Final Report Summary - RASTANEWS (Macro-Risk Assessment and Stabilization Policies with NewEarly Warning Signals)
Executive Summary:
RASTANEWS intends to enhance the knowledge base available to policymakers to enhance macro-economic and monetary integration in Europe, thus paving the way to a revised governance of the Economic and Monetary Union (EMU). We feel the need to re-think conceptual frameworks about the working of the EU macro-economy in order to incorporate three key issues: (i) the role of incomplete and informationally inefficient financial markets; (ii) the heterogeneity in expectations, which should play a fundamental role in explaining the behaviour of asset prices; (iii) the need to overcome the traditional dichotomy between Keynesian (short run) and neoclassical (long run) policy prescriptions. Taking these issues seriously in theoretical and empirical research has important implications for the conduct of EMU monetary and fiscal policies and for EMU governance system. In addition, to facilitate the timely identification of macro risks, we explore the properties of a new system of early warning indicators - to be implemented within the EMU surveillance mechanism – which is consistent with our theoretical framework and is based on an empirical macro-finance approach.
The project aims at addressing EMU design and policy weaknesses that only emerged after the onset of the Great Financial Crisis, particularly those that: (a) hamper the proper functioning and the uniform transmission of monetary policy throughout the euro area; and (b) limit the coordination of fiscal policies, prevent their use as countercyclical buffers, and impede the emergence of a political consensus over the design of redistributive mechanisms at EMU level
Theoretical and empirical results have been exploited to provide policy outputs to EU and Eurozone policymakers:
1. proposals to reform EMU macroeconomic policies – e.g. by aiming at a global fiscal stance for the Eurozone -- in order to decrease the likelihood of future crises, while at the same time supporting overall growth in the Eurozone;
2. proposals to reform EMU macro-prudential policies, improving the functioning of the Banking Union as a way to enhance convergence of economic conditions and a smoothening of the business cycle, all the while serving as prudential tools at the EMU level that shelter the monetary union from a renewed negative feedback loop of financial crises and inter-country contagion;
3. proposals to define a refined set of ex ante indicators of impending macroeconomic and financial imbalances. Such Early Warning Signals (EWS) could serve as improved and timely indicators of problematic disequilibria at the macro level, with the aim to allow European and national policymakers, regulators and supervisors to act as early as possible in order to rebalance national economies or the EMU as a whole before a full-fledged crisis can develop.
Policy recommendations resulting from RAstaNEWS partners’ work have been collected in a Green Book.
Project Context and Objectives:
The 2008 crisis erupted in a situation where markets and policymakers apparently underestimated the risk incorporated in financial assets due to i) the potentially devastating effect of financial derivatives on the balance sheets of financial institutions; ii) the unprecedented interconnectedness between financial institutions; iii) the very high leverage of the financial system. The unregulated expansion of informationally inefficient financial markets was quickly identified as the main culprit of the crisis. A complementary view emphasizes the role played by factors such as saving-investment imbalances, assets prices and real exchange rate misalignments, the accumulation of large stocks of private debt in some countries. In addition, the crisis hit at a time when many countries had experienced substantial increases in inequality over the previous three decades: inequality either depressed growth or triggered increasing debt by households at the bottom of the distribution.
When the crisis hit, the Euro area was characterized by substantial asymmetries concerning accumulated competitiveness differentials, public debt and deficit ratios, fragility of domestic financial sectors. There is no doubt that undisciplined fiscal policies caused the Greek crisis but in other cases, notably Ireland and Spain, there had been a clear neglect for non-fiscal risks associated to credit booms, asset-price increases and real exchange rate appreciation. Just like the Fed, the European Central Bank (ECB) was apparently taken aback by the financial crisis. The fragility of the Euro-area financial system was utterly neglected and just before the near-collapse of financial markets, the main ECB concern was for inflation risk. On the fiscal side, the Stability and Growth Pact (SGP) has had at best a limited effect on excessive debt accumulation in relatively good times and has been criticized for mitigating the necessary fiscal stimulus (IMF, 2009) in the aftermath of the 2008 financial crisis. The fiscal framework could not prevent the loss of competitiveness of countries that later were subject to speculative attacks. As pointed out by De Grauwe (2011), in a currency union investors may choose to shift their purchases of government bonds from “risky” borrowers to a safe issuer. This, in turn, raises risk spreads and depresses economic growth, hindering the stabilization of public deficits in the countries under attack.
In countries that retain their monetary sovereignty, this self-fulfilling equilibrium would be ruled out by the exchange rate depreciation associated to the outflow of capital. In a currency union the speculative attack would be prevented either if governments of member countries were committed to mutually support each other in the face of an attack, or if the Central bank were prepared to step in and buy government bonds. Within EMU neither mechanism has been at work with the necessary strength, due to a declared fear of ensuing moral hazard problems. More recently there have been steps towards the creation of a new “fiscal compact”, based on 1) fiscal rules, enshrined in national constitutions, that set limits to debt and to structural deficits; 2) a stricter sanctioning mechanism for countries noncomplying with the SGP deficit limits; 3) a supra-national stabilization mechanism. It should also be noted that both the European Commission and the ECB have proposed an enhanced system of macroeconomic surveillance that focuses on a set of indicators which include measures of competitiveness, output growth, domestic credit conditions and asset prices. All in all, the evolving EMU macroeconomic governance is inevitably bound to address a number of issues that typically matter for the sustainability of a fixed exchange rate system. In particular this entails the definition of 1) the ECB tasks, including the de facto lender of last resort role; 2) the definition of a global fiscal policy, with reference to both the medium and the long run; 3) the definition and coordination of national fiscal policies. In addition, design of both the “preemptive” and the “corrective” arms of the new “fiscal compact” should induce national fiscal policies to act consistently with goals 1) and 2). Finally, there is little doubt that the issue of which policy mix should be implemented in order to reduce debt will play a central role in the years to come.
RASTANEWS intends to enhance knowledge base, at both theoretical and applied level, on many aspects of the future of macro-economic and monetary integration in Europe, paving the way to a revised governance of the EMU, and in the wake of the debt crisis. We see three key issues about the working of the EU macro-economy that deserve deeper investigation. The first is the issue of incomplete and informationally inefficient financial markets, the Achilles’ heel of the consensus DSGE models. The second related issue is the heterogeneity in expectations, which should play a fundamental role in explaining the behaviour of asset prices. The third issue is the need to overcome the traditional dichotomy between Keynesian (short run) and neoclassical (long run) policy prescriptions. Taking these issues seriously has important implications for the conduct of EU monetary and fiscal policies and for EU governance system. In addition, to facilitate the timely identification of macro risks, we propose a new system of early warning indicators, to be implemented within the EMU surveillance mechanism. This proposal is consistent with our theoretical framework and is based on an empirical macro-finance approach.
At our boldest, we will contribute to reshape the way in which these issues and other related topics are addressed in the literature. In particular, we would like to bring what is still predominantly 20th century literature about macro-risk assessment, stabilization policies and early warning systems, into the 21st century. To this aim, RASTANEWS will provide state-of-the-art analysis whose impact is expected to be both analytical and normative.
At an analytical level, RASTANEWS will firstly identify and analyse the main reasons behind the European debt crisis by highlighting the relevance of undisciplined fiscal policies (including the limits of the Stability and Growth Pact-SGP) and its interaction with monetary policies, the instability prompted by financial systems, the European responses to the crisis both at the EU and national level, the traditional dichotomy between short and long run perspectives.
At a specific scholarly level one further impact of RASTANEWS is in the area of innovation in methodology and economic modelling of 1) incomplete and informationally inefficient financial markets; 2) the heterogeneity in expectations; 3) the link between short- and long-run macroeconomic outcomes.
At a normative level, RASTANEWS wishes to undertake pioneering research at the frontiers of new thinking in economics on macro-risk assessment, new early warning systems and links to stabilization policies. In our view, these activities are key elements in securing progress towards a stable monetary union. Once more, we wish to emphasize here that in our view monetary policy in the near future should respond to a set of indicators and policy objectives and openly interact with the fiscal policymakers in a way which would have been unthinkable in the pre-crisis era. Economic research in Europe in the 21st century, funded by the European Commission under the VII Framework Program, is rightly expected to have a positive impact on the lives of Europeans.
To this aim, the research must raise important questions with a view to avoiding a future crisis and prompting sustainable growth in the framework of a stable EU financial system. Clearly, this is no modest agenda as the final evaluation of RASTANEWS’s impact will stand or fall by its ability to contribute to European theoretical understanding and policy practice towards a stable and successful EMU.
The objectives and the content of the research to be carried on by the RASTANEWS team for each work package are as follows.
Regional imbalances, macroeconomic options and the design of the European financial network (WP1). The objectives of WP1 are: 1) to analyse the sources (real exchange rate misalignments, capital flows) and to measure the magnitude of regional imbalances within the EMU and the EU; 2) To collect data to reconstruct the European Financial Network (EFN), in order to evaluate its properties, build Early Warning Systems and study its resilience to systemic risk; 3) to study the patterns of post-crisis readjustment in CEECs and evaluate the current policy arrangements for CEECs, which may consider EMU accession.
Complex Systems and the Future of Macroeconomic and Monetary Integration in Europe
(WP2) This line of research is devoted to the analysis of macroeconomic models with heterogeneous expectations. The research tests in a controlled laboratory environment the validity of standard monetary policy recommendations as well as mixed fiscal-monetary stimuli to cope with liquidity traps, stagnation and deflationary spirals. Results are used to develop macroeconomic models consistent with individual expectational rules observed in the laboratory experiments, and to perform policy analysis within the resulting framework to prevent a financial crisis in the future.
Short and Long Term Effects of Macroeconomic Policy: Lessons for the European Governance (WP3). This line of research investigates how the interaction between income inequality and household debt shapes the dynamics of economic fluctuations and determines the fragility of the economy’s growth pattern. We are particularly interested in understanding the financial mechanisms that, in presence of high inequality, are able to generate extreme events such as crises.
Limited asset market participation, credit frictions, and the interaction of fiscal and monetary policies in a currency union. (WP4). The objectives of WP4 are: 1) To understand the theoretical and implications of limited asset market participation in the EMU; 2) To identify the potential role of national fiscal policies as a stabilization tool for EMU business cycle. 3) To study the interactions between the common monetary policy and the national fiscal policies in the currency union, including the optimal monetary-fiscal policy mix during the transition to lower debt-to-GDP ratios in the EMU. This is done by means of theoretical papers and by estimating an empirical DSGE model of the Eurozone.
Early warning indicators within the EMU surveillance mechanism. A macro-finance approach. (WP5). This line of research adopts an empirical macro-finance approach in order to construct an Early Warning Indicator System, grounded on a deeper understanding of the macrofinance interface. WP5 delivers 1) Econometric tools for large scale macroeconometric modelling and the construction of coincident and forward-looking indicators; 2) Divergence and convergence indicators, accounting for nonlinearities and persistence; 3) the assessment of macro-financial determinants of risk factors;4) The assessment of the oil price-macro-finance relationship and the Great Recession; 5) An early warning indicator system for macro-financial imbalances for the Euro Area, set within the framework of a large scale econometric model, allowing for the dynamic interactions across indicators.
Towards a revised economic governance: in search of stability. (WP6). We provide: 1) a critical review of the ongoing reforms of the EU (and the Eurozone) economic governance; 2) suggestions for design of a revised economic governance which translates the scientific results of the all the other WPs into concrete policy recommendations, with a focus on the potential revision of the ECB strategies/mission and on a new approach to the implementation of fiscal policies..
Dissemination and communication (WP7) are to engage the wider public on the network’s activities and aims, to communicate the network’s activities and output, and to involve both policymakers, experts and academics outside RAstaNEWS in the network’s reflections and products. Communication and feedback to the network are both relevant aspects of this WP, and in order to reach these aims ISPI must maintain a comprehensive website for the network, which is to be constantly updated with the latest deliverables and news; manage RAstaNEWS’s online presence; produce and disseminate the RAstaNEWS quarterly newsletter; manage RAstaNEWS Annual Conferences and Executive Briefings.
RASTANEWS intends to enhance knowledge base, at both theoretical and applied level, on many aspects of the future of macro-economic and monetary integration in Europe, paving the way to a revised governance of the EMU, and in the wake of the debt crisis. We see three key issues about the working of the EU macro-economy that deserve deeper investigation. The first is the issue of incomplete and informationally inefficient financial markets, the Achilles’ heel of the consensus DSGE models. The second related issue is the heterogeneity in expectations, which should play a fundamental role in explaining the behavior of asset prices. The third issue is the need to overcome the traditional dichotomy between Keynesian (short run) and neoclassical (long run) policy prescriptions. Taking these issues seriously has important implications for the conduct of EU monetary and fiscal policies and for EU governance system. In addition, to facilitate the timely identification of macro risks, we propose a new system of early warning indicators, to be implemented within the EMU surveillance mechanism. This proposal is consistent with our theoretical framework and is based on an empirical macro-finance approach.
At our boldest, we will contribute to reshape the way in which these issues and other related topics are addressed in the literature. In particular, we would like to bring what is still predominantly 20th century literature about macro-risk assessment, stabilization policies and early warning systems, into the 21st century. To this aim, RASTANEWS will provide state-of-the-art analysis whose impact is expected to be both analytical and normative.
At an analytical level, RASTANEWS will firstly identify and analyze the main reasons behind the European debt crisis by highlighting the relevance of undisciplined fiscal policies (including the limits of the Stability and Growth Pact-SGP) and its interaction with monetary policies, the instability prompted by financial systems, the European responses to the crisis both at the EU and national level, the traditional dichotomy between short and long run perspectives.
At a specific scholarly level one further impact of RASTANEWS is in the area of innovation in methodology and economic modelling of 1) incomplete and informationally inefficient financial markets; 2) the heterogeneity in expectations; 3) the link between short- and long-run macroeconomic outcomes.
At a normative level, RASTANEWS wishes to undertake pioneering research at the frontiers of new thinking in economics on macro-risk assessment, new early warning systems and links to stabilization policies. In our view, these activities are key elements in securing progress towards a stable monetary union. Once more, we wish to emphasize here that in our view monetary policy in the near future should respond to a set of indicators and policy objectives and openly interact with the fiscal policymakers in a way which would have been unthinkable in the pre-crisis era. Economic research in Europe in the 21st century, funded by the European Commission under the VII Framework Program, is rightly expected to have a positive impact on the lives of Europeans.
To this aim, the research must raise important questions with a view to avoiding a future crisis and prompting sustainable growth in the framework of a stable EU financial system. Clearly, this is no modest agenda as the final evaluation of RASTANEWS’s impact will stand or fall by its ability to contribute to European theoretical understanding and policy practice towards a stable and successful EMU.
The objectives and the content of the research to be carried on by the RASTANEWS team for each work package are as follows.
Regional imbalances, macroeconomic options and the design of the European financial network (WP1). The objectives of WP1 are: 1) to analyze the sources (real exchange rate misalignments, capital flows) and to measure the magnitude of regional imbalances within the EMU and the EU; 2) To collect data to reconstruct the European Financial Network (EFN), in order to evaluate its properties, build Early Warning Systems and study its resilience to systemic risk; 3) to study the patterns of post-crisis readjustment in CEECs and evaluate the current policy arrangements for CEECs, which may consider EMU accession.
Complex Systems and the Future of Macroeconomic and Monetary Integration in Europe
(WP2) This line of research is devoted to the analysis of macroeconomic models with heterogeneous expectations. The research tests in a controlled laboratory environment the validity of standard monetary policy recommendations as well as mixed fiscal-monetary stimuli to cope with liquidity traps, stagnation and deflationary spirals. Results are used to develop macroeconomic models consistent with individual expectational rules observed in the laboratory experiments, and to perform policy analysis within the resulting framework to prevent a financial crisis in the future.
Short and Long Term Effects of Macroeconomic Policy: Lessons for the European Governance (WP3). This line of research investigates how the interaction between income inequality and household debt shapes the dynamics of economic fluctuations and determines the fragility of the economy’s growth pattern. We are particularly interested in understanding the financial mechanisms that, in presence of high inequality, are able to generate extreme events such as crises.
Limited asset market participation, credit frictions, and the interaction of fiscal and monetary policies in a currency union. (WP4). The objectives of WP4 are: 1) To understand the theoretical and implications of limited asset market participation in the EMU; 2) To identify the potential role of national fiscal policies as a stabilization tool for EMU business cycle. 3) To study the interactions between the common monetary policy and the national fiscal policies in the currency union, including the optimal monetary-fiscal policy mix during the transition to lower debt-to-GDP ratios in the EMU. This is done by means of theoretical papers and by estimating an empirical DSGE model of the Eurozone.
Early warning indicators within the EMU surveillance mechanism. A macro-finance approach. (WP5). This line of research adopts an empirical macro-finance approach in order to construct an Early Warning Indicator System, grounded on a deeper understanding of the macrofinance interface. WP5 delivers 1) Econometric tools for large scale macroeconometric modelling and the construction of coincident and forward-looking indicators; 2) Divergence and convergence indicators, accounting for nonlinearities and persistence; 3) the assessment of macro-financial determinants of risk factors;4) The assessment of the oil price-macro-finance relationship and the Great Recession; 5) An early warning indicator system for macro-financial imbalances for the Euro Area, set within the framework of a large scale econometric model, allowing for the dynamic interactions across indicators.
Towards a revised economic governance: in search of stability. (WP6). We provide: 1) a critical review of the ongoing reforms of the EU (and the Eurozone) economic governance; 2) suggestions for design of a revised economic governance which translates the scientific results of the all the other WPs into concrete policy recommendations, with a focus on the potential revision of the ECB strategies/mission and on a new approach to the implementation of fiscal policies..
Dissemination and communication (WP7) are to engage the wider public on the network’s activities and aims, to communicate the network’s activities and output, and to involve both policymakers, experts and academics outside RAstaNEWS in the network’s reflections and products. Communication and feedback to the network are both relevant aspects of this WP, and in order to reach these aims ISPI must maintain a comprehensive website for the network, which is to be constantly updated with the latest deliverables and news; manage RAstaNEWS’s online presence; produce and disseminate the RAstaNEWS quarterly newsletter; manage RAstaNEWS Annual Conferences and Executive Briefings.
