keynesian theory according to which public expenditure was conceived as an instrument to sustain aggregate demand and achieve full employment, to the present theoretical framework in which, following the intertemporal approach, it has been downgraded to an external shock. The public debt issue is examined with the aim of explaining why sound public finance represents in the Eurozone a primary policy challenge.

The objective of the chapter is to delineate the policy framework as a result of the evolution of the economic theory in which the economic policy experienced a progressive reduction in its role in defining macroeconomic equilibrium. Fiscal policy goes from the Keynesian paradigm, whose core is the consumption theory of current income, until the New Neoclassical synthesis in which the intertempo-ral optimization strategy and rational expectations allow underling the distortive contribution of government intervention to macroeconomic equilibrium.

Monetary Policy in the EurozoneMonetary policy goes from the complete accommodative conditions of the 1950s to the interest rate setting rule defined by the Taylor rule. The inflation target-ing became the main central bank’s strategy with the aim of stabilizing prices, and assure the convergence toward the rate of full employment. The events fol-lowing the crisis caused a revision of these conclusions and brought back in the

Introduction 3

theoretical and empirical debate the role of economic policy, both in the short and in the long run. It will be shown that despite this changing path and the process of conclusion revisions, the institutional framework has not yet acquired these changes.

The role of money and monetary policy of the central bank in pursuing mac-roeconomic stability has significantly changed over the period since the end of World War II. Globalization, liberalization, integration, and transition processes generally shaped the crucial milestones of the macroeconomic development and substantial features of economic policy and its framework in Europe. Policy-driven changes together with a variety of exogenous shocks significantly affected the key features of macroeconomic environment on the European continent that fashioned the framework and design of monetary policies.

This chapter examines the key basis of the central bank’s monetary policy on its way to pursue and preserve the internal and external stability of the purchasing power of money. Substantial elements of the monetary policy like objectives and strategies are not only generally introduced, but also critically discussed accord-ing to their accuracy, suitability, and reliability in the changing macroeconomic conditions. Brief overview of the Eurozone common monetary policy milestones and the past Eastern bloc countries experience with a variety of exchange rate regimes provides interesting empirical evidence on origins and implications of vital changes in the monetary policy conduction in Europe and the Eurozone.

Policy Coordination in the EurozoneChapter 4 is devoted to the issue of policy coordination inside the Eurozone: the fixed rules find their underpinning in the spillover effects associated with dif-ferent debt and deficit levels inside a currency area. After having briefly recalled the meaning of fiscal and monetary policy coordination in the Keynesian and present paradigm, it describes the meaning of coordination inside the Eurozone: it emerges as a marked subordination of national fiscal policies to the objective of the common monetary policy that in terms of the common currency represents a stability of price level and interest rates in the Eurozone. This feature generates two main fragilities to which the entire Eurozone is exposed: the first deriving from the role assigned to financial markets and the second one linked to the pres-ence of external imbalances. Some reflections about the need to build up common policy institutions as a mean to grant stability and growth in the Eurozone are provided. After the crisis, the compliance to rules translated into external and internal imbalances and the issue of coordination translated into a balance-of-payment crises issue. The chapter will present alternative theories behind these imbalances and the possible solutions to ever-increasing processes of divergence among countries belonging to the Eurozone. Finally, some reflections about pos-sible future scenarios will be discussed.

ContentsList of Figures, TablesPrefaceAcknowledgementsIntroductionSubject and ApproachThe Policy Framework in the EurozoneFiscal Policy in the EurozoneMonetary Policy in the EurozonePolicy Coordination in the Eurozone