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Thursday, June 10, 2010

Breaking Cover

Well after a pretty hectic 48 hours being pursued all over the virtual globe by the economic and financial press, I am finally coming up for air. Those who don't know what I am talking about might try this, or this, or this (etc). Actually I am grateful to Catherine Rampell of the New York Times's Economix for rescuing a comment I made on Landon Thomas's original article, which summarises some of the argument I am advancing about housing bubbles and median population ages. Irrespective of whether the argument is right or wrong, I think the comment makes things clearer.

What I want to make clear in this post, is that none of the argument Claus and I are advancing at the present time is exactly new. Back in June 2007 (that is just before the crisis broke out) some of Europe's leading economic research Institutes (CPB, DIW, ESRI, ETLA, IfW, NIESR, OFCE, PROMETEIA, WIFO) organised their 4TH Euroframe Conference on Economic Policy Issues in the European Union in Bologna. The conference was entitled appropriately enough "Towards an Ageing and Globalising Europe: Challenges for the European Social Model(s)". They issued a call for paper abstracts (the call file is still online here), so Claus Vistesen and I, together with two other young European economists who were working with us at the time (Aapo Markkenen and Paula Silli) sent in four abstracts on related topics. Unsurprisingly, none of the proposals presented was considered sufficiently interesting to be accepted by the committee of experts appointed to take the decisions. (The Scientific Committee was made up as follows: Karl Aiginger (WIFO), Ray Barrell (NIESR), Alan Barrett (ESRI), Paolo Bosi (PROMETEIA), Klaus- Juergen Gern (IfW), Markku Kotilainen (ETLA), Alfred Steinherr and Christian Dreger (DIW), Henri Sterdyniak (OFCE), Wim Suyker (CPB), Catherine Mathieu (OFCE, Scientific Secretary)). So the problem isn't that the demographic argument has been studied, analysed and found to be wanting, the sorry situation is, it hasn't even been considered worth listening to.

Here is the first abstract.

Monetary Policy and Eurozone Imbalances - The Demographic Transition and Asymmetric Shocks

Authors: Paula Silli and Edward Hugh

It is by now part of our received wisdom as economists that the single greatest difficulty envisaged for an optimum currency area as the idea was originally conceived by Robert Mundell would be the issue of adapting a ‘one size fits all’ monetary policy (especially given the associated absence of exchange rate flexibility) to the need to adjust to the presence of asymmetric shocks. Now whilst methodologically it may be somewhat questionable to attempt to address Europe’s differential demography in terms of shocks since the demographic transition may be far better conceptualised as a process than as a series of ongoing shocks (a process which most notably occurs with differing intensity and at different velocities from one country to another), the problem of the asymmetric impact of such changes on the different member countries which presently constitute the eurozone is a real enough one. Surprisingly, to date, this topic has received comparatively little attention in the literature. This short paper will be an attempt to address this other ‘imbalance’, to summarise the issues which are involved, and to initiate the much needed reflection process on the policy implications of the continuing presence of such asymmetries.

In order to begin this reflection process it may well be worth asking ourselves a number of key questions. Firstly, just what Eurozone imbalances are involved here? Secondly, assuming such imbalances exist, what are the underlying reasons for, and the structural drivers of, the imbalances? Thirdy, in the light of the above, should we be asking ourselves the question as to whether it is really appropriate to continue to speak of the Eurozone as one single economy (or structural entity) as conceptualised under the ECB’s two pillar monetary framework? These three issues represent the pivotal points of this paper.

At the present time the concept of internal Eurozone imbalances is normally operationalized by drawing attention to the notable differences which exist between the external balances of the various member country economies. Perhaps the most telling example here is to be found in the difference between two of the zone’s largest countries: Germany and Spain. The former country exited 2006 with a current account surplus close to 6% of GDP while the latter was running a current account deficit of just over 8% of GDP. Another approach to the same issue has been to try and think about imbalances in the Eurozone in terms of ongoing divergences in real exchange rates (Breugel, 2006). Now in fact such divergences in real-exchange rates occur as a result of differences in the domestic inflation rate and of varying rates of growth in domestic demand. Put another way, the transmission mechanism for monetary policy seems to vary from one zone member economy to another, and the big question is why should this be?