Project Results:
For each work package RAstaNEWS research during the second period is summarized as follows.
WP1 Regional imbalances, macroeconomic options and the design of the European financial network
D1.1) Gallegati, M., Maggioni, D., and Presbitero, A., “Dataset on Country-level External Imbalances in Europe”
Database which has been built to explore the size and determinants of country-level external imbalances in Europe. The dataset is available in .dta (STATA) format on the RASTANEWS website (it is password protected), together with an excel file providing an exact definition of all the variables involved.
D1.2) Maggioni, D., “What drives Current Account Imbalances? The role of Complexity”
With this paper we contribute to the literature on the determinants of countries’ current account (CA) positions and trade imbalances by exploring the role of countries’ product complexity. We document the existence of important differences in terms of complexity level in the composition of trade basket across EMU and European countries. From our findings it emerges that countries’ complexity is positively associated with their CA position, and this relationship proves robust to a number of controls. Furthermore, product complexity of countries also plays a mediating role in shaping the impact of external trade shocks on countries’ CA balance. Finally, by investigating bilateral export flows of EMU countries, we show that the competition from new competitors mainly affected low complexity products’ trade.
D1.3) Alessandrini, P., and Fratianni, M., “In the absence of fiscal union the Eurozone needs a more flexible monetary policy”
This paper makes three points. The first is that inter-member external imbalances are relevant for the performance of a monetary union. The second is to design specific policies directed at reducing inter-member external disequilibria, for example by fixing targets on current-account imbalances applied symmetrically to both deficit and surplus countries. It is striking the contrast between the keen attention of the EZ on national fiscal imbalances and the belated and lukewarm attention given to external imbalances. The third is to propose a more flexible monetary policy aimed at controlling the distribution of liquidity among member countries resulting from inter-member external imbalances.
D1.4) Mellár, T., “Deviation from the path to Eurozone Accession: Current monetary and fiscal solutions managing macro-imbalances and debt in Hungary”
This study examines the dilemma of Hungary’s Accession to the Eurozone as opposed to that of the other Visegrád countries. In the aftermath of the economic crisis there has been a growing awareness of the fact that adjusting to the crisis is much easier for countries outside the Monetary Union which still use their own national currency. Successful crisis management by the Czech Republic and Poland are excellent examples. Hungary, however, represents precisely the opposite case, since, despite having its own national currency, it has been unable to adapt itself to the changed international situation. An analysis of Hungarian experience suggests that successful adaptation requires supply-side flexibility (production structure, labour market), rigorous control of fiscal policy and the avoidance of serious debt.
D1.5) Schepp, Z., and Pitz, M., “Foreign currency borrowing in Hungary: the pricing behaviour of banks”
Over the last decade foreign currency indebtedness in Hungary has become a systemic financial problem, significantly constraining economic policy. In international comparative terms, however, there are certain specific features relating to Hungary which make this issue particularly problematic, and during the financial crisis both exchange rates and interest rates were important factors in increasing the burden on individual households. We present here a case study whereby our research focuses on the causes and determining factors of the pricing of Swiss franc denominated mortgage loans. Our empirical exercise examines four potential price shocks which might have affected the pricing decisions of credit institutions. The questions which arise concern the relationship of these costs to the changes in interest rates and the extent to which these cost shocks were passed on by banks to their clients. Empirical evidence based on Vector Error Correction Model (VECM) shows a significant long-run relationship between cost factors and CHF denominated mortgage loans interest rates. Finding a tractable solution to the foreign currency debt trap is only possible if a fair distribution of burdens is achieved and this should be supported by empirical facts. At the end of the day all three affected parties (debtors, banks and the Hungarian State) had made their contribution, but how fair and reasonable the distribution was remains an open issue for further research.
D1.6) Spelta, A., and Delli Gatti, D., “Dataset on the European Financial Network”
This deliverable consists of a dataset and an accompanying paper (“Mapping the European Financial Network: A Preliminary Exploration” by Spelta and Delli Gatti). Since the lack of bilateral data have prevented the investigation of the topological properties of the European Financial Network as a whole, Authors have made use of the structure of the European ownership network to construct the backbone of the European Financial Network. The resulting network encompasses 38460 nodes of 13 different types of actors. The European Financial Network presents a highly sparse, asymmetric and not clustered topology meaning that institutions prefer to avoid cross ownerships and to have stocks of interconnected nodes in their portfolios Moreover institutions with a large number of controlled partners tend to attach to institutions that control few other nodes and institutions with a high market power tend to be attached to institutions whose total assets are almost entirely controlled by others nodes. Results also suggest that banks seems to be the "medium" thanks to which institutions exert control over other institutions.
D1.7) Spelta, A., “A unified view of systemic risk: detecting SIFIs and forecasting the financial cycle via EWSs”
Following the definition of systemic risk by the Financial Stability Board, the International Monetary Fund and the Bank for International Settlements, Spelta proposes a method able to simultaneously address the two dimensions in which this risk materializes: the cross-sectional and the time dimension. The method is based on the W-TOPHITS algorithm, that exploits the connectivity information of an evolving network, and decomposes its tensor representation as the outer product of three vectors: borrowing, lending and time scores. The first two vectors represent the systemic importance of the borrowing and the lending associated with each financial institution, whereas the time score represents an empirical Early Warning Signal of the financial crisis since it varies according to the changes of the bipartite network of lenders and borrowers that typically occurs prior to the crisis. The time score, being able to simultaneously consider the temporal distribution of the whole traded volume over time as well as the spatial distribution of the transactions between players in each period, turns out to be a useful Early Warning Signal of the financial crisis.
WP2 Complex Systems and the Future of Macroeconomic and Monetary Integration in Europe
D2.1) Hommes, C., Massaro, D. and Salle, I., “Monetary and Fiscal Policy Design at the Zero Lower Bound: evidence from the lab”
The work presents a laboratory experiment with human subjects in which we elicit expectations in an otherwise fully controlled macroeconomic New Keynesian model. This experiment has two main goals. First, we aim at testing the adaptive learning predictions within this model. Second, and most importantly, we want to compare alternative monetary and fiscal policy designs and measure the effects of these policies on expectations, with a special focus on a situation at the zero-lower bound. This is a critical insight of our work, as expectations play a key role in the failure or success of policies, but measuring the so-called expectation channel in the real macroeconomy is a quite challenging task, as expectations are not directly observable and episodes of zero-lower bounds are rare.
D2.2) Rovira Kaltwasser, P., and Spelta, A., “Systemic Risk in the Interbank Market with Heterogeneous Agents”
In this deliverable the authors focus their attention on the money market. The article briefly describes the importance of macroprudential supervision to achieve financial stability. In the article different methods to rank financial institutions according to their systemic importance are discussed, including the one implemented under Basel III. The paper argues that so-called feedback centrality measures are better suited to measure systemic importance. A well-known feedback centrality measure (PageRank) is modified and its performance is compared against the Basel III method, using data form the electronic platform eMID. Based on the empirical results a Heterogeneous agent model of the money market is proposed.
D2.3) Seppecher, P., and Salle, I., “Deleveraging crises and Deep Recession: a behavioural approach”
The article presents an heterogeneous agent model in which the entire macroeconomic dynamics is driven by animal spirits: waves of pessimism endogenously drive the financial behaviour of agents, and result in debt-deflation type of crises. The paper then discusses a wide range of policies to smooth the impact of such crises in terms of output and employment loss, and highlights the potential stabilizing role of inflationary policies that would feed wages.
WP3 Short and Long Term Effects of Macroeconomic Policy: Lessons for the European Governance
D3.1) Creel, J., and Iacopetta, M., “Macroeconomic policy and potential growth”
This paper makes the case for investigating the gap between the potential and the actual level of production, and review contributions that point to the reduced power of standard policy instruments in presence of a prolonged gap. The paper also highlights difficulties in measuring where an economy stands relative to its potential.
D3.2) Vona, F., “Renewable Energy, Technology, Policy, Product Market Regulation”
This survey examines the determinants of renewable energy innovations. The paper focuses on three mechanisms highlighted by innovation models: 1. Policy inducement; 2. market structure and energy market regulation; 3. demand for environmental quality, affecting both policy and technology. The central problem of existing research in this field is to account for the dynamic interaction between policy and technology. Empirically, this interaction makes it difficult to establish a causality nexus going from former to the latter. From our reading of the literature, future research should examine more carefully factors affecting both policy and technology, such as the degree of competition in the energy market and the level of inequality, and the factors favouring the full diffusion of renewable energy technologies, e.g. human capital. The survey sheds light on the relationship between innovation in green technology and long term growth
D3.3) Saraceno, F., “Inequality and Growth: A Survey”
This paper examines how economists have dealt with the issue of inequality along the 20th century. After an initial pioneering phase, initiated by Simon Kuznets, the issue of income distribution virtually disappeared from the landscape, because of the advent of a "Traditional View" that limited the field of investigation of economics to efficiency in the allocation of resources, and rested on the intrinsic fairness of distribution implied by the equality of marginal product and factor remuneration. The crisis of 2007 has challenged this view, and highlighted how rent-seeking impacted income distribution and by this channel also macroeconomic performance. The paper concludes with a brief discussion of Thomas Piketty's “Le Capital au XXIème Siècle”.
D3.4) Amendola, M., and Gaffard, J.L. “Novelty, hysteresis, and growth”
Novelty and hysteresis are the main engines of economic evolution. However, they are also at the origin of co-ordination issues, as the consequences of any innovative choice can never be fully expected. Thus, there is no sense in analysing economic change as an intertemporal equilibrium with rational expectations. Not only growth and fluctuations cannot be dissociated, but there is no long-term trend that would be independent from what happens in the short term. The explicit consideration of essential evolutionary phenomena like novelty and hysteresis help a clearer understanding of some important episodes of contemporaneous economic history. The periods considered are characterized by crises and structural changes, and it is exactly when important disturbances affect the functioning of the economies that the relevant features of their behaviour come to the surface and hence the right interpretations of the phenomena taking place, with the adequate policy implications, can be formulated.
D3.5) Hubert, P., “A survey on the expectations formation process”
This paper provides a description of the full information rational expectations hypothesis and its alternatives: backward-looking models, sticky and noisy information models, adaptive learning models, and models of heterogeneous expectations. The paper presents the three different options to measure empirically expectations: surveys, financial markets measures and laboratory experiments, as well as the different research works about the determinants, the anchoring and the disagreement of inflation expectations.
D.3.6) Hubert, P., “Dataset on Inflation Expectations”
It presents the dataset – all series are publicly available – on inflation expectations, which will be used to analyze the role of forward-looking information in inflation expectation dynamics. The dataset focuses on quarterly US data for which survey forecasts from the Survey of Professional Forecasters (SPF) are available on a fixed-horizon and for a long time span: 1981Q3-2012Q3. The dataset is composed of a number of standard macroeconomic variables (GDP, unemployment, etc), together with real time data and forecasts.
D.3.7) Amendola, M., Gaffard, J.L. and Patriarca, F., “Inequality and Growth: The perverse relation between the productive and the non-productive assets of the economy”
The explosion of the global financial crisis in 2008 and its transmission to the real economies have been interpreted as calling for new kinds of regulation of the banking and the financial systems that would have allowed re-establishing a virtuous relation between the real and the financial sectors of the economy. In this paper we maintain the different view that the financial crisis and the ensuing real crisis have roots in the strong increase in incomes inequality that has been taking place in the Western world in the last thirty years or so. This has created an all-around aggregate demand deficiency crisis that has strongly reduced prospects and opportunities for investments in productive capacities and shifted resources toward other uses, thus feeding a perverse relation between the productive and the non-productive assets of the economy. The viability of the economic process is therefore hampered by excessive inequality. In this context the way out of the crisis is re-establishing the right distributive conditions: which cannot be obtained by a policy aimed at relieving the weight of private or public debts but calls for a redistribution through taxes on the incomes of non-productive sectors, according to a fine tuning that should prevent from excessive taxations transforming positive into negative effects.
D.3.8) Hubert, P., and Mirza, H., “Inflation Expectation Dynamics: The Role of Past, Present, and Forward-Looking Information”
Assuming that private agents need to learn inflation dynamics to form their inflation expectations and that they believe a hybrid New-Keynesian Phillips Curve (NKPC) is the true data generating process of inflation, the authors aim at establishing the role of forward-looking information in inflation expectation dynamics. They find that longer term expectations are crucial in shaping shorter-horizon expectations. Professional forecasters put a greater weight on forward-looking information – presumably capturing beliefs about the central bank inflation target or trend inflation – while lagged inflation remains significant. Finally, the NKPC-based inflation expectations model fits well for professional forecasts in contrast to consumers'.
D.3.9) Creel, J., Hubert, P., and Saraceno, F., “An Empirical Analysis of the Link between Public and Private Investment in four OECD countries”
Research has focused on the relationship between public investment and investment decisions by firms. In theory, public investment may have contradictory effects on private investment, either crowding-out or crowding-in effects. The authors disentangle these effects in different agnostic linear models, in which they assess, for four OECD countries, the existence and the sign of relationship between public and private investment, including a VAR model in which private investment, GDP growth, and interest rates interact and are affected by public investment and debt among other determinants. They further look at the possibly time-varying sign of the relationship between public and private investment and its state-contingence. In a third stage, they assess the possible international spillovers of public investment. This allows producing evidence on the impact of public investment on the economy, both in the short and in the long run, taking into account different types of interaction. They find a crowding-in effect in France, a weak crowding-out effect in the US, and no robust effect in the UK and Germany
D.3.10) Vona, F., “Building the knowledge base for a greener economy: skills, innovation and technology diffusion”.
This deliverable is an empirical investigation on the drivers of green investments and green employment. The ultimate goals of this investigation are: 1. to provide policy recommendations based on the findings of the investigation, 2. to provide insights for soundly modelling strategies. More specifically, estimates provided in this work can guide the construction of integrated assessments capable of providing accurate projections of both the climate and the long-term economic effects of environmental policies. The first part deals with the issue of endogenous technical change and on the effectiveness of targeted renewable energy policies and pro-market reforms in spurring innovation. The second part poses the simple and novel question of which skills are required to develop and operate green technologies. The original contribution here is to propose a data-driven methodology to identify green skills and to gauge the ways in which the demand for these competences responds to environmental regulation. The third part questions the usual theoretical dichotomy between green and brown technologies suggesting that brown technologies, especially fast-reacting fossil technologies, allow dealing with the intermittency of renewable energy technologies.
D.3.11) Cardaci, A., and Saraceno, F., “Inequality, Financialisation and Economic Crises: An Agent-Based Macro Model”
By means of a macroeconomic model with an agent-based household sector and a stock-flow consistent structure, the authors analyse the impact of rising income inequality on the likelihood of a crisis for different institutional settings. In particular, they study how economic crises emerge in the presence of different credit conditions and policy reactions to rising income disparities. The simulations show the relevance of the “degree” of financialisation of an economy. In fact, when inequality grows, a Scylla and Charybdis kind of dilemma seems to arise: on the one hand, low credit availability implies a drop in aggregate demand and output; on the other hand, relaxed credit constraints and a higher willingness to lend result in greater financial instability and a debt-driven boom and bust cycle. The authors also point out that policy reactions play a key role: a real structural reform that tackles inequality, by means of a more progressive tax system, actually compensates for the rise in income disparities thereby stabilising the economy. Results also show that this is a better solution compared to a stronger fiscal policy reaction, which, instead, only leads to a larger duration of the boom and bust cycle.
WP4 Limited asset market participation, credit frictions, and the interaction of fiscal and monetary policies in a currency union.
D4.1) Ferrara, M. and Tirelli, P., “Limited Asset Market Participation and Macro-dynamics in Medium-scale DSGE models. A perspective for the Eurozone”
This deliverable develops a medium scale DSGE model that incorporates Limited Asset Market Participation (LAMP) and studies interactions between the common monetary policy and the global fiscal stance of the Eurozone. Main results are summarized as follows. A relatively large body of empirical research has pointed out that inflation is particularly harmful for the poor, and high inflation and inequality are positively related. We show that this need not be the case when monetary and fiscal policies are optimally designed. In the Eurozone the fiscal implications of the ECB inflation target are purposely neglected to preserve Central Bank independence and where also justified by theoretical results about the optimality of zero inflation in DSGE models. In fact, we show that LAMP calls for positive and potentially non-negligible inflation rates. The underlying intuition is rather simple. Richer households consume more and hold more money, therefore they contribute more to inflation tax revenues that can be used to reduce the burden of direct taxes. As a result worked hours and the relative consumption of constrained households increase. In our full model the optimal inflation rate is 2.48% when the steady state public-debt-to-GDP ratio is 60%. For a 80% debt ratio optimal inflation is above 3%. We also obtain new results concerning optimal stabilization policies. In fact, LAMP generates a tradeoff between the efficiency motive to the use of debt, that calls for optimal consumption smoothing through the permanent adjustment of debt, and the equity motive, that induces the planner to front-load tax adjustment in order to limit the redistributive effects of permanent public debt variations. Turning to the analysis of simple rules, we show that, absent fiscal redistributive policies, LAMP causes a large increase in volatility following a monetary policy shock. By contrast, redistributive fiscal policies have a powerful dampening effect on volatility. We have also shown that redistributive policies targeting consumption inequality bring the dynamic performance of the model close to the one generated by representative agent DSGE models. This suggests an intriguing conjecture: these latter models might apparently succeed in matching business cycle facts when in the real economy the underlying fiscal policy regime compensates for the effects of LAMP, but their performance might not be robust to fiscal reforms that limit discretionary policies and/or reduce the effectiveness of automatic fiscal stabilizers. Finally, D4.1 shows that an appropriate mix of fiscal and monetary policies can substantially ease the strain typically associated to fiscal consolidations. The public expenditure reduction should be supported either by a temporary public transfers increase or by a tax rates fall that undershoots their new post consolidation values. Such policies have a strong stabilizing effect on the disposable income of rule-of-thumb consumers. This, in turn, stimulates demand and supports growth. As a result, the pace of debt reduction is substantially preserved because the revenues loss from lower tax rates (larger transfers) is almost entirely compensated for by an increase in the tax base. The result is even strengthened when the monetary authority targets both inflation and output gap. In this case the stronger interest rate fall is beneficial because it exploits the complementarity between the consumption of Ricardian households and the disposable income of rule-of-thumb consumers.
