Assymetric shocks

European Economic Issues: Adjustment to Asymmetric Shocks in the Euro-zone countries

Graded writing assignment SS 2006

(European Economic Issues)

“Adjustment to Asymmetric Shocks in the Eurozone countries”

WORDCOUNT: 3276 Words

ETHICS STATEMENT:

Herewith I (we) declare that I (we) have prepared the following work alone and without the use of materials other than those cited.

SIGNATURES:

Diana Mateo: ____________________

Nils Urban: ____________________

Andreas Schnepf: ____________________

Table of Contents

Introduction 1

Main Part 2

I. Macroeconomic Shocks 2

Temporary and permanent shocks 2
Country-specific and sector specific shocks 3
Real and financial shocks 3
Exogeneous and policy-induced shocks 3

II. Dealing with asymmetric shocks in the EMU 3

Market oriented tools 4
Institutional mechanisms 7

Conclusion and argumentation 8

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A. Introduction:

Abstract:

This paper will analyze how countries should deal with asymmetric shocks when they are hit by an asymmetric shock and which instruments of economic policy have to deal with these types of economic problems. Furthermore it will supply the reader with a brief information on the EMU and its history together with basic information concerning the “taxonomy of shocks”.

The Conclusion will touch several issues of the main part, clarifying the current circumstances of the EMU and pointing out the key problems it has to struggle with, when hit by asymmetric shocks.

A brief history of the Economic and Monetary Union (EMU):

In the late 1960’s the vision of a common currency for Europe was beginning to take shape, but it would still take more than 30 years until it would become reality.

The main reason for creating such an EMU was partly political and partly economic and derived from the wish to make trade between the EU countries easier. Removing uncertainties about exchange rates and cutting out currency exchange costs have been but one of the reasons. Another element has been the belief that increased integration between the economies of the EU countries will create better conditions for achieving shared objectives such as a strong growth rate and high level of employment.

Four political milestones – with intervals of about ten years – were needed to reach the final goal to create a single currency area in Europe:

I. 1969 – The den Haag summit and the Werner Report:

An expert group chaired by the Luxembourg’s President and Finance Minister, Pierre Werner, presented the first commonly agreed blue print to create an economic and monetary union in three stages in October 1970, the Werner Report.

II. 1979 – The Florence summit and the EMS:

To set up a zone of monetary stability and to increase efforts to achieve closer economic convergence between member-states a second attempt was made to move towards the final goal of the EMU, and the European Monetary System was established.

III. 1989 – The Hannover Summit and the Delors Report:

On request during the Hannover summit, in April 1989 a report drafted by the Delors Committee was presented. It proposed intense steps towards economic convergence, price stability and budgetary discipline before effecting the fixing of the exchange rates of the currencies. The development of a single currency - the European Currency Unit (ECU) - was decided soon after.

IV. 1999 – The” three Stages” and the coming of the EMU:

The new single currency was introduced within three stages. The first stage started 1990 entailing the liberalisation of capital and the freedom of movement of capital. The second one started in 1994 implemented all secondary legislation on EMU for the member states. The third stage began in 1999 and marked the effective start of the monetary union with the introduction of the Euro (€), but it was not until 2002, with the introduction of the euro banknotes and coins, that the “final act” was achieved.

B. Main Part:

I. Macroeconomic Shocks:

Of course the EMU has not been blessed by a lack of scepticism. Politicians, journalists and economists state that there might be no real mechanism to counter “asymmetric shocks” (in the following referred to as AS). The main point of concern is that the European Union might not be an “optimum currency area” (OCA) and a very serious issue arising from this critique is the fear for AS.

Four distinctions are made between: (Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 13)

temporary and permanent shocks;

country-specific and sector specific shocks;

real and financial shocks; and

exogenous and policy-induced shocks.

a.) Temporary and permanent shocks:

QA distinction is to be made between shocks having temporary effect and the likes entailing a permanent, negative impact. A distinction is important for confusion between them can lead to provisions worsening the situation rather than improving it. A long-term effect might require an intensive structural reform. Therefore each member state is obliged to take adequate action and not wait for external support.