Data will be presented to illustrate how those countries experiencing fairly high rates of domestic demand growth generally have seen their real exchange rate rise relative to the countries which have had an ongoing weakness in domestic demand and which have become structurally dependent on leveraging exports in order to achieve respectable rates of GDP growth (and hence, indirectly, sustain that other imbalance, the government deficit one). In particular it is noteworthy how Germany - the zone's largest economy - has developed a very complex series of relationships with the other Eurozone countries in terms of both the notable depreciation of its real-exchange rate since the 1990s, and the presence of systematic capital flows out of Germany into other member countries. These flows are associated with the relatively high savings rate which is to be found in Germany.

A variety of explanations are of course possible for the occurrence of such imbalances but few of those adanced to date seem able to account for the apparently systematic nature of the imbalances and the precise mix which is to be found. The differences which are to be found in the recent economic performance between the French and German economies would be a clear case in point. In an influential paper Duval and Elmeskov (2005) drew attention to the way the single interest rate policy might produce differential outcomes at the individual country level based on the character of the institutional response and degree of structural reform. However it is widely accepted that the structural reform process has gone much further in Germany than it has in France, and in the light of this the relatively robust performance of the French economy in recent years should certainly be considered puzzling. A similar argument could be made about the impact of globalisation and the so called ‘global labour arbitrage’ process. From the perspective of the more conventional narratives it is hard to see why domestic demand should be more robust to this impact in France than it is in Germany.

Now all of this begins to assume some importance when we return to the theoretical starting point for Mundell’s idea of optimum currency areas which assumed that a fixed exchange rate regime was the right choice for a group of countries which were tightly integrated through international trade and factor movements. It was always anticipated that asymmetric shocks would to some extent be in evidence as a result of an initial adjustment process among and between the economies which constituted the zone, and the contents of Maastricht Convergence criteria, as well as the growth and stability pact, obviously reflect just this awareness. Such initial shocks were normally conceptualised in terms of the well-known Balassa-Samuelson effects on relative prices. However the apparently endemic and ongoing character of the imbalances now begins to suggest that the process may be more than simply transitory, and that other factors may well be at work.

The present paper will therefore seek to develop the idea that the cause, nature, and crucially the future path, of the internal macroeconomic imbalances in the Eurozone may be best addressed by modifying the original theory of optimum currency areas to incorporate the presence of ongoing endogenous shocks experienced in the context of a fixed exchange rate regime as participating countries proceed through the demographic transition from different starting points and most importantly with considerable variance in tempo.

In particular this paper will formally expand on and develop the theoretical framework advanced by Ralph Bryant (Bryant 2006), who argues that cross-border transmissions arising from demographic processes which occur with differing velocities and outcomes significantly modify national macroeconomic performance, with the respective demographic transitions having particularly important effects on exchange rates (notional or otherwise), saving and investment ratios, current account balances and, hence, net capital flows.

The focus of the paper will be on the specific case of the Eurozone and the ECB’s single interest rate policy. We will suggest (and data will be presented to indicate) that the ECB’s monetary policy may inadvertantly have become a vehicle for transmitting systematic asymmetric shocks across the whole range of Eurozone economies.

Taking Modigliani’s idea of a life cycle saving and consumption pattern as applied to populations as a first approximation, and using movements in population median ages as a convenient proxy for a whole gamit of underlying processes, a simple model will be presented which it will be argued does a reasonably satisfactory job of accounting for the structural differences which are to be found across the various national economies in the zone, and at the same time offers a plausible framework for attempting to examine possible forward-looking scenarios.


Ralph C Bryant. Asymmetric Demography and Macroeconomic Interactions Across National Borders. Paper presented to the Demography and Financial Markets G20 Workshop organised by the Reserve Bank of Australia. 2006.

Duval, Romain and Jørgen Elmeskov. The Effects of EMU on Structural Reforms in Labour and Product Markets. Paper presented to the ECB conference "What effects is EMU having on the euro area and its member countries?". 2005.

R.A. Mundell, "A Theory of Optimum Currency Areas," American Economic Review, November 1961.
Bruegel, The Euro: Only For The Agile, Bruegel Policy Brief. 2006.

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