D4.2) Albonico, A., Paccagnini, A., Tirelli, P., “Estimating a DSGE model with Limited Asset Market Participation for the Euro Area”
We incorporate the Limited Asset Market Participation (LAMP) hypothesis in a medium scale closed economy DSGE model akin to Smets and Wouters (2005, 2007). The estimated model also shares the key features of the full macromodel presented in D4.1. We find that the share of LAMP households is sizable throughout the 1972-2012 sample, about 32%. In comparison with the representative-agent (RA) counterpart, the LAMP model is preferred on the grounds of both the Bayes factor and the average forecasting performance. As far as the predictive ability is concerned, the LAMP model has a relative advantage in explaining the dynamics of output, consumption, inflation, and investment during the recent financial crisis. Turning to the analysis of subsample periods, we obtain that the importance of LAMP declines in periods of increasing financial integration and optimism in the European financial markets, such as the apparently successful period that ended with the demise of the hard European Monetary System (EMS) in 1992-93. By contrast, the period following the EMS collapse and the 2007-financial crisis are associated with a surge in LAMP. To sharpen our analysis of the European Monetary Union (EMU) years, we then focus on the model estimated over the 1993-2012 period. The Bayes factor now provides even stronger support for the LAMP model. In the RA model, the risk premium shock is the main driver of output volatility while in LAMP model this role is played by the investment-specific shock. Our intuition is that RA models require risk premium shocks to match the consumption correlation with output because all households can smooth consumption. Instead, in the LAMP model investment specific shocks gain of importance because Non-Ricardian households introduce a Keynesian multiplier effect and raise the correlation between consumption and investments, The observed correlation between these two variables is in fact notoriously difficult to replicate in standard RA models. Finally, both the RA and LAMP models pinpoint the contractionary role of monetary policy shocks during the post-2007 years. According to the LAMP model, in this period consumption of Non-Ricardian households fell dramatically, but this outcome might have been avoided by a more aggressive policy stance.
D4.3) Albonico, A., Paccagnini, A., Tirelli, P., “In search of the Euro Area Fiscal Stance”
This deliverable investigates the role of fiscal and monetary policies over the aggregate European Monetary Union (EMU) business cycle, with a specific focus on fiscal policies. Relative to previous contributions concerned with EMU fiscal policies, we obtain a much larger posterior estimate for the share of non-Ricardian households, 53%. As a consequence, our estimates for public consumption and public transfer multipliers are also substantially larger. We could not identify a systematic reaction of tax rates and public expenditure variables to the Eurozone cyclical conditions. In other words, there seem to be no fiscal Taylor rule for the Eurozone as a whole. Historical output growth decomposition shows that fiscal shocks were substantially irrelevant before and after the financial crisis. Thus, our results convey the picture of a Euro area where the burden of implementing stabilization policies entirely falls on the European central Bank, whereas fiscal policies remain neutral in spite of their potentially important effects identified by the estimated multipliers. Finally, we are able to identify the shocks that caused the post-2007 increase in the public-consumption-to-GDP ratio. The increase in this ratio, typically regarded as an indicator of governments profligacy, was almost entirely determined by persistently adverse non-policy shocks.
D4.4) Cardani, R., and Tirelli, P., “The Optimal Policy Mix to Achieve Public Debt Consolidation”
Following the large increases in public-debt-to-GDP ratios observed in the aftermath of the 2007-financial crisis, fiscal consolidation, i.e. a reduction in the debt-to-GDP ratio, has come to the forefront of political debate and macroeconomic analyses (Blanchard et al., OECD 2012). The issue is particularly relevant for the Eurozone, where institutional arrangements such as the Maastricht Treaty and the Stability and Growth Pact (SGP) should oblige member states to pursue a 60% debt-to-GDP ratio. In fact the `corrective arm' of the SGP should be activated whenever public debt exceeds 60% of GDP and the excess debt is not reduced by 5% per year on average over three years (European Commission). In this paper we adopt a Ramsey-optimal approach to the identification of debt reduction strategies, that is, we identify the optimal policy mix for income taxes, public expenditures and inflation designed to achieve an exogenous debt reduction path as envisaged in the Stability and Growth Pact. There is a number of questions the paper is meant to address. The first one concern the optimal combination of public expenditure reductions and tax increases. The second one relates to the desirability of adjusting the inflation target during the debt consolidation period. Finally, the third question we address concerns redistributive effects of alternative policies. To capture these effects our model accounts for LAMP. We find that consolidations entail a persistent tax (public expenditure) increase (reduction). We also find that inflation follows a hump-shaped pattern, raising up to 2 percentage points above the pre-consolidation level. The consolidation is associated to a sharp reduction in investment and to a milder but persistent reduction in aggregate consumption. Output remains below the pre-consolidation level throughout the transition to the new debt-to-GDP ratios, and the consumption gains associated to the consolidation begin to materialize only after consolidation is achieved. We also identify important redistributive effects. Wealthy capital owners exploit the reduction in investment expenditures to stabilize their consumption. In addition, they reduce their labour supply in response to the increase in labour taxation. When monetary policy is not involved in the consolidation exercise and the central bank sticks to her inflation targeting strategy the fiscal contraction is inevitably stronger and the output loss much larger. Constrained households bear the brunt of this alternative policy strategy, suffering a deeper reduction in consumption. One key message is that an integrated package of fiscal and monetary policies may prove quite beneficial relative to a situation where the Central Bank is only concerned with inflation stability and the inflation target is defined as a ceiling, as in the Eurozone, where the ECB has repeatedly justified expansionary monetary policies on the grounds that inflation was below target. In fact the fiscal consolidation would require far more aggressive monetary policies, accepting that inflation overshoots the target for a prolonged period. As a matter of fact our results emphasize important shortcomings in the EMU system of economic governance, which utterly neglects the desirability of coordinated fiscal and monetary policy actions. In this context such coordination would entail a great deal of flexibility in the inflation target choice, based on the explicit recognition that accommodative monetary policies provide an essential contribution to limit the undesirable effects of fiscal consolidations.
D4.5) Albonico, A., Paccagnini, A., Tirelli, P., “PIIGS in the Euro Area. An Empirical DSGE Model”
Evaluating the foreseeable performance of the European Monetary Union (EMU) system of economic governance with respect to the task of fostering convergence and macroeconomic stability requires an understanding of the causes of the adverse gaps (growth, competiveness, unemployment) that characterize the Eurozone periphery. To this end D4.5 extends D4.2 incorporating core-periphery interactions in the empirical DSGE model of the Eurozone. This allows to understand regional drivers of the crisis in the core and in the periphery. According to our estimates, temporary disruptions to the risk-sharing mechanism that operates through the EMU financial market have potentially large contractionary effects in the periphery, entailing a persistent fall in investment, output and inflation. However, our variance and historical decompositions of output growth suggest that this shock had minimal effects. In addition, on the grounds of the marginal data density, the model specification accounting for permanent productivity shocks is strongly preferred to the alternative specifications, including the one based on financial market shocks. Historical decomposition of growth suggests that the output response to the 2008-2009 financial crisis, quantitatively similar in the two regions, was in fact caused by different types of shocks. The interest rate policy had common contractionary effects, but in the core region demand shocks were more important than in the PIIGS, where the main determinants were temporary and permanent supply shocks. The post-2010 period, when the PIIGS experienced slower recovery and then deeper recession, is mainly explained by adverse permanent technology shocks in the periphery and by demand shocks in the CORE region. Finally, public consumption shocks played a negligible role throughout the EMU years, implying that the post-2008 deterioration in fiscal indicators such as the public-consumption-to-GDP ratio was crucially driven by non-policy shocks. A crucial difference exists between the two regions is that in the CORE countries the deterioration of fiscal indicators was mainly caused by temporary shocks, whereas in the PIIGS region permanent shocks were a key driver, so that one cannot expect their reversal when the economy recovers.
These results bear important implications for the EMU system of economic governance, which is clearly inadequate, and for the evaluation of some recent proposals for governance reform, such as the Five Presidents Report (Junker, 2015), which appears as too timid. Under the pressure of the Euro-crisis, European countries have done great progress in improving fiscal budget monitoring and in the coordination of national budgets. The European Semester has better coordinated the budget procedures, a process completed with the Two Packs and its requirement for an early presentation to the Council and the Commission of budget proposals; the Six Packs have strengthened the mechanism of supervision and control by the Commission, reinforcing the role of the Commission; the macroeconomic imbalance indicators have moved surveillance from budget procedures to more general economic issues. The Fiscal compact had enshrined in the constitutions of the Euro countries the requirement of fiscal stability. Yet, the European construction remains largely incomplete. As the last decade of economic and political crisis shows, this kind of governance suffers the ability to respond to shocks, in particular the ones that hit asymmetrically the member states. Our study contributes to a large body of research supporting the view that crisis in the EMU periphery should not be related to undisciplined national fiscal policies. Our estimates point at permanent adverse productivity shocks as the main cause of the apparently divergent growth paths followed by the PIIGS countries relative to the rest of the Eurozone. By contrast, risk premium shocks, which might be related to expectations about government solvency, did not play an important role. Further, in our model only a subset of households have access to the integrated EMU capital markets. As a result, risk sharing is incomplete and a large fraction of households cannot efficiently smooth consumption, Thus, as pointed out in the "Blueprint for a deep and genuine EMU", progress is still needed towards developing stabilization tools and fiscal capacity. Developing a novel, stabilization-oriented fiscal framework is crucial for EMU sustainability in the future. We also draw some conclusions about the foreseeable consequences of the current system of economic governance in the current predicament, characterized by large debt-to-GDP ratios and cumulative competitiveness loss in the PIIGS, and a persistent reduction in the stock of physical capital throughout the Eurozone, also taking into account some recent proposals for governance reform, such as the Five Presidents Report.
Efficiency-enhancing reforms and fiscal discipline. European institutions systematically call for efficiency-enhancing reforms in the PIIGS region, but rules are enshrined for debt reduction and deficit control (European commission, 2015). PIIGS countries are therefore set to adopt politically difficult and divisive decisions, involving both contractionary fiscal shocks and reforms that entail redistributive effects in addition to increases in productivity. This daunting task is complicated by the presence of a non-negligible share of the population that cannot engage in consumption smoothing. EMU rules for the reduction of accumulated debt are rather strict, but there is some leverage to facilitate reforms (European Commission, 2014, 2015). Our results emphasize the importance of structural reform if PIIGS are to make up with competitiveness losses incurred during the crisis. Further, our results suggests that a large part in the deterioration of fiscal ratios was caused by the productivity slowdown. Therefore, return to "prudent" fiscal ratios should be sought through efficiency gains and not only through public expenditures compression. Our estimated model is not designed to fully investigate the scope for and the effects of reforms. However, in our framework we can get insights from the analysis of favourable price and markup shocks, which can be seen as the consequence of market deregulation. We find that the shocks have beneficial effects on PIIGS, raising consumption for all households and investment. Given these outcomes, it is also obvious that the effects on budget deficits are also beneficial, and even one-off liberalization schemes may have beneficial effects on public-debt-to-GDP ratios. Thus, such future benefits can justify temporary deviations from fiscal discipline, as envisaged in the Fiscal Compact, in order to gain the necessary support for politically divisive reforms.
Fiscal policy coordination and risk sharing. Concern for moral hazard problems has shaped the Fiscal Compact, imposing limitations to national discretionary fiscal policies, which cannot therefore provide adequate stimuli in the face of large shock. Given the documented weak external transmission effects of fiscal policy actions, the deficit ceilings envisaged in the Fiscal Compact also make it very difficult to provide adequate response to asymmetric shocks by means of coordinated fiscal policies. Thus further fiscal integration, i.e. provision of fiscal capacity at the central level, is required to provide the necessary amount of cyclical smoothing which should be entrusted to fiscal policies.
The Five Presidents' Report (Junker, 2015) emphasizes the importance of achieving a fiscal governance system that guarantees long run sustainability of public finances, allows the proper working of automatic stabilizers, determines an appropriate global fiscal stance for the Eurozone as a whole. According to the Report, fine tuning of the global fiscal policies should be avoided to focus on large macroeconomic shocks. However, the global fiscal policy should not be an instrument for crisis management, a role already performed by the European Stability Mechanism. As a first step, the Report points at the European Fund for Strategic Investments, which could pool of financing sources and investment projects to be tapped into the Eurozone according to business cycle conditions. On the grounds of our results, the Report certainly is a welcome attempt to address "The" unresolved issue in the design of fiscal policy governance, that is, lack of provisions for the EMU fiscal stance. However, there is still considerable ambiguity concerning the timing and scope for fiscal action. Large shocks are associated to crisis situations that require quick recognition of the problem, swift action and use of policy tools that have immediate impact on households' and firms' choices. A possible solution could be inspired to the "constrained discretion" regime that implicitly defines relationships between national governments and the European Commission when deviations from medium-term budgetary objective (MTO) are negotiated to react to exceptional circumstances or to facilitate reforming actions. As for the proposed fiscal tool, it seems more adequate to correct medium -and long- run imbalances rather than dealing with emergencies. In fact, finalizing investment projects inevitably requires time and, given the relatively large share of constrained households, policymakers should be wary of announcement effects about future investments. Furthermore, the Report ignores that risk sharing is incomplete and the poorer part of the population cannot efficiently smooth consumption. To put it bluntly, current discussions on fiscal policy governance in the Eurozone grossly underestimate the issues at stake. The present institutional mechanism was inadequate for the gravity of the crisis, and neither financial markets nor fiscal policies provide adequate insurance to households that were most affected. As a result, the Eurozone lost legitimacy and political consensus. In its present state, it is doubtful it could survive another crisis or even a persistent stagnation. Institutional change is inevitable and new stabilization tools must be designed. So far, EMU fiscal institutions were shaped by concern for moral hazard problems and for the risk that a fiscal capacity motivated as an insurance against transitory asymmetric shocks could degenerate into a permanent transfer system. If moral hazard problems require national deficit ceilings, then more fiscal space at the central level is necessary. Such additional fiscal space might incorporate a common unemployment insurance system and possibly some elements of a joint tax system, i.e. devolution of the power to levy a specific "European" tax and an expenditure stabilization mechanism (Bargain et al. 2013, Dolls et al. 2014). In a sense the key message is very simple: fiscal tools that are standard in federal states are necessary even in the Eurozone, where member states retain sovereignty. As pointed out in Van Rompuy (2011), it is now time to seek a new political balance between collective responsibility (or solidarity) and the responsibility of each individual country for the Eurozone common good
WP5 Early warning indicators within the EMU surveillance mechanism. A macro-finance approach.
D5.1) Morana, C., Baillie, R.T. Kapetanios, G., Papailias, F., “A New Approach for Large-Scale Macro-Financial Econometric Modeling”
A general framework for large scale macroeconometric modeling is introduced, i.e. the Fractionally Integrated Heteoskedastic Factor Vector Autoregressive model (FI-HF-VAR). The model is very general, accounting for different sources of persistence, i.e. stochastic (short or long memory) and deterministic (structural breaks). It can be thought of as bridging the F-VAR and (the most recent) G-VAR literature, as a weakly stationary cyclical representation is employed; yet, principal components analysis (PCA) is employed for the estimation of the latent factors. Modelling of comovement through common stochastic or deterministic factors is allowed for, as well as conditional heteroskedsticity in the common stochastic factors. The key issue of model specification and estimation are dealt with, as well as those related to asymptotic properties and Monte Carlo analysis. Overall, the proposed FI-HF-VAR model yields a unified framework for large-scale econometric modeling, allowing for accurate investigation of cross-sectional and time series features, independent of persistence and heteroskedasticity properties of the data, from comovement to impulse responses, forecast error variance and historical decomposition analysis. The modeling framework is then employed in the applied part or the research to the purpose of investigating macro-financial linkages, assessing and constructing early warning indicators.
D5.2) Karanasos, M., Dafnos, S., and Yfanti, S., “Theoretical Properties of Time Varying Models and their Use in the Construction of Forward Looking Indicators”
In the light of the well-known forward-looking properties of stock market returns and volatility for economic activity, a comprehensive and robust framework where the latter can be modeled and predicted is contributed. The authors introduce and utilize new theoretical results on time varying AR asymmetric GARCH models, unifying several recent econometric approaches to univariate time series modelling, which they also extend to account for basic properties of financial returns, likewise breaks in mean and/or volatility. Among the new theoretical results related to the estimation of time varying parameter models, the authors also provide the solution to their multi-step ahead prediction problem. Overall, the authors develop a general time varying parameter theory, encompassing a number of seemingly unrelated models and the authors identify common properties, which are basic to each of the particular application. The authors believe that time varying parameter models should take center stage in the forward-looking indicators literature, and this is why the authors develop a theory with rigorous foundations that can encompass a variety of dynamic systems, i.e. periodic and cyclical processes, and AR models which contain multiple structural breaks. Moreover, still with the purpose of accurately modeling (to accurately predicting) stock returns of our research also deals with the long memory feature in models the authors estimate to compute stock market volatility and dynamic correlations. As it is well documented that disentangling structural breaks and long memory is rather difficult, a comprehensive modeling approach is likely to better achieving the target of accurately forecasting future economic and financial scenarios. To the purpose the authors assess the joint contribution of long memory and structural breaks in variance to the modeling of contagion across key European and other international stock markets during the Asian and the recent Global financial crisis. The authors document time varying persistence in their corresponding conditional variances and show the existence of dynamic correlations as well as time varying shock and volatility spillovers across markets. The authors also document higher dynamic correlations of stock markets after a crisis event, which means increased contagion effects between markets. Moreover, during the recent Global financial crisis the correlations remained on a much higher level than during the Asian financial crisis.