However, the distinction should not be made too strict. Shocks often consist of both, short- and long-term effects implying that quick adjustments as well as structural reforms are necessary. (Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 13)

b.) Country specific and sector specific shocks:

A shock affecting a country is correlated to typical problems of the individual country, whereas a sector specific shock concentrates on an industry sector. So far, sector specific shocks occurred far more often than country specific shocks. Changes in monetary policy or in the exchange rate are the wrong method ...

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b.) Country specific and sector specific shocks:

c.) Real and financial shocks:

If a shock affects the real aggregate demand, then a variation in exchange rates is reasonable. If it is purely financial, a good counter is to answer with fixed exchange rates or a single currency, minimising the obstacle for money flowing across national borders. (Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 16)

d.) Exogenous and policy-induced shocks:

An exogenous shock is caused by unpredictable events, not subject to direct control of any kind. Policy-induced shocks are “home-made” shocks triggered by internal policies.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. pp16-17)

II. Dealing with asymmetric shocks in the EMU

Whenever an AS between two countries (A and B) arises, one country has to deal with high unemployment and the other country is affected by high rates of inflation.

If we suppose that both countries produce homogeneous goods (e.g. textiles), and the demand for that particular good rises in country B, the demand in country A decreases.

Consequently the unemployment in that sector in country A increases.

Affected by high money supply in country B, the inflation rate rises.

One possible solution to better the situation in both countries is the exchange rate mechanism.

If country A decreases its currency power (for instance by influencing the exchange market through increasing domestic currency supply), real wages and prices fall.

Consequently the competitive power increases and the demand in country B falls, so that inflation decreases back again (Mundells theory of optimal currency areas).

The main attribute of the European Monetary Union (EMU) is that there is one common currency. Therefore there are no exchange rates that could regulate and solve an AS.

In case an AS. arises, other mechanisms to regulate the situation must be implemented.

As pointed out already, lowering the own currency power, by the aid of the exchange market mechanism, results in lower prices for foreign countries when buying a particular good, and finally in a competitive advantage, and higher demand; consequently in decreasing unemployment and higher common welfare.

In the EMU other tools than the exchange market mechanism must be used, to effectuate these positive developments.

In the following we will name and explain several instruments that can intervene in the different stages of bettering the welfare, and solve the symptoms of AS, similar to the exchange market mechanism.

Mechanisms to lower the impact of AS can either be market oriented, or institutional.

1. The market oriented tools intervene into the market internally and result in betterment by using own capacity.

The main market oriented tools are:

Wage- and price flexibility,
Flexibility in labour mobility
Flexibility in capital movement.

Each one will be explained in the following paragraphs.

Wage- and price flexibility can be used to lower the nominal wages and lower the prices within an affected region or member state. By doing that the same effect arises, as if the member state would lower their currency power.

The region (member state) becomes competitive again and demand increases.

This tool is very effective and important; however it cannot be used by the EMU that properly, because of the so called “slackness of price level” and “inelasticity” of nominal wages.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 25)

The slackness of price levels and the inelasticity of nominal wages result from social assurance mechanisms, such as wage agreements and minimum wages, protected by institutions like the labour union and the employee representation. Nominal wages and prices are highly correlated. If prices in the EU increase by 1%, unemployment increases proportionally.

(EU Commission, 1990, from p.21 of Ben Patterson, 1998)

In the US and Japan this tool can be used more properly, due to higher preparedness to lower wages and prices effectuated by an unproportional correlation between unemployment and increase in price.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 25)

Flexibility in labour mobility is a tool to solve the primary syndrome of AS: the unemployment. If workers are not willing to work for the market regulated price in case of a dropping demand of labour, they can easily migrate to a market of higher demand of labour (lower supply of labour) and higher wages. The problem of unemployment would be solved and common welfare would recommence to increase.

In this argumentation shall be mentioned that migration might be also linked with costs. The cost-benefit balance could turn out negative for regions with immigration as well as for regions with emigration. The receiving country is faced with maintenance and supporting insurance duties. The emigration country might be faced with the loss of qualified and skilled labour. The beneficiaries are the ones who stay employed further on because they do not loose their working place.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 29)

However, the motivation in Europe for migrating is much lower than in the US, for instance.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 27)

Surveys from the Organisation for Economic Co-operation and Development (OECD) in 1987 illustrate, that the willingness of German and French citizens, to move to another region (national) equals 1/3 of the willingness of US–citizens. The extraordinary low willingness to migrate in an international context is therefore exponentially higher.

Obstfeld and Peri (1998) argued that, the frequency in which AS strike a region or a member state and the preparedness to migrate, are linked to each other. The more often an AS occurs, the higher the preparedness to react in form of migration.

According to Obstfeld and Peri, the EMU is less often stricken by AS than the USA, for instance. However, suitable measurement tools need to be invented, in order to compare AS when it comes to estimating the intensity.

But fact is that for Europeans, migration is less likely.

Reasons are difficulties resulting from differences in culture and language, non-transferability of pension claims, reservations in social security, low flexibility in residential markets and the disavowal of qualifications.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 27)

Another important barrier is the social security system. In the US the system is not that strongly distinct. Therefore US citizens have no other possibility than to migrate, because nobody will pay them for doing nothing (unless they are not demonstrably disabled).

Europeans often rely on the support from the state, as social security is deep-seated in the constitution. A “Moral Hazard Problem” might result.

Last but not least must be mentioned, that facing the improvement of technology such as the World Wide Web, we have an increase in high flexibility of the working place. Out-sourcing becomes an often used instrument in adjusting to given market conditions. Distance loses in importance.

As a consequence, local mobility becomes less important, while occupational mobility gains in significance.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 32)

Flexibility in capital movement is the third important tool in market oriented control.

Short-term capital can solve a disequilibrium between regions affected by AS.

They permit structural changes in a timely manner. Whenever an AS concerns a nation, current accrual of funds may balance and improve the financial situation and absorb the consequences.

Far more critical is the long-term investment that forms structural prevention in order to avoid AS.

Segmentation of capital markets decreased respectably during the existence of the EMU, because common currency implies no risk of instability in exchange rates. New, integrated stock markets arise and the flexibility in capital movement rose.

The European Commission detected in a representative survey, that more than 10% of European banking- and insurance-clients have a trans-boundary interest in buying goods.

Although, only 5% of these clients hold an international bank giro account, only 1% of the private clients take a hypothecary credit from foreign European countries. And not more than 3% have a foreign credit card or a private retirement provision contract, abroad.

(Müller, Klaus Peter (2007) Gemeinsamer EU-Finanzmarkt: Ein Weg mit vielen Etappen [Online]. (Nr.4) [Accessed 11.05.2007]. Avail. F. World Wide Web:<http://www.diebank.de/index.asp?issue=042007&channel=151010&art=538>)

Nevertheless, monetary means tend to agglomerate in areas with already high investments and cyclical activity, not in poor and stagnating regions. A survey from “Eurostat” in 1993 detected that 75% of the entire investments within the EU flew into the northern states, while less than 20% flew into the three poorest counties: Greece, Spain and Portugal.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 31)

2. Institutional mechanisms derive from external intervention of common European institutions, for instance by implementing a corresponding fiscal policy.

Pelagides (1996) argued that the implementation of such institutions, in order to re-allocate revenues between member states, is essential.

On the other hand, long-term financial backing retrieves the risk of affecting the “Moral Hazard Problem”.

In the US there is a federal security system implemented (interstate insurance), that balances financial inequalities between states by using the federal taxes as “fiscal pump“.