D5.3) Morana, C., “Insights on the Global Macro-Finance Interface: Structural Sources of Risk Factors Fluctuations and the Cross-Section of Expected Stock Returns”
This study contributes to the investigation of the macro-finance interface by assessing the economic content and risk based interpretation of widely employed risk factors in the specification of empirical asset pricing models, i.e. Fama-French size and value, Carhart momentum, as well as the more recent Pastor-Stambaugh liquidity and Adrian-Etula-Muir leverage factors. Strong support for their risk based interpretation and forward-looking properties, encompassing evidence on cause, persistence and direction of the size, value and momentum effects, and new insights on the specification of systematic risk, are provided. The overall evidence is then strongly supportive for the potential use of risk factor information within an early warning system of macro-financial risk. We find that different sources of macroeconomic and financial risk are reflected by the various risk factors; namely, productivity and monetary policy stance shocks for SMB; labor market and term structure slope shocks for HML; aggregate demand and US terms of trade shocks for MOM. Also, procyclical size, value and momentum, as well as market-wide, leverage and stock market liquidity effects, appear to be mostly generated by demand-side macroeconomic shocks. Finally, clear-cut evidence of signaling properties of risk factors shocks for the economic outlook are detected. For instance, it is found that unanticipated higher profitability of small and value firms, i.e. positive size and value structural shocks signal favorable changes in the investment opportunity set and therefore an improved macroeconomic outlook. Moreover, an unanticipated increase in risk aversion, signals unfavorable changes in the investment opportunity set, and therefore a worsening in the macroeconomic outlook. Finally, we find that not all the structural sources of risk factor fluctuations might be priced by the market, and filtering out non-priced components improves the performance of empirical asset pricing models.
D5.4) Morana, C., “Macroeconomic and Financial Effects of Oil Price Shocks: Evidence for the Euro Area and the Global Economy”
The research yields innovative contributions to the oil price-macroeconomy, concerning its relevance, the presence of asymmetric responses, the sources of shocks, the role of the Great Moderation, the contribution of the 2008 oil price boom-bust episode to the Great Recession; the contribution of the post-2009 oil price dynamics to the weak and scattered recovery in the euro area, as well as the implications of the current oil price slump for deflation risk and economic growth in the euro area. We use both a global, large scale econometric model, and a local euro area model. The global model allows for unobserved factors, reflecting global macro-financial conditions, which is estimated using data for fifty OECD and emerging countries. We show that oil market shocks contribute more strongly to macro-financial fluctuations in the long- than in the short-term. Different explanations have been proposed in the literature for the apparent resilience of the global economy to the 2008 oil price boom-bust episode. We show that the phenomenon is accounted for by the combined effect of two mitigation factors, i.e. the endogenous contraction in real wages and the concurrent expansionary stabilization policies implemented to counteract the subprime financial crisis, in the face of a mostly macro-finance driven oil price shock. Turning to results for the euro area, we argue that the available empirical evidence, neglecting that ECB monetary policy is currently working at the zero lower-bound, is of no guidance concerning the prediction of the effects of the oil price slump. We find strong evidence of asymmetric real effects of oil price shocks for the euro area, with recessionary effects triggered not only by oil price hikes, but also by oil price slumps in some cases, likewise for the most recent episode. The latter oil price slump also contributes to raising deflationary risk, as well as financial distress. Concerning the ECB response to the oil price shocks, the observed increase in real money balances is consistent with the progressive deepening of the expansionary stance during 2014, eventually culminated with the introduction of Quantitative Easing in January 2015. As nominal interest rates are currently at the zero lower-bound, the real short term rate increase brought about by the deflationary effects of the oil price slump might then account for its recessionary bias observed so far. Overall, our findings have a key policy implication. In so far as Q.E. failed to generate inflationary expectations within the expected environment of soft oil prices, the case for a much more expansionary use of fiscal policy than in the past would become even more compelling, in order to counteract the deflationary and recessionary threats to the euro area.
D5.5) Morana, C., Conrad, C., Baillie, R.T. Zumbach, K.U. and Cho, D., “The US$/€ Exchange Rate: Structural Determinants and Properties”
In the first part of the research we specify and estimate an econometric model grounded on the asset pricing theory of exchange rate determination. In the latter theoretical framework current exchange rate fluctuations are determined by the entire path of current and future revisions in expectations about fundamentals. In this perspective, the research innovates the literature by conditioning on Fama-French and Charart risk factors, which directly measure changing market expectations about the economic outlook, as well as on new financial condition indexes and a large set of macroeconomic variables. The macro-finance augmented econometric model has a remarkable in-sample and out of sample predictive ability, largely outperforming a standard autoregressive specification neglecting macro-financial information. We also document a stable relationship between the US$/€-Charart momentum conditional correlation and the euro area business cycle, potentially exploitable also within a system of early warning indicators of macro-financial imbalances. In the second part of the research we analyze whether the communication of European politicians with respect to the sovereign debt crisis affects the US$/€ exchange rate as well as the European stock and bond markets. Results show that positive communication regarding the periphery countries or the EA as a whole leads to a significant appreciation of the US$/€. Further, the stock markets of the core European countries (Germany, France and Belgium) as well as the periphery countries (Greece, Ireland, Italy, Portugal and Spain) instantaneously increase in response to positive communication regarding the stance of the economy in the periphery countries or positive communication with respect to the EA as a whole. Finally, in the third part of the research, we further explore the role of nonlinearity in the determination of the US$/€ exchange rate. In particular, the research focuses on the so called forward premium anomaly and the apparent failure of the theory of Uncovered Interest Rate Parity for the US$/€ exchange rate, as well as for other seven different currencies considered for comparison. Our results clearly indicate the futility of trying to classify forward premium series as being stable, time invariant processes. Rather, the evidence strongly suggests that persistence substantially changes across regimes. Moreover, we also find evidence of unstable anomaly over time, both in magnitude and sign, actually even showing a reversal for the US$/€ exchange rate, after the financial crisis of 2008.
D5.6) Conrad, C. and Hartmann, M., “Cross-sectional evidence on the relation between macroeconomic conditions, stock market volatility, monetary policy, and low-frequency inflation uncertainty”
We examine how financial market volatility and the interaction between monetary policy and macroeconomic conditions affect inflation uncertainty in the long-term. Moreover, the direct and indirect influences of stock market volatility on inflation and output growth are examined. The unobservable inflation uncertainty is quantified by means of the slowly evolving long-term variance component of inflation in the framework of the Spline-GARCH model (Engle and Rangel, 2008). For a cross-section of 13 developed economies, we document that long-term inflation uncertainty is high if central bank governors are perceived as less inflation-averse, if the conduct of monetary policy is ad-hoc rather than rule-based and during times of heightened volatility in financial markets. Moreover, we find that financial market volatility has a direct effect on both the level of inflation and output growth and an indirect influence on these variables which is transmitted through its relation to low-frequency inflation uncertainty.
D5.7) Conrad, C., and Loch, K., “Macroeconomic expectations and the time-varying stock-bond correlation: international evidence”
The article explains the time-varying correlation between stock and bond returns by survey expectations on the future macroeconomic development. A modified DCC-MIDAS specification allows to relate daily changes in the correlation to monthly expectations data. For a cross-section of countries, the authors show that the stock-bond correlation is mainly determined by expectations regarding the future course of monetary policy as well as stress in financial markets. From a European perspective, the asymmetry in the response of the stock-bond correlation to heightened stock market volatility in the UK, Germany and France on the one hand, and Italy on the other hand is of high policy relevance.
D5.8) Morana, C., Karanasos, M., Baiardi, D., Koutroumpis, P., Karavias, Y., and Arakelian, V., “Nominal and Real Convergence in the Euro Area”
The research yields innovative contributions along several perspective. For instance, concerning within country real income convergence, we innovate by introducing a new specification of the Kuznets curve (KC), where turning point per capita income is conditioned to the level of financial development. We then use the latter model to study euro area (EA) income distribution inequality since the mid-1980s, with a special focus on the subprime cum sovereign debt financial crisis period. We find strong empirical evidence in favor of a steady-state financial Kuznets curve (FKC) for the EA and of ongoing convergence across EA members towards a common per capita income turning point level, also resilient to the financial crisis. By means of a counterfactual analysis, we then find a sizable worsening in income inequality not only for the countries that were most severely hit by crisis, i.e. Cyprus, Ireland, Spain, Portugal, Greece and Italy, but also for core EA countries, Austria, Belgium, Luxemburg, Finland, France and Germany, which were little affected by the sovereign debt crisis. Concerning nominal convergence, we study the convergence properties of EA inflation rates since the early 1980s. By applying recently developed panel unit root/stationarity tests we are able to accept the stationarity/convergence hypothesis. This means that some differentials are stationary and therefore there might be clubs of countries which have been in the process of converging absolutely or relatively. We detect three absolute convergence clubs in the pre-euro period, which comprise early accession countries. In particular, Luxemburg clusters with Austria and Belgium, while a second sub-group includes Germany and France and the third The Netherlands and Finland. We also detect two separate clusters of early accession countries in the post-1997 period: a sub-group with Germany, Austria, Belgium and Luxemburg, and one with France and Finland. For the rest of the countries/cases we find evidence of divergent behaviour.
D5.9) Morana, C., “Divided we Fall: Early Warning Signals of Macro-Financial Distress in the Euro Area”
The article proposes a new framework for the setting up of an Early Warning Indicator System for the euro area, which directly includes, among other indicators, risk factors and measures of real, nominal and financial divergence. In particular, the author develops a measure of stock market uncertainty/risk aversion based on the cross-sectional dispersion of stock market returns; the latter, by embedding both cross-sectional and temporal dimensions is likely to provide a more accurate measurement than indicators exploiting the temporal dimension only. The analysis is also innovative in terms of the econometric methodology employed, as it is performed by means of a time-varying parameter model for the euro area, cast within the framework of the semiparametric dynamic conditional correlation model (SPDCC) of Morana (2015a). The author provides clear-cut evidence of leading indicator properties of the proposed stock market uncertainty/risk aversion measure for the episodes of financial and economic distress that have hit the euro area since 1999. In particular, higher stock market divergence/uncertainty might accurately signal a worsening in the expected economic outlook, by pointing to higher financial instability, lower stock returns (financial busts) and economic growth (recessions); by rising bond market divergence, the latter signal would also be reflected in a positive momentum factor, consistent with the stronger resilience of firms with good fundamentals during recessions. A direct linkage of stock market divergence with momentum is also detected; the latter would however hold only when the economic downturn is expected to be sizable.
D5.10) Bagliano, F.C. and Morana, C., “It ain’t over till it’s over: A global perspective on the Great Moderation-Great Recession interconnection and transition to the euro area sovereign debt crisis”
A large-scale model of the global economy is used to investigate the determinants of the Great Moderation and the transition to the Great Recession (1986-2010) and euro area sovereign debt crisis. Beside the global economy perspective, the model presents the novel feature of a broad range of included financial variables and risk factor measures. The results point to the relevance of various mechanisms related to the global monetary policy stance (Great Deviation), financial institutions’ risk taking behavior (Great Leveraging) and global imbalances (savings glut), in shaping aggregate fluctuations. The paper finally contributes to the literature on early warning indicators, assessing the information content of risk factor innovations for the prediction of real activity dynamics during the Great Recession and the early phase of the euro area sovereign debt crisis.
WP6 Towards a revised economic governance: in search of stability
D6.15) Villa, M. and Villafranca, A., “New policies and institutions to escape the fate of recurring crises”
Building on RAstaNEWS research, the deliverable draws substantive policy recommendations for the Eurozone as a whole. While the EU (and the EMU in particular) has been reformed to shelter the currency union from the likelihood and impact of future crises, the EMU is still not an optimal currency area. Within and across countries, asymmetries and disequilibria abound, demanding constant monitoring and extensive policy action. RAstaNEWS partners believe that, in the short term, it would be possible and advisable to support the ongoing nascent (but still tentative) Eurozone economic recovery through bolder action on both the monetary and fiscal side. At the same time, the EMU governance should be reformed by making fiscal rules more flexible in times of crisis and more rigid in good times (in order to force Member States to undertake the necessary adjustments to safeguard their economies from future idiosyncratic crises). Decision making processes should be depoliticized, especially with regards the Excessive Deficit Procedure, the Macroeconomic Imbalance Procedure, and ECB monetary policy decisions. Moreover, a coherent push in favor of public investment would be advisable both for those core countries that tend to focus on fiscal discipline too early in the economic recovery, and for periphery countries that need to support their own recovery and close the competitiveness gap with the rest of the Eurozone. The ECB should be allowed to undertake bolder measures, which would support the domestic recovery, bring inflation closer to the official target, and increase the external competitiveness of the EMU by indirectly lowering the real effective exchange rate. Meanwhile, much closer coordination of national fiscal policies would be strongly advised. In the medium run, the preferred outcome should be to enforce rigid budgetary rules for each Member State, while at the same time making discretionary fiscal spending more and more supranational (and flexible). This would allow for collective decisions on fiscal readjustments for the whole of the EMU, while substantively decreasing moral hazard in the single Eurozone economies and, possibly, increase a sense of common destiny in each Member State and its national policymakers.
D6.16) Villa, M. and Villafranca, A., “Monetary Policy and Prudential Regulation: In Search of a New Normal”
This deliverable focuses on: proposals to reform EMU macro-prudential policies, improving the functioning of the Banking Union as a way to enhance convergence of economic conditions and a smoothing of the business cycle, all the while serving as prudential tools at the EMU level that shelter the monetary union from a renewed negative feedback loop of financial crises and inter-country contagion. While recognizing that monetary policy and prudential regulation are characterized by intertwined transmission mechanisms and reciprocal spillovers, we advocate an operational separation between the two. The rationale for this separation is essentially the fact that the sign, size and time dimension of the effects of changes in monetary policy (e.g. a change in the policy rate) on financial institutions are too uncertain to justify the assignment of a financial stability objective to monetary policy. The assessment is more nuanced as to the effects of prudential policies on the output and inflation gaps. Adequate macro-prudential policies can often (but not always) improve the trade-off faced by monetary policy, enlarging its policy space. However, the goal of macro-stabilization cannot be reasonably assigned to prudential policy. In the end, therefore, we would (i) stick to the dual mandate for monetary policy, and (ii) assign a financial stability objective to prudential policies. Operational separation implies that interest rate setting should be employed to preserve monetary stability, while capital and liquidity requirements should be used to preserve financial stability. We also advocate the centralization of both monetary and prudential policy to a single institution: the central bank. In this way, the central bank can exploit the obvious synergies between the two spheres mentioned above. Going deeper into the institutional arrangement of prudential policy, we emphasize the limits of the current situation where macro-prudential supervisory decisions are delegated to the national authorities, with the ESRB and the ECB playing a quite limited (mainly advisory) role. The institutional design should be streamlined and centralized. As far as the euro area is concerned, it seems reasonable to attribute the responsibility of macro-prudential supervision to the SSM. This is an issue that needs to be further analysed and discussed by policy-makers.
D6.16) Villa, M. and Villafranca, A., “The Green Book”
This Green Book collects final policy recommendations that originated from the research of the RAstaNEWS consortium. The Green Book was presented during the Final Dissemination Conference and amended taking into account feedback from policy makers, scholars and experts. In the years following the launch of the RAstaNEWS project in early 2013, the Eurozone crisis seems to have somewhat subsided. However, the recent Greek crisis and the negotiations leading to the country’s third bailout program in August 2015 reminded us of the effects that unsustainable debt levels and dangerous macroeconomic imbalances can still have on the stability and resilience of the Eurozone.
Meanwhile, economic growth levels in the Eurozone are still a far cry from the relatively healthy recovery recorded in other advanced economies, above all the United States. Recent data suggests that the euro area may have grown by 1.5% in 2015, markedly lower than the US economy (2.5%; IMF 2016). Such sluggish growth prospects have endured since the end of the Great Financial Crisis, so much so that euro area real GDP is still below the pre-crisis peak, while the US exceeded it already in 2010 and is now almost 10% above those levels. Stymied growth prospects have translated in much lower job-growth rates and very low inflation. At the policy level, EU Institutions and Eurozone national governments have painstakingly taken a number of important steps in the direction of reforming EMU policies and the overall EMU governance framework, often at the cost of long debates and deep political divisions. However, EU Institutions have mainly focused on fiscal policy sustainability, over which they enjoy greater latitude since the formalization of debt and deficit rules within the Stability and Growth Pact (SGP).
In light of the persistent need to rebalance the Eurozone, the challenge for the RAstaNEWS consortium has been to single out what is still missing from the EMU policy framework – something the consortium has consistently referred to as “holes in the cheese” – in order to spot weak points and propose desirable policy solutions. Drawing from current ongoing RAstaNEWS research, the consortium partners present here a multi-pronged strategy to reform EMU macroeconomic policies and avoid the fate of recurring crises. In the short-to-medium term, the strategy includes the following elements:
1. A revamped Juncker plan;
2. Much closer coordination of national fiscal policies at the supranational level, making room for the possibility to define a euro-area fiscal stance;
3. An even more accommodating monetary policy, implemented until macroeconomic conditions change significantly in the Eurozone periphery;
4. A true euro-area wide implementation of macro-prudential policies, which should also account for potential contagion effects between different financial institutions.
The rationale for such expansionary policies should be cast in the perspective of the “jobless growth” phenomenon, a persistent feature of the global business cycle. This means that unconventional monetary policy should last sufficiently long to allow for the dissipation of recessionary and deflationary trends not only at the euro area level, but also at the Member State level, in order to allow for the unemployment rate to come down considerably, and that an important role could and should be played by fiscal policies. In this regard, it is also crucial to reverse cumulated competitiveness imbalances as soon as possible during the correction and stabilization phases. In the longer run, RAstaNEWS partners consider that there is a need to set out a new course for EMU policies and governance. Such new course should have the following objectives as priorities:
1. A full, conscious shift from fiscal to full macroeconomic surveillance with a renewed emphasis on growth enhancing reforms. It should also be acknowledged that faster nominal income growth is crucial to obtain fiscal consolidation that are both sustainable and socially acceptable. In this regard, it would be crucial to re-evaluate the “contractual” dimension of intra-EMU bargaining, as proposed in the 2012 Van Rompuy report, whereby EMU member states may be awarded some fiscal room to support growth in the short term by binding themselves to enact detailed structural reforms within a certain time horizon. As it is right now, the concession of flexibility by the Commission takes place within a sanctions-waiver, ex post scheme. Establishing the flexibility allowance more firmly would allow to greatly reduce short-term uncertainty that risks stifling the effects of flexibility on aggregate demand;
2. The creation of a proper euro-area fiscal capacity. The EU budget currently amounts to around 1% of GDP and 2% of total member state governments’ expenditure. This is clearly insufficient in order to give the EU and the euro area sufficient room to agree upon and enact credible countercyclical policies;
3. The setting of a differentiated, politically-consensual, EMU-wide fiscal stance, with a Eurogroup that is tasked with deciding upon what the EMU’s overall fiscal stance should be, while also agreeing upon temporary relaxations (or strengthening) of Member States’ fiscal positions, according to country-specific cyclical conditions;
4. A “depoliticized” ECB and strengthened macro-prudential regulation at both the EMU and EU level
Potential Impact:
RASTANEWS intends to enhance knowledge base, at both theoretical and applied level, on many aspects of the future of macro-economic and monetary integration in Europe, paving the way to a revised governance of the EMU, and in the wake of the debt crisis. The results are meant to contribute to reshape the way in which these issues and other related topics are addressed in the literature.
At a normative level, RASTANEWS undertakes pioneering research at the frontiers of new thinking in economics on macro-risk assessment, new early warning systems and links to stabilization policies. In our view, these activities are key elements in securing progress towards a stable monetary union. Once more, we wish to emphasize here that in our view monetary policy in the near future should respond to a set of indicators and policy objectives and openly interact with the fiscal policymakers in a way which would have been unthinkable in the pre-crisis era. To this aim, our research raises big questions with a view to avoiding a future crisis and prompting sustainable growth in the framework of a stable EU financial system. Clearly, this is no modest agenda, as the final evaluation of RASTANEWS’s impact will stand or fall by its ability to contribute to European theoretical understanding and policy practice towards a stable and successful EMU.
RASTANEWS considers its ability to disseminate its findings to be an essential component for the overall success of the project. The development of an extensive and targeted dissemination strategy is key to accomplish the above mentioned task. The spotlight is not only on the dissemination of RASTANEWS’s scholarly work and its more applied, policy focused work to the scholarly community, but also to the wider public and private sector policy communities particularly interested in RASTANEWS’s research. In addition, RASTANEWS researchers provide both analysis and policy recommendations targeted to civil servants and political leaders, both at the EU and national levels.
What is crucial in our view is to put in place a sufficiently wide range of beyond state-of-the-art research and high level dissemination activities so as to ensure that if not all are successful then at least some of the initiatives find their target publics. The other key issue is to allow research consortium will have the opportunity to share views and present/discuss research findings and policy recommendation with target-publics. To this aim, it is necessary for target-publics to feel some sense of ownership of the project. RASTANEWS has put in place a range of activities which genuinely wishes to achieve this result. Indeed, RASTANEWS has constantly tried to have a significant impact on decision-making processes through a dissemination strategy whose main components are:
- engage and raise awareness through a preliminary mapping of all the stakeholders to be involved (also as target-groups) in RASTANEWS ;
- synchronize activities with the main ongoing decisions taken at the EU level and be coherent with the most relevant EU policies in the fields and period covered by this project;
- translate research analysis/findings in policy recommendations;
- design an overall economic governance of the EMU and EU as a whole
RASTANEWS researchers have ensured that much of the activities were not only of a high scientific quality but also provided useful insights to the wider public, and significant policy recommendations to civil servants and political leaders. In order to do so, dissemination activities have been targeted not only at institutional actors at various levels (especially the EU Commission and the ECB) but also at non-institutional actors (managers, journalists, experts etc.).
More specifically, the RASTANEWS dissemination strategy aimed at communicating and engaging interactively with five target groups: 1) policymakers, 2) academics, 3) media, 4) business, and 5) the general public. Our overall aims for engaging with these groups were to:
- Create greater awareness of the aims and results of the RASTANEWS project;
- Improve understanding of how the RASTANEWS approach can contribute to insights into macro-risk assessment, stabilization policies and early warning systems;
- Increase involvement of key actors in the RASTANEWS research program and application of its results;
- Get feedback and constructive critiques on the RASTANEWS program;
- Create the basis for long-term impact on the policymaking community, in support of the FP7 grant objectives;
The following sections provide further details on these objectives and our channels/tools for achieving them. Specific attention is devoted to the character, quantity and timing of different communication activities specifically designed for the above-mentioned target groups.
--Objectives--
Dissemination activities commenced at the start of the project and were be carried out during its entire duration. They aimed specifically at:
a) engaging policymakers, particularly from central banks, EU Institutions and finance/economic ministries, in the design of the RASTANEWS models, reviewing and criticizing the work, and in proof-of-concept applications to policy design;
b) working with private sector institutions who can contribute both expertise and experience to the substantive issues of the project (e.g. banks and other private financial Institutions);
c) disseminating the results of the project within the academic community to build support for further research, build an on-going community around this work, and to broaden the impact of the project on economics as a field and its application to improving policymaking;
d) engaging the broader public, both directly (e.g. the Annual Conferences) as well as through the media (including the website, the newsletter, social networks etc.).
--Target groups--
Dissemination was carried out using a variety of channels and tools adapted to different target audiences. In this respect all the consortium partners concentrated on the users’ and stakeholders’ needs and their preferred communication tools. An important outcome we strived for in the project was to create partnerships with key institutions that could help further develop and propagate RASTANEWS after project completion.
We worked with the Directorate General for Economic and Financial Affairs (DG ECFIN) of the Commission, the ECB, national central banks/Ministries of finance to provide a contribution to their modelling and policy support tools.
The target audience consisted of 5 main target groups:
- Policymakers: senior principal decision makers, as well as the staff and advisors that support them. Key institutions: European central banks, EU Institutions, finance and economic ministries.
A number of such institutions have already agreed to engage in the project. The International Advisory Board (IAB) has been a primary vehicle for creating a community of interest in the policymaker and in the scientific community. The ambition for the senior policymakers in the IAB is to see RASTANEWS as representing a new way of understanding the economy and supporting policy decisions. We expect that many IAB members will continue to serve as ambassadors for the project after it completes, working with members of the RASTANEWS team to create on-going engagement with senior policymakers.
The RASTANEWS team also sought to build broad policymaker interest through events, publications, and a media strategy that will lead to continued engagement after completion of the project
- Academics (from the economics, finance, and policy research communities, as well as from the complexity science and computer science communities). The academic members of RASTANEWS have long-standing research interests in the topics covered by RASTANEWS and will likely continue to pursue those interests and utilize the model, data, and findings of RASTANEWS. These individuals publish widely, are regular lecturers and speakers, and are well networked in the academic community – including those institutions and working groups with specific interests in RASTANEWS topics.
- Business (Financial sector private institutions) have been asked to contribute to the research through suggestions and feedbacks on the preliminary research findings of RASTANEWS, but, above all, through comments on the policy recommendations provided by RASTANEWS.
- Media (including traditional, electronic, and social) have been a key channel for shaping opinion leadership and general public opinion. While there is limited interest in technical academic topics, there is a high level of interest in new insights into the financial and euro crisis and an appetite to debate possible solutions. Through the media we hoped to show the relevance of this project to those debates and to improving policymaking in a way that betters peoples’ lives.
- Civil society and the general public. Although the project’s subject matter is fairly technical, there is a very strong interest in civil society and the general public around the crisis, instabilities in the financial system, and avenues for creating a more robust, economically productive, and fairer system.
Target-groups and, more generally, institutional and non-institutional actors were identified through a preliminary Political Context Analysis (PCA) which will allow to identify stakeholders and key policy-makers (the most relevant institutional and non-institutional actors, including individuals and groups at both the EU and national levels) who can influence or affect policy processes.
In addition, RASTANEWS’ activities were synchronized through a Functional Calendar (FC) which took into account the main steps of the European policy processes (agenda-setting, decision-making, implementation and evaluation) for the period covered by the project; dissemination activities were then developed, as much as possible, to cohere with this Calendar and to enhance the potential for the impact of the dissemination. The Functional calendar allowed partners to synchronize as much as possible research and dissemination related activities within the RASTANEWS network with the main political and economic events taking place in the Eurozone. In order to maximize relevance and the probability that high-level officials would take part in RASTANEWS dissemination activities, ISPI also took constant care to identify event dates that would match the agenda of relevant EU and national stakeholders. The Functional calendar also allowed RASTANEWS partners to decide upon which content to prioritize first in terms of policy outcomes and recommendations. Indeed, coming just a few months after the ECB’s announcement of its quantitative easing programme and the publication of the Five Presidents’ Report, the First Annual Report focused on expansionary monetary policies and the possibility of a step-by-step establishment of a Eurozone fiscal capacity. The Second Annual report, timed with ongoing discussions on completing the Banking Union, focused on macro-prudential policies and on ways to make financial institutions more resilient to shocks.
A particular feature of RASTANEWS was to organize ‘Executive Briefings (EBs), i.e. meetings with the appropriate senior officials in Brussels and at the major EU capitals in order to secure a formal agreement from them to participate in these innovative feedback-input processes.
All these actions aimed at assuring the highest level of visibility and impact to RASTANEWS activities. In particular, building on the results of the Political Context Analysis and Functional Calendar, a multidimensional dissemination strategy was pursued involving a range of means (Events and Publications) and a number of activities (Conferences, Workshops, On-line Publications etc.) depending on the specific target group RASTANEWS intended to reach.
--Channels/Tools--
Work package 7 was entirely dedicated to impact and dissemination. In addition to PCA and FC, it had 4 key components:
a) Website and Newsletter
RASTANEWS Website hosted all the information about the consortium and listed all the research and dissemination activities (including video-recording of the main RASTANEWS events). The electronic Newsletter ‘RASTANEWS’ has been issued four times per year, informing on all the initiatives promoted by RASTANEWS partners and circulating preliminary research outcomes. The Newsletter was sent to the stakeholder database built upon PCA and to the electronic mailing lists of the Partners (over 30,000 contacts all over Europe It was also available for download on the Website of the project.
b) Scholarly and Policy Focused Publications
Our research products concentrated less on edited collections and more on high quality peer-reviewed work in international journals . Our ‘Policy Focused Publications’ were a series of electronic policy briefs, circulated to the available mailing list. These products translated preliminary research findings in policy recommendations
c) Annual Dissemination Conferences and Executive Briefings
The dissemination of results via the active participation of RASTANEWS scholars in the annual conventions of the disciplines represented in the project (mainly economics and politics) have been complemented by attendance at the 3 Annual Conferences: each event brought together project partners with 6-7 stakeholders from the EU, including outstanding representatives of the political and economic communities, especially thanks to the great expertise and networks by ISPI and PISM (two of the most prestigious think-tanks in Europe ). These events –held in Milan, Brussels and Warsaw – were meant to raise awareness, promote debate and disseminate preliminary research outcomes. The video of these events is also available for download on the project website, and the link for the download was also included in the Newsletter in order to involve a broader audience. The three Annual Conferences were the biggest RASTANEWS public events, gathering outstanding international personalities and scholars (such as the Nobel Prize in Economics Prof. Michael Spence and the former President of the European Commission Romano Prodi) and European and national policy makers and civil servants (among others: an ECB Vice-President, two Italian Ministers of Economy and Finance, a Member of the European Parliament, and representatives from the European Commission’s DG ECFIN, the European Stability Mechanism, and the Single Resolution Board). Speakers were invited to discuss RASTANEWS research – especially policy outcomes and recommendations – and the current predicament of the European economy, and to reflect upon reform proposals on the Eurozone economic governance. The Annual Conferences were live streamed and their recordings remain available online. On the sidelines of these Conferences, Scientific Workshops allowed experts and scholars to join RASTANEWS partners in order to discuss the network’s preliminary and final research findings, all the while allowing for a fruitful debate and cross-fertilization between different research fields. Another event – the conference ‘EU Economic Governance in the Making – the CEE Perspectives’ – was organized by PISM in Warsaw and brought together high-ranking personalities, scholars and experts to discuss on the specific role and contribution of Central and Eastern Europe (CEE) countries to the EMU In addition, a special edition of the PISM Quarterly on “Eurozone crisis and the Visegrad countries experience: performance and perception” has been issued, including contributions from scholars/experts in Poland, the Czech Republic, Slovakia and Hungary.
The audience of the 2 ‘Executive Briefings’ included at least 30 policy-makers at both national and international levels and other stakeholders, including business and civil society actors (preliminarily identified thank to PCA). These meetings had an informal consultation character and were relevant in sharing both research results and their practical implications. In particular RASTANEWS partners had the opportunity to meet about 25 stakeholders (also identified in the Political Context Analysis), present and discuss research outcomes with a policy-oriented focus. In addition, it is also important to note that many RASTANEWS partners organized scientific workshops/seminars in their to discuss/present preliminary scientific findings with other scholars/experts.
d) Annual Reports and ‘Green Book’
The Consortium provided 3 Annual Reports which will allow to list the activities promoted by RASTANEWS partners every year and the most significant scientific findings. These Reports will be circulated to the scientific community in Europe and abroad. Users will also be able to download them from the official project Website.
The ‘Green Book’ was the third and final report of the entire project. It plays a central role in RASTANEWS as it translates all the main scientific findings of the project in concrete policy recommendations.
--Most significant results. --
Throughout the three years of the project, dissemination and communication activities allowed RASTANEWS partners to reach a very wide range of stakeholders. Among the latter were EU and national policymakers and civil servants, scholars, experts, and the public at large. The three Annual Conferences were attended by an average of 240 people each, while Executive Briefings were attended by over 30 participants each. This allowed for fruitful discussions among policy experts and for a broad dissemination of RASTANEWS scientific findings and policy recommendation (especially in the case of the Final RASTANEWS Green Book).
The Website and the Newsletter allowed people from outside the network to stay informed about the project’s activities; the RASTANEWS newsletter, in particular, kept people engaged throughout the whole length of the project, reaching over 40,000 contacts for each issue.
All events were timed so as to maximize attendance of policy makers, civil servants and the public at large. The Calendar served to ensure that the topics discussed at events were highly relevant to stakeholders engaged in the reform of the Eurozone economic governance. The involvement of important scholars in economics from outside the network also allowed RASTANEWS partners to disseminate further their research findings.
Finally, the internal peer-review process was not only crucial to safeguard the quality of the network’s scientific output, but also served as a first foray through which preliminary research findings could be disseminated to high-level scholars.
List of Websites:
http://rastanews.eu/
RASTANEWS intends to enhance the knowledge base available to policymakers to enhance macro-economic and monetary integration in Europe, thus paving the way to a revised governance of the Economic and Monetary Union (EMU). We feel the need to re-think conceptual frameworks about the working of the EU macro-economy in order to incorporate three key issues: (i) the role of incomplete and informationally inefficient financial markets; (ii) the heterogeneity in expectations, which should play a fundamental role in explaining the behaviour of asset prices; (iii) the need to overcome the traditional dichotomy between Keynesian (short run) and neoclassical (long run) policy prescriptions. Taking these issues seriously in theoretical and empirical research has important implications for the conduct of EMU monetary and fiscal policies and for EMU governance system. In addition, to facilitate the timely identification of macro risks, we explore the properties of a new system of early warning indicators - to be implemented within the EMU surveillance mechanism – which is consistent with our theoretical framework and is based on an empirical macro-finance approach.
The project aims at addressing EMU design and policy weaknesses that only emerged after the onset of the Great Financial Crisis, particularly those that: (a) hamper the proper functioning and the uniform transmission of monetary policy throughout the euro area; and (b) limit the coordination of fiscal policies, prevent their use as countercyclical buffers, and impede the emergence of a political consensus over the design of redistributive mechanisms at EMU level
Theoretical and empirical results have been exploited to provide policy outputs to EU and Eurozone policymakers:
1. proposals to reform EMU macroeconomic policies – e.g. by aiming at a global fiscal stance for the Eurozone -- in order to decrease the likelihood of future crises, while at the same time supporting overall growth in the Eurozone;
2. proposals to reform EMU macro-prudential policies, improving the functioning of the Banking Union as a way to enhance convergence of economic conditions and a smoothening of the business cycle, all the while serving as prudential tools at the EMU level that shelter the monetary union from a renewed negative feedback loop of financial crises and inter-country contagion;
3. proposals to define a refined set of ex ante indicators of impending macroeconomic and financial imbalances. Such Early Warning Signals (EWS) could serve as improved and timely indicators of problematic disequilibria at the macro level, with the aim to allow European and national policymakers, regulators and supervisors to act as early as possible in order to rebalance national economies or the EMU as a whole before a full-fledged crisis can develop.
Policy recommendations resulting from RAstaNEWS partners’ work have been collected in a Green Book.
Project Context and Objectives:
The 2008 crisis erupted in a situation where markets and policymakers apparently underestimated the risk incorporated in financial assets due to i) the potentially devastating effect of financial derivatives on the balance sheets of financial institutions; ii) the unprecedented interconnectedness between financial institutions; iii) the very high leverage of the financial system. The unregulated expansion of informationally inefficient financial markets was quickly identified as the main culprit of the crisis. A complementary view emphasizes the role played by factors such as saving-investment imbalances, assets prices and real exchange rate misalignments, the accumulation of large stocks of private debt in some countries. In addition, the crisis hit at a time when many countries had experienced substantial increases in inequality over the previous three decades: inequality either depressed growth or triggered increasing debt by households at the bottom of the distribution.