Areas of higher wealth and greater tax revenues balance the account of poorer areas that are hit by an AS. Cerano (1992) argues that the main task of that federal fiscal pump implements the establishment of confidence in the self regulating market mechanism on a psychic level.

However, the EU budget is not able to provide such interstate insurances.

While the US budget covers 33% of GDP, the EU budget does not exceed 1,5% of GDP.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 35)

C. Conclusion and argumentation:

As outlined throughout this paper, in the EMU, there are several tools to regulate the market that affect the stability of international trade, similar to the currency exchange mechanism.

Nevertheless, these tools are not that efficient as they are desired to be.

The following paragraphs are going to differentiate the tools and will give an overview about how to achieve more efficiency within these regulation tools.

“Due to limited and even declining mobility of workers within the new member states, and given the formal restrictions on the free movement labour for new EU members, it is unlikely that migration can be considered an efficient tool for coping with adverse shocks.”

(Babetskii, I. (2006) Aggregate Wage Flexibility in Selected New EU Member States, Prague: Czech National Bank. Page 1)

Several steps of development need to be supported in order to expand flexibility of labour in the EMU.

Flexibility in mobility needs to be prepared by the EURES-Portal.

Migration should be supported and a higher amount of information provided. Employees and their families need support in all phases of migration. In order to decrease fear, return to the domestic market should be mentioned as possible solution also.

Mobility should become a common element of job-related and personal development for all Europeans, therefore:

2.1. Labour legislation need to be accommodated.

2.2. Social security laws need to be accommodated.

Bonds and debentures need to be accommodated.

3. An improvement in education policy in order to provide the labour market with skilled people is as essential as the implementation of new working laws in order to keep the labour market flexible.

On the one hand social laws try to protect employees, but on the other hand they prevent companies from hiring new employees because each one would cause higher costs. However, it is important to mention that the labour market already changed in the last decade. It became more flexible, but compared to the United Kingdom and specially the US it is still pretty inflexible. (Münchau, W. (1998) Europe's Fragile Recovery, Financial Times)

A fluent movement within the EU, comparable to movement in the US, is imaginable – but within several years of development only.

The flexibility of wages and prices in the EMU is relatively low.

However there is a kind of inflation mechanism in some countries and regions to detect, even if there is one common currency. Therefore the terms-of-trade-index is high between Poland and Germany, yet.

The Balassa-Samuelson- hypothesis explains how convergence in prices of non-trading goods (like haircuts and consultancy) and consequently inflation rates within the EMU, rise. Low prices of non-trading goods within one region or member state result from low labour costs. Low labour costs are a consequence of low productivity in trading goods. Supported by developing technology, for instance, productivity in trading-goods will grow – faster as in already producing member states. The level of wages and consequently the entire price level will increase, relatively to the developed member states.

This phenomenon has a balancing effect, and leads to assimilation within the EMU.

Nevertheless, the Balassa-Samuelson- hypothesis cannot be used to explain inflation as tool for regulating currency power, because it is based on non-trading goods.

Fact is, that price and wage flexibility in the EU is not sufficient to deal with AS.

Flexibility is hampered by minimum wages, as well as by long contract periods.

Furthermore, in some countries (Spain, Belgium, Finland, Luxembourg), wages and prices are going to be adjusted to inflation rate.

In average, prices within the EMU are not changed during five quarters (1 ¼ years) – as double as in the EU. Prices for non-trading goods and invisibles need the longest time to adapt.

(Henzel, S. and Sauer, S. (2006) Konsequenzen der Inflationsunterschiede im Euroraum, München: Ludwig-Maximilians-Universität. Page 18)

The only possible solution to improve the tool of flexible wages and prices is to implement a common regulation for contract periods and minimum wages and to eliminate the mechanism of adapting prices to inflation rates.

By implementing these common guidelines, also the problem of low flexibility in migration could be solved, because short-term advantages in labour markets would disappear.

The flexibility of capital seems to improve, however agglomeration hampers the effect of balancing accounts.