When the crisis hit, the Euro area was characterized by substantial asymmetries concerning accumulated competitiveness differentials, public debt and deficit ratios, fragility of domestic financial sectors. There is no doubt that undisciplined fiscal policies caused the Greek crisis but in other cases, notably Ireland and Spain, there had been a clear neglect for non-fiscal risks associated to credit booms, asset-price increases and real exchange rate appreciation. Just like the Fed, the European Central Bank (ECB) was apparently taken aback by the financial crisis. The fragility of the Euro-area financial system was utterly neglected and just before the near-collapse of financial markets, the main ECB concern was for inflation risk. On the fiscal side, the Stability and Growth Pact (SGP) has had at best a limited effect on excessive debt accumulation in relatively good times and has been criticized for mitigating the necessary fiscal stimulus (IMF, 2009) in the aftermath of the 2008 financial crisis. The fiscal framework could not prevent the loss of competitiveness of countries that later were subject to speculative attacks. As pointed out by De Grauwe (2011), in a currency union investors may choose to shift their purchases of government bonds from “risky” borrowers to a safe issuer. This, in turn, raises risk spreads and depresses economic growth, hindering the stabilization of public deficits in the countries under attack.
In countries that retain their monetary sovereignty, this self-fulfilling equilibrium would be ruled out by the exchange rate depreciation associated to the outflow of capital. In a currency union the speculative attack would be prevented either if governments of member countries were committed to mutually support each other in the face of an attack, or if the Central bank were prepared to step in and buy government bonds. Within EMU neither mechanism has been at work with the necessary strength, due to a declared fear of ensuing moral hazard problems. More recently there have been steps towards the creation of a new “fiscal compact”, based on 1) fiscal rules, enshrined in national constitutions, that set limits to debt and to structural deficits; 2) a stricter sanctioning mechanism for countries noncomplying with the SGP deficit limits; 3) a supra-national stabilization mechanism. It should also be noted that both the European Commission and the ECB have proposed an enhanced system of macroeconomic surveillance that focuses on a set of indicators which include measures of competitiveness, output growth, domestic credit conditions and asset prices. All in all, the evolving EMU macroeconomic governance is inevitably bound to address a number of issues that typically matter for the sustainability of a fixed exchange rate system. In particular this entails the definition of 1) the ECB tasks, including the de facto lender of last resort role; 2) the definition of a global fiscal policy, with reference to both the medium and the long run; 3) the definition and coordination of national fiscal policies. In addition, design of both the “preemptive” and the “corrective” arms of the new “fiscal compact” should induce national fiscal policies to act consistently with goals 1) and 2). Finally, there is little doubt that the issue of which policy mix should be implemented in order to reduce debt will play a central role in the years to come.
RASTANEWS intends to enhance knowledge base, at both theoretical and applied level, on many aspects of the future of macro-economic and monetary integration in Europe, paving the way to a revised governance of the EMU, and in the wake of the debt crisis. We see three key issues about the working of the EU macro-economy that deserve deeper investigation. The first is the issue of incomplete and informationally inefficient financial markets, the Achilles’ heel of the consensus DSGE models. The second related issue is the heterogeneity in expectations, which should play a fundamental role in explaining the behaviour of asset prices. The third issue is the need to overcome the traditional dichotomy between Keynesian (short run) and neoclassical (long run) policy prescriptions. Taking these issues seriously has important implications for the conduct of EU monetary and fiscal policies and for EU governance system. In addition, to facilitate the timely identification of macro risks, we propose a new system of early warning indicators, to be implemented within the EMU surveillance mechanism. This proposal is consistent with our theoretical framework and is based on an empirical macro-finance approach.
At our boldest, we will contribute to reshape the way in which these issues and other related topics are addressed in the literature. In particular, we would like to bring what is still predominantly 20th century literature about macro-risk assessment, stabilization policies and early warning systems, into the 21st century. To this aim, RASTANEWS will provide state-of-the-art analysis whose impact is expected to be both analytical and normative.
At an analytical level, RASTANEWS will firstly identify and analyse the main reasons behind the European debt crisis by highlighting the relevance of undisciplined fiscal policies (including the limits of the Stability and Growth Pact-SGP) and its interaction with monetary policies, the instability prompted by financial systems, the European responses to the crisis both at the EU and national level, the traditional dichotomy between short and long run perspectives.
At a specific scholarly level one further impact of RASTANEWS is in the area of innovation in methodology and economic modelling of 1) incomplete and informationally inefficient financial markets; 2) the heterogeneity in expectations; 3) the link between short- and long-run macroeconomic outcomes.
At a normative level, RASTANEWS wishes to undertake pioneering research at the frontiers of new thinking in economics on macro-risk assessment, new early warning systems and links to stabilization policies. In our view, these activities are key elements in securing progress towards a stable monetary union. Once more, we wish to emphasize here that in our view monetary policy in the near future should respond to a set of indicators and policy objectives and openly interact with the fiscal policymakers in a way which would have been unthinkable in the pre-crisis era. Economic research in Europe in the 21st century, funded by the European Commission under the VII Framework Program, is rightly expected to have a positive impact on the lives of Europeans.
To this aim, the research must raise important questions with a view to avoiding a future crisis and prompting sustainable growth in the framework of a stable EU financial system. Clearly, this is no modest agenda as the final evaluation of RASTANEWS’s impact will stand or fall by its ability to contribute to European theoretical understanding and policy practice towards a stable and successful EMU.
The objectives and the content of the research to be carried on by the RASTANEWS team for each work package are as follows.
Regional imbalances, macroeconomic options and the design of the European financial network (WP1). The objectives of WP1 are: 1) to analyse the sources (real exchange rate misalignments, capital flows) and to measure the magnitude of regional imbalances within the EMU and the EU; 2) To collect data to reconstruct the European Financial Network (EFN), in order to evaluate its properties, build Early Warning Systems and study its resilience to systemic risk; 3) to study the patterns of post-crisis readjustment in CEECs and evaluate the current policy arrangements for CEECs, which may consider EMU accession.
Complex Systems and the Future of Macroeconomic and Monetary Integration in Europe
(WP2) This line of research is devoted to the analysis of macroeconomic models with heterogeneous expectations. The research tests in a controlled laboratory environment the validity of standard monetary policy recommendations as well as mixed fiscal-monetary stimuli to cope with liquidity traps, stagnation and deflationary spirals. Results are used to develop macroeconomic models consistent with individual expectational rules observed in the laboratory experiments, and to perform policy analysis within the resulting framework to prevent a financial crisis in the future.
Short and Long Term Effects of Macroeconomic Policy: Lessons for the European Governance (WP3). This line of research investigates how the interaction between income inequality and household debt shapes the dynamics of economic fluctuations and determines the fragility of the economy’s growth pattern. We are particularly interested in understanding the financial mechanisms that, in presence of high inequality, are able to generate extreme events such as crises.
Limited asset market participation, credit frictions, and the interaction of fiscal and monetary policies in a currency union. (WP4). The objectives of WP4 are: 1) To understand the theoretical and implications of limited asset market participation in the EMU; 2) To identify the potential role of national fiscal policies as a stabilization tool for EMU business cycle. 3) To study the interactions between the common monetary policy and the national fiscal policies in the currency union, including the optimal monetary-fiscal policy mix during the transition to lower debt-to-GDP ratios in the EMU. This is done by means of theoretical papers and by estimating an empirical DSGE model of the Eurozone.
Early warning indicators within the EMU surveillance mechanism. A macro-finance approach. (WP5). This line of research adopts an empirical macro-finance approach in order to construct an Early Warning Indicator System, grounded on a deeper understanding of the macrofinance interface. WP5 delivers 1) Econometric tools for large scale macroeconometric modelling and the construction of coincident and forward-looking indicators; 2) Divergence and convergence indicators, accounting for nonlinearities and persistence; 3) the assessment of macro-financial determinants of risk factors;4) The assessment of the oil price-macro-finance relationship and the Great Recession; 5) An early warning indicator system for macro-financial imbalances for the Euro Area, set within the framework of a large scale econometric model, allowing for the dynamic interactions across indicators.
Towards a revised economic governance: in search of stability. (WP6). We provide: 1) a critical review of the ongoing reforms of the EU (and the Eurozone) economic governance; 2) suggestions for design of a revised economic governance which translates the scientific results of the all the other WPs into concrete policy recommendations, with a focus on the potential revision of the ECB strategies/mission and on a new approach to the implementation of fiscal policies..
Dissemination and communication (WP7) are to engage the wider public on the network’s activities and aims, to communicate the network’s activities and output, and to involve both policymakers, experts and academics outside RAstaNEWS in the network’s reflections and products. Communication and feedback to the network are both relevant aspects of this WP, and in order to reach these aims ISPI must maintain a comprehensive website for the network, which is to be constantly updated with the latest deliverables and news; manage RAstaNEWS’s online presence; produce and disseminate the RAstaNEWS quarterly newsletter; manage RAstaNEWS Annual Conferences and Executive Briefings.
RASTANEWS intends to enhance knowledge base, at both theoretical and applied level, on many aspects of the future of macro-economic and monetary integration in Europe, paving the way to a revised governance of the EMU, and in the wake of the debt crisis. We see three key issues about the working of the EU macro-economy that deserve deeper investigation. The first is the issue of incomplete and informationally inefficient financial markets, the Achilles’ heel of the consensus DSGE models. The second related issue is the heterogeneity in expectations, which should play a fundamental role in explaining the behavior of asset prices. The third issue is the need to overcome the traditional dichotomy between Keynesian (short run) and neoclassical (long run) policy prescriptions. Taking these issues seriously has important implications for the conduct of EU monetary and fiscal policies and for EU governance system. In addition, to facilitate the timely identification of macro risks, we propose a new system of early warning indicators, to be implemented within the EMU surveillance mechanism. This proposal is consistent with our theoretical framework and is based on an empirical macro-finance approach.
At our boldest, we will contribute to reshape the way in which these issues and other related topics are addressed in the literature. In particular, we would like to bring what is still predominantly 20th century literature about macro-risk assessment, stabilization policies and early warning systems, into the 21st century. To this aim, RASTANEWS will provide state-of-the-art analysis whose impact is expected to be both analytical and normative.
At an analytical level, RASTANEWS will firstly identify and analyze the main reasons behind the European debt crisis by highlighting the relevance of undisciplined fiscal policies (including the limits of the Stability and Growth Pact-SGP) and its interaction with monetary policies, the instability prompted by financial systems, the European responses to the crisis both at the EU and national level, the traditional dichotomy between short and long run perspectives.
At a specific scholarly level one further impact of RASTANEWS is in the area of innovation in methodology and economic modelling of 1) incomplete and informationally inefficient financial markets; 2) the heterogeneity in expectations; 3) the link between short- and long-run macroeconomic outcomes.
At a normative level, RASTANEWS wishes to undertake pioneering research at the frontiers of new thinking in economics on macro-risk assessment, new early warning systems and links to stabilization policies. In our view, these activities are key elements in securing progress towards a stable monetary union. Once more, we wish to emphasize here that in our view monetary policy in the near future should respond to a set of indicators and policy objectives and openly interact with the fiscal policymakers in a way which would have been unthinkable in the pre-crisis era. Economic research in Europe in the 21st century, funded by the European Commission under the VII Framework Program, is rightly expected to have a positive impact on the lives of Europeans.
To this aim, the research must raise important questions with a view to avoiding a future crisis and prompting sustainable growth in the framework of a stable EU financial system. Clearly, this is no modest agenda as the final evaluation of RASTANEWS’s impact will stand or fall by its ability to contribute to European theoretical understanding and policy practice towards a stable and successful EMU.
The objectives and the content of the research to be carried on by the RASTANEWS team for each work package are as follows.
Regional imbalances, macroeconomic options and the design of the European financial network (WP1). The objectives of WP1 are: 1) to analyze the sources (real exchange rate misalignments, capital flows) and to measure the magnitude of regional imbalances within the EMU and the EU; 2) To collect data to reconstruct the European Financial Network (EFN), in order to evaluate its properties, build Early Warning Systems and study its resilience to systemic risk; 3) to study the patterns of post-crisis readjustment in CEECs and evaluate the current policy arrangements for CEECs, which may consider EMU accession.
Complex Systems and the Future of Macroeconomic and Monetary Integration in Europe
(WP2) This line of research is devoted to the analysis of macroeconomic models with heterogeneous expectations. The research tests in a controlled laboratory environment the validity of standard monetary policy recommendations as well as mixed fiscal-monetary stimuli to cope with liquidity traps, stagnation and deflationary spirals. Results are used to develop macroeconomic models consistent with individual expectational rules observed in the laboratory experiments, and to perform policy analysis within the resulting framework to prevent a financial crisis in the future.
Short and Long Term Effects of Macroeconomic Policy: Lessons for the European Governance (WP3). This line of research investigates how the interaction between income inequality and household debt shapes the dynamics of economic fluctuations and determines the fragility of the economy’s growth pattern. We are particularly interested in understanding the financial mechanisms that, in presence of high inequality, are able to generate extreme events such as crises.
Limited asset market participation, credit frictions, and the interaction of fiscal and monetary policies in a currency union. (WP4). The objectives of WP4 are: 1) To understand the theoretical and implications of limited asset market participation in the EMU; 2) To identify the potential role of national fiscal policies as a stabilization tool for EMU business cycle. 3) To study the interactions between the common monetary policy and the national fiscal policies in the currency union, including the optimal monetary-fiscal policy mix during the transition to lower debt-to-GDP ratios in the EMU. This is done by means of theoretical papers and by estimating an empirical DSGE model of the Eurozone.
Early warning indicators within the EMU surveillance mechanism. A macro-finance approach. (WP5). This line of research adopts an empirical macro-finance approach in order to construct an Early Warning Indicator System, grounded on a deeper understanding of the macrofinance interface. WP5 delivers 1) Econometric tools for large scale macroeconometric modelling and the construction of coincident and forward-looking indicators; 2) Divergence and convergence indicators, accounting for nonlinearities and persistence; 3) the assessment of macro-financial determinants of risk factors;4) The assessment of the oil price-macro-finance relationship and the Great Recession; 5) An early warning indicator system for macro-financial imbalances for the Euro Area, set within the framework of a large scale econometric model, allowing for the dynamic interactions across indicators.
Towards a revised economic governance: in search of stability. (WP6). We provide: 1) a critical review of the ongoing reforms of the EU (and the Eurozone) economic governance; 2) suggestions for design of a revised economic governance which translates the scientific results of the all the other WPs into concrete policy recommendations, with a focus on the potential revision of the ECB strategies/mission and on a new approach to the implementation of fiscal policies..
Dissemination and communication (WP7) are to engage the wider public on the network’s activities and aims, to communicate the network’s activities and output, and to involve both policymakers, experts and academics outside RAstaNEWS in the network’s reflections and products. Communication and feedback to the network are both relevant aspects of this WP, and in order to reach these aims ISPI must maintain a comprehensive website for the network, which is to be constantly updated with the latest deliverables and news; manage RAstaNEWS’s online presence; produce and disseminate the RAstaNEWS quarterly newsletter; manage RAstaNEWS Annual Conferences and Executive Briefings.
Project Results:
For each work package RAstaNEWS research during the second period is summarized as follows.
WP1 Regional imbalances, macroeconomic options and the design of the European financial network
D1.1) Gallegati, M., Maggioni, D., and Presbitero, A., “Dataset on Country-level External Imbalances in Europe”
Database which has been built to explore the size and determinants of country-level external imbalances in Europe. The dataset is available in .dta (STATA) format on the RASTANEWS website (it is password protected), together with an excel file providing an exact definition of all the variables involved.
D1.2) Maggioni, D., “What drives Current Account Imbalances? The role of Complexity”
With this paper we contribute to the literature on the determinants of countries’ current account (CA) positions and trade imbalances by exploring the role of countries’ product complexity. We document the existence of important differences in terms of complexity level in the composition of trade basket across EMU and European countries. From our findings it emerges that countries’ complexity is positively associated with their CA position, and this relationship proves robust to a number of controls. Furthermore, product complexity of countries also plays a mediating role in shaping the impact of external trade shocks on countries’ CA balance. Finally, by investigating bilateral export flows of EMU countries, we show that the competition from new competitors mainly affected low complexity products’ trade.
D1.3) Alessandrini, P., and Fratianni, M., “In the absence of fiscal union the Eurozone needs a more flexible monetary policy”
This paper makes three points. The first is that inter-member external imbalances are relevant for the performance of a monetary union. The second is to design specific policies directed at reducing inter-member external disequilibria, for example by fixing targets on current-account imbalances applied symmetrically to both deficit and surplus countries. It is striking the contrast between the keen attention of the EZ on national fiscal imbalances and the belated and lukewarm attention given to external imbalances. The third is to propose a more flexible monetary policy aimed at controlling the distribution of liquidity among member countries resulting from inter-member external imbalances.
D1.4) Mellár, T., “Deviation from the path to Eurozone Accession: Current monetary and fiscal solutions managing macro-imbalances and debt in Hungary”
This study examines the dilemma of Hungary’s Accession to the Eurozone as opposed to that of the other Visegrád countries. In the aftermath of the economic crisis there has been a growing awareness of the fact that adjusting to the crisis is much easier for countries outside the Monetary Union which still use their own national currency. Successful crisis management by the Czech Republic and Poland are excellent examples. Hungary, however, represents precisely the opposite case, since, despite having its own national currency, it has been unable to adapt itself to the changed international situation. An analysis of Hungarian experience suggests that successful adaptation requires supply-side flexibility (production structure, labour market), rigorous control of fiscal policy and the avoidance of serious debt.
D1.5) Schepp, Z., and Pitz, M., “Foreign currency borrowing in Hungary: the pricing behaviour of banks”
Over the last decade foreign currency indebtedness in Hungary has become a systemic financial problem, significantly constraining economic policy. In international comparative terms, however, there are certain specific features relating to Hungary which make this issue particularly problematic, and during the financial crisis both exchange rates and interest rates were important factors in increasing the burden on individual households. We present here a case study whereby our research focuses on the causes and determining factors of the pricing of Swiss franc denominated mortgage loans. Our empirical exercise examines four potential price shocks which might have affected the pricing decisions of credit institutions. The questions which arise concern the relationship of these costs to the changes in interest rates and the extent to which these cost shocks were passed on by banks to their clients. Empirical evidence based on Vector Error Correction Model (VECM) shows a significant long-run relationship between cost factors and CHF denominated mortgage loans interest rates. Finding a tractable solution to the foreign currency debt trap is only possible if a fair distribution of burdens is achieved and this should be supported by empirical facts. At the end of the day all three affected parties (debtors, banks and the Hungarian State) had made their contribution, but how fair and reasonable the distribution was remains an open issue for further research.
D1.6) Spelta, A., and Delli Gatti, D., “Dataset on the European Financial Network”
This deliverable consists of a dataset and an accompanying paper (“Mapping the European Financial Network: A Preliminary Exploration” by Spelta and Delli Gatti). Since the lack of bilateral data have prevented the investigation of the topological properties of the European Financial Network as a whole, Authors have made use of the structure of the European ownership network to construct the backbone of the European Financial Network. The resulting network encompasses 38460 nodes of 13 different types of actors. The European Financial Network presents a highly sparse, asymmetric and not clustered topology meaning that institutions prefer to avoid cross ownerships and to have stocks of interconnected nodes in their portfolios Moreover institutions with a large number of controlled partners tend to attach to institutions that control few other nodes and institutions with a high market power tend to be attached to institutions whose total assets are almost entirely controlled by others nodes. Results also suggest that banks seems to be the "medium" thanks to which institutions exert control over other institutions.
D1.7) Spelta, A., “A unified view of systemic risk: detecting SIFIs and forecasting the financial cycle via EWSs”
Following the definition of systemic risk by the Financial Stability Board, the International Monetary Fund and the Bank for International Settlements, Spelta proposes a method able to simultaneously address the two dimensions in which this risk materializes: the cross-sectional and the time dimension. The method is based on the W-TOPHITS algorithm, that exploits the connectivity information of an evolving network, and decomposes its tensor representation as the outer product of three vectors: borrowing, lending and time scores. The first two vectors represent the systemic importance of the borrowing and the lending associated with each financial institution, whereas the time score represents an empirical Early Warning Signal of the financial crisis since it varies according to the changes of the bipartite network of lenders and borrowers that typically occurs prior to the crisis. The time score, being able to simultaneously consider the temporal distribution of the whole traded volume over time as well as the spatial distribution of the transactions between players in each period, turns out to be a useful Early Warning Signal of the financial crisis.
WP2 Complex Systems and the Future of Macroeconomic and Monetary Integration in Europe
D2.1) Hommes, C., Massaro, D. and Salle, I., “Monetary and Fiscal Policy Design at the Zero Lower Bound: evidence from the lab”
The work presents a laboratory experiment with human subjects in which we elicit expectations in an otherwise fully controlled macroeconomic New Keynesian model. This experiment has two main goals. First, we aim at testing the adaptive learning predictions within this model. Second, and most importantly, we want to compare alternative monetary and fiscal policy designs and measure the effects of these policies on expectations, with a special focus on a situation at the zero-lower bound. This is a critical insight of our work, as expectations play a key role in the failure or success of policies, but measuring the so-called expectation channel in the real macroeconomy is a quite challenging task, as expectations are not directly observable and episodes of zero-lower bounds are rare.
D2.2) Rovira Kaltwasser, P., and Spelta, A., “Systemic Risk in the Interbank Market with Heterogeneous Agents”
In this deliverable the authors focus their attention on the money market. The article briefly describes the importance of macroprudential supervision to achieve financial stability. In the article different methods to rank financial institutions according to their systemic importance are discussed, including the one implemented under Basel III. The paper argues that so-called feedback centrality measures are better suited to measure systemic importance. A well-known feedback centrality measure (PageRank) is modified and its performance is compared against the Basel III method, using data form the electronic platform eMID. Based on the empirical results a Heterogeneous agent model of the money market is proposed.
D2.3) Seppecher, P., and Salle, I., “Deleveraging crises and Deep Recession: a behavioural approach”
The article presents an heterogeneous agent model in which the entire macroeconomic dynamics is driven by animal spirits: waves of pessimism endogenously drive the financial behaviour of agents, and result in debt-deflation type of crises. The paper then discusses a wide range of policies to smooth the impact of such crises in terms of output and employment loss, and highlights the potential stabilizing role of inflationary policies that would feed wages.
WP3 Short and Long Term Effects of Macroeconomic Policy: Lessons for the European Governance
D3.1) Creel, J., and Iacopetta, M., “Macroeconomic policy and potential growth”
This paper makes the case for investigating the gap between the potential and the actual level of production, and review contributions that point to the reduced power of standard policy instruments in presence of a prolonged gap. The paper also highlights difficulties in measuring where an economy stands relative to its potential.
D3.2) Vona, F., “Renewable Energy, Technology, Policy, Product Market Regulation”
This survey examines the determinants of renewable energy innovations. The paper focuses on three mechanisms highlighted by innovation models: 1. Policy inducement; 2. market structure and energy market regulation; 3. demand for environmental quality, affecting both policy and technology. The central problem of existing research in this field is to account for the dynamic interaction between policy and technology. Empirically, this interaction makes it difficult to establish a causality nexus going from former to the latter. From our reading of the literature, future research should examine more carefully factors affecting both policy and technology, such as the degree of competition in the energy market and the level of inequality, and the factors favouring the full diffusion of renewable energy technologies, e.g. human capital. The survey sheds light on the relationship between innovation in green technology and long term growth
D3.3) Saraceno, F., “Inequality and Growth: A Survey”
This paper examines how economists have dealt with the issue of inequality along the 20th century. After an initial pioneering phase, initiated by Simon Kuznets, the issue of income distribution virtually disappeared from the landscape, because of the advent of a "Traditional View" that limited the field of investigation of economics to efficiency in the allocation of resources, and rested on the intrinsic fairness of distribution implied by the equality of marginal product and factor remuneration. The crisis of 2007 has challenged this view, and highlighted how rent-seeking impacted income distribution and by this channel also macroeconomic performance. The paper concludes with a brief discussion of Thomas Piketty's “Le Capital au XXIème Siècle”.
D3.4) Amendola, M., and Gaffard, J.L. “Novelty, hysteresis, and growth”
Novelty and hysteresis are the main engines of economic evolution. However, they are also at the origin of co-ordination issues, as the consequences of any innovative choice can never be fully expected. Thus, there is no sense in analysing economic change as an intertemporal equilibrium with rational expectations. Not only growth and fluctuations cannot be dissociated, but there is no long-term trend that would be independent from what happens in the short term. The explicit consideration of essential evolutionary phenomena like novelty and hysteresis help a clearer understanding of some important episodes of contemporaneous economic history. The periods considered are characterized by crises and structural changes, and it is exactly when important disturbances affect the functioning of the economies that the relevant features of their behaviour come to the surface and hence the right interpretations of the phenomena taking place, with the adequate policy implications, can be formulated.
D3.5) Hubert, P., “A survey on the expectations formation process”
This paper provides a description of the full information rational expectations hypothesis and its alternatives: backward-looking models, sticky and noisy information models, adaptive learning models, and models of heterogeneous expectations. The paper presents the three different options to measure empirically expectations: surveys, financial markets measures and laboratory experiments, as well as the different research works about the determinants, the anchoring and the disagreement of inflation expectations.
D.3.6) Hubert, P., “Dataset on Inflation Expectations”
It presents the dataset – all series are publicly available – on inflation expectations, which will be used to analyze the role of forward-looking information in inflation expectation dynamics. The dataset focuses on quarterly US data for which survey forecasts from the Survey of Professional Forecasters (SPF) are available on a fixed-horizon and for a long time span: 1981Q3-2012Q3. The dataset is composed of a number of standard macroeconomic variables (GDP, unemployment, etc), together with real time data and forecasts.
D.3.7) Amendola, M., Gaffard, J.L. and Patriarca, F., “Inequality and Growth: The perverse relation between the productive and the non-productive assets of the economy”
The explosion of the global financial crisis in 2008 and its transmission to the real economies have been interpreted as calling for new kinds of regulation of the banking and the financial systems that would have allowed re-establishing a virtuous relation between the real and the financial sectors of the economy. In this paper we maintain the different view that the financial crisis and the ensuing real crisis have roots in the strong increase in incomes inequality that has been taking place in the Western world in the last thirty years or so. This has created an all-around aggregate demand deficiency crisis that has strongly reduced prospects and opportunities for investments in productive capacities and shifted resources toward other uses, thus feeding a perverse relation between the productive and the non-productive assets of the economy. The viability of the economic process is therefore hampered by excessive inequality. In this context the way out of the crisis is re-establishing the right distributive conditions: which cannot be obtained by a policy aimed at relieving the weight of private or public debts but calls for a redistribution through taxes on the incomes of non-productive sectors, according to a fine tuning that should prevent from excessive taxations transforming positive into negative effects.
D.3.8) Hubert, P., and Mirza, H., “Inflation Expectation Dynamics: The Role of Past, Present, and Forward-Looking Information”
Assuming that private agents need to learn inflation dynamics to form their inflation expectations and that they believe a hybrid New-Keynesian Phillips Curve (NKPC) is the true data generating process of inflation, the authors aim at establishing the role of forward-looking information in inflation expectation dynamics. They find that longer term expectations are crucial in shaping shorter-horizon expectations. Professional forecasters put a greater weight on forward-looking information – presumably capturing beliefs about the central bank inflation target or trend inflation – while lagged inflation remains significant. Finally, the NKPC-based inflation expectations model fits well for professional forecasts in contrast to consumers'.
D.3.9) Creel, J., Hubert, P., and Saraceno, F., “An Empirical Analysis of the Link between Public and Private Investment in four OECD countries”
Research has focused on the relationship between public investment and investment decisions by firms. In theory, public investment may have contradictory effects on private investment, either crowding-out or crowding-in effects. The authors disentangle these effects in different agnostic linear models, in which they assess, for four OECD countries, the existence and the sign of relationship between public and private investment, including a VAR model in which private investment, GDP growth, and interest rates interact and are affected by public investment and debt among other determinants. They further look at the possibly time-varying sign of the relationship between public and private investment and its state-contingence. In a third stage, they assess the possible international spillovers of public investment. This allows producing evidence on the impact of public investment on the economy, both in the short and in the long run, taking into account different types of interaction. They find a crowding-in effect in France, a weak crowding-out effect in the US, and no robust effect in the UK and Germany
D.3.10) Vona, F., “Building the knowledge base for a greener economy: skills, innovation and technology diffusion”.
This deliverable is an empirical investigation on the drivers of green investments and green employment. The ultimate goals of this investigation are: 1. to provide policy recommendations based on the findings of the investigation, 2. to provide insights for soundly modelling strategies. More specifically, estimates provided in this work can guide the construction of integrated assessments capable of providing accurate projections of both the climate and the long-term economic effects of environmental policies. The first part deals with the issue of endogenous technical change and on the effectiveness of targeted renewable energy policies and pro-market reforms in spurring innovation. The second part poses the simple and novel question of which skills are required to develop and operate green technologies. The original contribution here is to propose a data-driven methodology to identify green skills and to gauge the ways in which the demand for these competences responds to environmental regulation. The third part questions the usual theoretical dichotomy between green and brown technologies suggesting that brown technologies, especially fast-reacting fossil technologies, allow dealing with the intermittency of renewable energy technologies.
D.3.11) Cardaci, A., and Saraceno, F., “Inequality, Financialisation and Economic Crises: An Agent-Based Macro Model”
By means of a macroeconomic model with an agent-based household sector and a stock-flow consistent structure, the authors analyse the impact of rising income inequality on the likelihood of a crisis for different institutional settings. In particular, they study how economic crises emerge in the presence of different credit conditions and policy reactions to rising income disparities. The simulations show the relevance of the “degree” of financialisation of an economy. In fact, when inequality grows, a Scylla and Charybdis kind of dilemma seems to arise: on the one hand, low credit availability implies a drop in aggregate demand and output; on the other hand, relaxed credit constraints and a higher willingness to lend result in greater financial instability and a debt-driven boom and bust cycle. The authors also point out that policy reactions play a key role: a real structural reform that tackles inequality, by means of a more progressive tax system, actually compensates for the rise in income disparities thereby stabilising the economy. Results also show that this is a better solution compared to a stronger fiscal policy reaction, which, instead, only leads to a larger duration of the boom and bust cycle.
WP4 Limited asset market participation, credit frictions, and the interaction of fiscal and monetary policies in a currency union.
D4.1) Ferrara, M. and Tirelli, P., “Limited Asset Market Participation and Macro-dynamics in Medium-scale DSGE models. A perspective for the Eurozone”
This deliverable develops a medium scale DSGE model that incorporates Limited Asset Market Participation (LAMP) and studies interactions between the common monetary policy and the global fiscal stance of the Eurozone. Main results are summarized as follows. A relatively large body of empirical research has pointed out that inflation is particularly harmful for the poor, and high inflation and inequality are positively related. We show that this need not be the case when monetary and fiscal policies are optimally designed. In the Eurozone the fiscal implications of the ECB inflation target are purposely neglected to preserve Central Bank independence and where also justified by theoretical results about the optimality of zero inflation in DSGE models. In fact, we show that LAMP calls for positive and potentially non-negligible inflation rates. The underlying intuition is rather simple. Richer households consume more and hold more money, therefore they contribute more to inflation tax revenues that can be used to reduce the burden of direct taxes. As a result worked hours and the relative consumption of constrained households increase. In our full model the optimal inflation rate is 2.48% when the steady state public-debt-to-GDP ratio is 60%. For a 80% debt ratio optimal inflation is above 3%. We also obtain new results concerning optimal stabilization policies. In fact, LAMP generates a tradeoff between the efficiency motive to the use of debt, that calls for optimal consumption smoothing through the permanent adjustment of debt, and the equity motive, that induces the planner to front-load tax adjustment in order to limit the redistributive effects of permanent public debt variations. Turning to the analysis of simple rules, we show that, absent fiscal redistributive policies, LAMP causes a large increase in volatility following a monetary policy shock. By contrast, redistributive fiscal policies have a powerful dampening effect on volatility. We have also shown that redistributive policies targeting consumption inequality bring the dynamic performance of the model close to the one generated by representative agent DSGE models. This suggests an intriguing conjecture: these latter models might apparently succeed in matching business cycle facts when in the real economy the underlying fiscal policy regime compensates for the effects of LAMP, but their performance might not be robust to fiscal reforms that limit discretionary policies and/or reduce the effectiveness of automatic fiscal stabilizers. Finally, D4.1 shows that an appropriate mix of fiscal and monetary policies can substantially ease the strain typically associated to fiscal consolidations. The public expenditure reduction should be supported either by a temporary public transfers increase or by a tax rates fall that undershoots their new post consolidation values. Such policies have a strong stabilizing effect on the disposable income of rule-of-thumb consumers. This, in turn, stimulates demand and supports growth. As a result, the pace of debt reduction is substantially preserved because the revenues loss from lower tax rates (larger transfers) is almost entirely compensated for by an increase in the tax base. The result is even strengthened when the monetary authority targets both inflation and output gap. In this case the stronger interest rate fall is beneficial because it exploits the complementarity between the consumption of Ricardian households and the disposable income of rule-of-thumb consumers.
D4.2) Albonico, A., Paccagnini, A., Tirelli, P., “Estimating a DSGE model with Limited Asset Market Participation for the Euro Area”
We incorporate the Limited Asset Market Participation (LAMP) hypothesis in a medium scale closed economy DSGE model akin to Smets and Wouters (2005, 2007). The estimated model also shares the key features of the full macromodel presented in D4.1. We find that the share of LAMP households is sizable throughout the 1972-2012 sample, about 32%. In comparison with the representative-agent (RA) counterpart, the LAMP model is preferred on the grounds of both the Bayes factor and the average forecasting performance. As far as the predictive ability is concerned, the LAMP model has a relative advantage in explaining the dynamics of output, consumption, inflation, and investment during the recent financial crisis. Turning to the analysis of subsample periods, we obtain that the importance of LAMP declines in periods of increasing financial integration and optimism in the European financial markets, such as the apparently successful period that ended with the demise of the hard European Monetary System (EMS) in 1992-93. By contrast, the period following the EMS collapse and the 2007-financial crisis are associated with a surge in LAMP. To sharpen our analysis of the European Monetary Union (EMU) years, we then focus on the model estimated over the 1993-2012 period. The Bayes factor now provides even stronger support for the LAMP model. In the RA model, the risk premium shock is the main driver of output volatility while in LAMP model this role is played by the investment-specific shock. Our intuition is that RA models require risk premium shocks to match the consumption correlation with output because all households can smooth consumption. Instead, in the LAMP model investment specific shocks gain of importance because Non-Ricardian households introduce a Keynesian multiplier effect and raise the correlation between consumption and investments, The observed correlation between these two variables is in fact notoriously difficult to replicate in standard RA models. Finally, both the RA and LAMP models pinpoint the contractionary role of monetary policy shocks during the post-2007 years. According to the LAMP model, in this period consumption of Non-Ricardian households fell dramatically, but this outcome might have been avoided by a more aggressive policy stance.