Mainly in areas like common investment programs and investment in common pension funds should be established a sort of assimilation. In order to provide that, supervisory regulation needs to be implemented. In how far a supervisory regulation in general is intended by all member states, is not clear yet.

(Patterson, B. (1998) Adjustment To Asymmetric Shocks, Luxembourg: European Parliament. Page 76)

One other critical issue is the question of taxation. Many member states want to keep their own fiscal jurisdiction. On the other hand, different taxation systems may lead to an unfair competition in location advantages.

Several treaties concerning adjustment are in progress. However it will be very difficult to find a suitable solution for all member states.

Overall it can be concluded that several tools to deal with AS are available.

However most of them are not efficient yet. The main source of problems is the disunity of the EMU, in view of legal prescriptions.

Disunity in legal prescriptions leads to barriers in the flexibility of migration, the flexibility of wages and prices, as well as in movement of capital.

Eliminating the barriers is theoretically easy, but in practise huge problems arise, based on the different aims of national policy. (Lane, P. (1999) Asymmetrical Shocks and Monetary Policy in a Currency Union, Dublin: Trinity College. pp 27-28. Technical Paper Nr. 99/4)

The only way to solve problems originating from dissension – in order to become a strong union – is to pursue common goals and to find agreements that provide overall, cross-national convenience. (Di Gennaro, L. (2005) Asymmetric Shocks and Fiscal Federalism in European Union, Marakesh: University Of Bolognia. pp 11-12. An Extract from Chapter 5 of: New Frontiers Of European Union)

Reference List

The crises arising from the non-convertibility of the US dollar into gold in August 1971 and from rising oil prices in 1972 were a serious setback for the EMU project.

More emphasis was put on an ambitious Single Market programme and less on the immediate creation of a monetary union.

Some key concepts were: excessive deficit procedure / prohibition of privileged access / prohibition on the central banks granting credit facilities to public authorities and undertakings / broad economic policy guidelines and convergence criteria.

The ECU was named into Euro and for the first three years it was used as a "book currency" on the financial markets.

An event causing an economic shock (effect) that varies between areas.

OCA is a region or area where economic efficiency is maximized due to the share of a single currency. Robert Mundell is said to be the pioneer of this theory. Some key principals of OCA are: Labour mobility across the region, Openness with capital mobility and price and wage flexibility across the region, An automatic fiscal transfer mechanism.

Examples: Unexpected “mega-trends”, ecological disaster, etc.

Examples: A rise in wages or artificial stimulation of an economy before an election.

A decrease in currency power in a region would not work out, since a region, as a part of a country, does not dispose of an own currency in most cases.

However that development would become visible much more slowly than by using the exchange rate mechanism itself. Therefore the exchange rate mechanism seems to be more efficient. (Ochel, 1997, from p.21 of Ben Patterson, 1998).

This preparedness is also influenced by some other factors, named in the following.

As the reference is from the year 1998, the situation in some fields improved.

.The model consists of an agent who controls the drift or drift and

volatility of a diffusion process for which the rights are owned by the principal

(Westerfield, Mark M. (2006) Optimal Dynamic Contracts with Hidden Actions in Continuous Time, Los Angeles: University of Southern California. Page 1)

However the latest development shows that both, Ireland and Portugal gain on high investments and experience a sound growth of their accounts. Nevertheless time will show to what extent agglomeration will occur.

The EURES is an abbreviation for: EURopean Employment Services, It was founded in 1993. The EURES is a Europe-wide network that supports mobility of the labour market crossing borders. Partners are public labour administrations, unions, and Confederation of Employers. The network is coordinated by the European Commission and is responsible for the following elements:

Consulting for employees, regarding working possibilities abroad ( within Europe )
Supporting employers in searching for international labour.
Special consultancy for employers and employees in border areas.

Disparities will disappear during time, however an assimilation of price and wage levels are a long time coming.

An economic model, based on the assumption that productivity or productivity growth-rates vary more by country in the traded goods' sectors than in other sectors.