D4.3) Albonico, A., Paccagnini, A., Tirelli, P., “In search of the Euro Area Fiscal Stance”
This deliverable investigates the role of fiscal and monetary policies over the aggregate European Monetary Union (EMU) business cycle, with a specific focus on fiscal policies. Relative to previous contributions concerned with EMU fiscal policies, we obtain a much larger posterior estimate for the share of non-Ricardian households, 53%. As a consequence, our estimates for public consumption and public transfer multipliers are also substantially larger. We could not identify a systematic reaction of tax rates and public expenditure variables to the Eurozone cyclical conditions. In other words, there seem to be no fiscal Taylor rule for the Eurozone as a whole. Historical output growth decomposition shows that fiscal shocks were substantially irrelevant before and after the financial crisis. Thus, our results convey the picture of a Euro area where the burden of implementing stabilization policies entirely falls on the European central Bank, whereas fiscal policies remain neutral in spite of their potentially important effects identified by the estimated multipliers. Finally, we are able to identify the shocks that caused the post-2007 increase in the public-consumption-to-GDP ratio. The increase in this ratio, typically regarded as an indicator of governments profligacy, was almost entirely determined by persistently adverse non-policy shocks.
D4.4) Cardani, R., and Tirelli, P., “The Optimal Policy Mix to Achieve Public Debt Consolidation”
Following the large increases in public-debt-to-GDP ratios observed in the aftermath of the 2007-financial crisis, fiscal consolidation, i.e. a reduction in the debt-to-GDP ratio, has come to the forefront of political debate and macroeconomic analyses (Blanchard et al., OECD 2012). The issue is particularly relevant for the Eurozone, where institutional arrangements such as the Maastricht Treaty and the Stability and Growth Pact (SGP) should oblige member states to pursue a 60% debt-to-GDP ratio. In fact the `corrective arm' of the SGP should be activated whenever public debt exceeds 60% of GDP and the excess debt is not reduced by 5% per year on average over three years (European Commission). In this paper we adopt a Ramsey-optimal approach to the identification of debt reduction strategies, that is, we identify the optimal policy mix for income taxes, public expenditures and inflation designed to achieve an exogenous debt reduction path as envisaged in the Stability and Growth Pact. There is a number of questions the paper is meant to address. The first one concern the optimal combination of public expenditure reductions and tax increases. The second one relates to the desirability of adjusting the inflation target during the debt consolidation period. Finally, the third question we address concerns redistributive effects of alternative policies. To capture these effects our model accounts for LAMP. We find that consolidations entail a persistent tax (public expenditure) increase (reduction). We also find that inflation follows a hump-shaped pattern, raising up to 2 percentage points above the pre-consolidation level. The consolidation is associated to a sharp reduction in investment and to a milder but persistent reduction in aggregate consumption. Output remains below the pre-consolidation level throughout the transition to the new debt-to-GDP ratios, and the consumption gains associated to the consolidation begin to materialize only after consolidation is achieved. We also identify important redistributive effects. Wealthy capital owners exploit the reduction in investment expenditures to stabilize their consumption. In addition, they reduce their labour supply in response to the increase in labour taxation. When monetary policy is not involved in the consolidation exercise and the central bank sticks to her inflation targeting strategy the fiscal contraction is inevitably stronger and the output loss much larger. Constrained households bear the brunt of this alternative policy strategy, suffering a deeper reduction in consumption. One key message is that an integrated package of fiscal and monetary policies may prove quite beneficial relative to a situation where the Central Bank is only concerned with inflation stability and the inflation target is defined as a ceiling, as in the Eurozone, where the ECB has repeatedly justified expansionary monetary policies on the grounds that inflation was below target. In fact the fiscal consolidation would require far more aggressive monetary policies, accepting that inflation overshoots the target for a prolonged period. As a matter of fact our results emphasize important shortcomings in the EMU system of economic governance, which utterly neglects the desirability of coordinated fiscal and monetary policy actions. In this context such coordination would entail a great deal of flexibility in the inflation target choice, based on the explicit recognition that accommodative monetary policies provide an essential contribution to limit the undesirable effects of fiscal consolidations.
D4.5) Albonico, A., Paccagnini, A., Tirelli, P., “PIIGS in the Euro Area. An Empirical DSGE Model”
Evaluating the foreseeable performance of the European Monetary Union (EMU) system of economic governance with respect to the task of fostering convergence and macroeconomic stability requires an understanding of the causes of the adverse gaps (growth, competiveness, unemployment) that characterize the Eurozone periphery. To this end D4.5 extends D4.2 incorporating core-periphery interactions in the empirical DSGE model of the Eurozone. This allows to understand regional drivers of the crisis in the core and in the periphery. According to our estimates, temporary disruptions to the risk-sharing mechanism that operates through the EMU financial market have potentially large contractionary effects in the periphery, entailing a persistent fall in investment, output and inflation. However, our variance and historical decompositions of output growth suggest that this shock had minimal effects. In addition, on the grounds of the marginal data density, the model specification accounting for permanent productivity shocks is strongly preferred to the alternative specifications, including the one based on financial market shocks. Historical decomposition of growth suggests that the output response to the 2008-2009 financial crisis, quantitatively similar in the two regions, was in fact caused by different types of shocks. The interest rate policy had common contractionary effects, but in the core region demand shocks were more important than in the PIIGS, where the main determinants were temporary and permanent supply shocks. The post-2010 period, when the PIIGS experienced slower recovery and then deeper recession, is mainly explained by adverse permanent technology shocks in the periphery and by demand shocks in the CORE region. Finally, public consumption shocks played a negligible role throughout the EMU years, implying that the post-2008 deterioration in fiscal indicators such as the public-consumption-to-GDP ratio was crucially driven by non-policy shocks. A crucial difference exists between the two regions is that in the CORE countries the deterioration of fiscal indicators was mainly caused by temporary shocks, whereas in the PIIGS region permanent shocks were a key driver, so that one cannot expect their reversal when the economy recovers.
These results bear important implications for the EMU system of economic governance, which is clearly inadequate, and for the evaluation of some recent proposals for governance reform, such as the Five Presidents Report (Junker, 2015), which appears as too timid. Under the pressure of the Euro-crisis, European countries have done great progress in improving fiscal budget monitoring and in the coordination of national budgets. The European Semester has better coordinated the budget procedures, a process completed with the Two Packs and its requirement for an early presentation to the Council and the Commission of budget proposals; the Six Packs have strengthened the mechanism of supervision and control by the Commission, reinforcing the role of the Commission; the macroeconomic imbalance indicators have moved surveillance from budget procedures to more general economic issues. The Fiscal compact had enshrined in the constitutions of the Euro countries the requirement of fiscal stability. Yet, the European construction remains largely incomplete. As the last decade of economic and political crisis shows, this kind of governance suffers the ability to respond to shocks, in particular the ones that hit asymmetrically the member states. Our study contributes to a large body of research supporting the view that crisis in the EMU periphery should not be related to undisciplined national fiscal policies. Our estimates point at permanent adverse productivity shocks as the main cause of the apparently divergent growth paths followed by the PIIGS countries relative to the rest of the Eurozone. By contrast, risk premium shocks, which might be related to expectations about government solvency, did not play an important role. Further, in our model only a subset of households have access to the integrated EMU capital markets. As a result, risk sharing is incomplete and a large fraction of households cannot efficiently smooth consumption, Thus, as pointed out in the "Blueprint for a deep and genuine EMU", progress is still needed towards developing stabilization tools and fiscal capacity. Developing a novel, stabilization-oriented fiscal framework is crucial for EMU sustainability in the future. We also draw some conclusions about the foreseeable consequences of the current system of economic governance in the current predicament, characterized by large debt-to-GDP ratios and cumulative competitiveness loss in the PIIGS, and a persistent reduction in the stock of physical capital throughout the Eurozone, also taking into account some recent proposals for governance reform, such as the Five Presidents Report.
Efficiency-enhancing reforms and fiscal discipline. European institutions systematically call for efficiency-enhancing reforms in the PIIGS region, but rules are enshrined for debt reduction and deficit control (European commission, 2015). PIIGS countries are therefore set to adopt politically difficult and divisive decisions, involving both contractionary fiscal shocks and reforms that entail redistributive effects in addition to increases in productivity. This daunting task is complicated by the presence of a non-negligible share of the population that cannot engage in consumption smoothing. EMU rules for the reduction of accumulated debt are rather strict, but there is some leverage to facilitate reforms (European Commission, 2014, 2015). Our results emphasize the importance of structural reform if PIIGS are to make up with competitiveness losses incurred during the crisis. Further, our results suggests that a large part in the deterioration of fiscal ratios was caused by the productivity slowdown. Therefore, return to "prudent" fiscal ratios should be sought through efficiency gains and not only through public expenditures compression. Our estimated model is not designed to fully investigate the scope for and the effects of reforms. However, in our framework we can get insights from the analysis of favourable price and markup shocks, which can be seen as the consequence of market deregulation. We find that the shocks have beneficial effects on PIIGS, raising consumption for all households and investment. Given these outcomes, it is also obvious that the effects on budget deficits are also beneficial, and even one-off liberalization schemes may have beneficial effects on public-debt-to-GDP ratios. Thus, such future benefits can justify temporary deviations from fiscal discipline, as envisaged in the Fiscal Compact, in order to gain the necessary support for politically divisive reforms.
Fiscal policy coordination and risk sharing. Concern for moral hazard problems has shaped the Fiscal Compact, imposing limitations to national discretionary fiscal policies, which cannot therefore provide adequate stimuli in the face of large shock. Given the documented weak external transmission effects of fiscal policy actions, the deficit ceilings envisaged in the Fiscal Compact also make it very difficult to provide adequate response to asymmetric shocks by means of coordinated fiscal policies. Thus further fiscal integration, i.e. provision of fiscal capacity at the central level, is required to provide the necessary amount of cyclical smoothing which should be entrusted to fiscal policies.
The Five Presidents' Report (Junker, 2015) emphasizes the importance of achieving a fiscal governance system that guarantees long run sustainability of public finances, allows the proper working of automatic stabilizers, determines an appropriate global fiscal stance for the Eurozone as a whole. According to the Report, fine tuning of the global fiscal policies should be avoided to focus on large macroeconomic shocks. However, the global fiscal policy should not be an instrument for crisis management, a role already performed by the European Stability Mechanism. As a first step, the Report points at the European Fund for Strategic Investments, which could pool of financing sources and investment projects to be tapped into the Eurozone according to business cycle conditions. On the grounds of our results, the Report certainly is a welcome attempt to address "The" unresolved issue in the design of fiscal policy governance, that is, lack of provisions for the EMU fiscal stance. However, there is still considerable ambiguity concerning the timing and scope for fiscal action. Large shocks are associated to crisis situations that require quick recognition of the problem, swift action and use of policy tools that have immediate impact on households' and firms' choices. A possible solution could be inspired to the "constrained discretion" regime that implicitly defines relationships between national governments and the European Commission when deviations from medium-term budgetary objective (MTO) are negotiated to react to exceptional circumstances or to facilitate reforming actions. As for the proposed fiscal tool, it seems more adequate to correct medium -and long- run imbalances rather than dealing with emergencies. In fact, finalizing investment projects inevitably requires time and, given the relatively large share of constrained households, policymakers should be wary of announcement effects about future investments. Furthermore, the Report ignores that risk sharing is incomplete and the poorer part of the population cannot efficiently smooth consumption. To put it bluntly, current discussions on fiscal policy governance in the Eurozone grossly underestimate the issues at stake. The present institutional mechanism was inadequate for the gravity of the crisis, and neither financial markets nor fiscal policies provide adequate insurance to households that were most affected. As a result, the Eurozone lost legitimacy and political consensus. In its present state, it is doubtful it could survive another crisis or even a persistent stagnation. Institutional change is inevitable and new stabilization tools must be designed. So far, EMU fiscal institutions were shaped by concern for moral hazard problems and for the risk that a fiscal capacity motivated as an insurance against transitory asymmetric shocks could degenerate into a permanent transfer system. If moral hazard problems require national deficit ceilings, then more fiscal space at the central level is necessary. Such additional fiscal space might incorporate a common unemployment insurance system and possibly some elements of a joint tax system, i.e. devolution of the power to levy a specific "European" tax and an expenditure stabilization mechanism (Bargain et al. 2013, Dolls et al. 2014). In a sense the key message is very simple: fiscal tools that are standard in federal states are necessary even in the Eurozone, where member states retain sovereignty. As pointed out in Van Rompuy (2011), it is now time to seek a new political balance between collective responsibility (or solidarity) and the responsibility of each individual country for the Eurozone common good
WP5 Early warning indicators within the EMU surveillance mechanism. A macro-finance approach.
D5.1) Morana, C., Baillie, R.T. Kapetanios, G., Papailias, F., “A New Approach for Large-Scale Macro-Financial Econometric Modeling”
A general framework for large scale macroeconometric modeling is introduced, i.e. the Fractionally Integrated Heteoskedastic Factor Vector Autoregressive model (FI-HF-VAR). The model is very general, accounting for different sources of persistence, i.e. stochastic (short or long memory) and deterministic (structural breaks). It can be thought of as bridging the F-VAR and (the most recent) G-VAR literature, as a weakly stationary cyclical representation is employed; yet, principal components analysis (PCA) is employed for the estimation of the latent factors. Modelling of comovement through common stochastic or deterministic factors is allowed for, as well as conditional heteroskedsticity in the common stochastic factors. The key issue of model specification and estimation are dealt with, as well as those related to asymptotic properties and Monte Carlo analysis. Overall, the proposed FI-HF-VAR model yields a unified framework for large-scale econometric modeling, allowing for accurate investigation of cross-sectional and time series features, independent of persistence and heteroskedasticity properties of the data, from comovement to impulse responses, forecast error variance and historical decomposition analysis. The modeling framework is then employed in the applied part or the research to the purpose of investigating macro-financial linkages, assessing and constructing early warning indicators.
D5.2) Karanasos, M., Dafnos, S., and Yfanti, S., “Theoretical Properties of Time Varying Models and their Use in the Construction of Forward Looking Indicators”
In the light of the well-known forward-looking properties of stock market returns and volatility for economic activity, a comprehensive and robust framework where the latter can be modeled and predicted is contributed. The authors introduce and utilize new theoretical results on time varying AR asymmetric GARCH models, unifying several recent econometric approaches to univariate time series modelling, which they also extend to account for basic properties of financial returns, likewise breaks in mean and/or volatility. Among the new theoretical results related to the estimation of time varying parameter models, the authors also provide the solution to their multi-step ahead prediction problem. Overall, the authors develop a general time varying parameter theory, encompassing a number of seemingly unrelated models and the authors identify common properties, which are basic to each of the particular application. The authors believe that time varying parameter models should take center stage in the forward-looking indicators literature, and this is why the authors develop a theory with rigorous foundations that can encompass a variety of dynamic systems, i.e. periodic and cyclical processes, and AR models which contain multiple structural breaks. Moreover, still with the purpose of accurately modeling (to accurately predicting) stock returns of our research also deals with the long memory feature in models the authors estimate to compute stock market volatility and dynamic correlations. As it is well documented that disentangling structural breaks and long memory is rather difficult, a comprehensive modeling approach is likely to better achieving the target of accurately forecasting future economic and financial scenarios. To the purpose the authors assess the joint contribution of long memory and structural breaks in variance to the modeling of contagion across key European and other international stock markets during the Asian and the recent Global financial crisis. The authors document time varying persistence in their corresponding conditional variances and show the existence of dynamic correlations as well as time varying shock and volatility spillovers across markets. The authors also document higher dynamic correlations of stock markets after a crisis event, which means increased contagion effects between markets. Moreover, during the recent Global financial crisis the correlations remained on a much higher level than during the Asian financial crisis.
D5.3) Morana, C., “Insights on the Global Macro-Finance Interface: Structural Sources of Risk Factors Fluctuations and the Cross-Section of Expected Stock Returns”
This study contributes to the investigation of the macro-finance interface by assessing the economic content and risk based interpretation of widely employed risk factors in the specification of empirical asset pricing models, i.e. Fama-French size and value, Carhart momentum, as well as the more recent Pastor-Stambaugh liquidity and Adrian-Etula-Muir leverage factors. Strong support for their risk based interpretation and forward-looking properties, encompassing evidence on cause, persistence and direction of the size, value and momentum effects, and new insights on the specification of systematic risk, are provided. The overall evidence is then strongly supportive for the potential use of risk factor information within an early warning system of macro-financial risk. We find that different sources of macroeconomic and financial risk are reflected by the various risk factors; namely, productivity and monetary policy stance shocks for SMB; labor market and term structure slope shocks for HML; aggregate demand and US terms of trade shocks for MOM. Also, procyclical size, value and momentum, as well as market-wide, leverage and stock market liquidity effects, appear to be mostly generated by demand-side macroeconomic shocks. Finally, clear-cut evidence of signaling properties of risk factors shocks for the economic outlook are detected. For instance, it is found that unanticipated higher profitability of small and value firms, i.e. positive size and value structural shocks signal favorable changes in the investment opportunity set and therefore an improved macroeconomic outlook. Moreover, an unanticipated increase in risk aversion, signals unfavorable changes in the investment opportunity set, and therefore a worsening in the macroeconomic outlook. Finally, we find that not all the structural sources of risk factor fluctuations might be priced by the market, and filtering out non-priced components improves the performance of empirical asset pricing models.
D5.4) Morana, C., “Macroeconomic and Financial Effects of Oil Price Shocks: Evidence for the Euro Area and the Global Economy”
The research yields innovative contributions to the oil price-macroeconomy, concerning its relevance, the presence of asymmetric responses, the sources of shocks, the role of the Great Moderation, the contribution of the 2008 oil price boom-bust episode to the Great Recession; the contribution of the post-2009 oil price dynamics to the weak and scattered recovery in the euro area, as well as the implications of the current oil price slump for deflation risk and economic growth in the euro area. We use both a global, large scale econometric model, and a local euro area model. The global model allows for unobserved factors, reflecting global macro-financial conditions, which is estimated using data for fifty OECD and emerging countries. We show that oil market shocks contribute more strongly to macro-financial fluctuations in the long- than in the short-term. Different explanations have been proposed in the literature for the apparent resilience of the global economy to the 2008 oil price boom-bust episode. We show that the phenomenon is accounted for by the combined effect of two mitigation factors, i.e. the endogenous contraction in real wages and the concurrent expansionary stabilization policies implemented to counteract the subprime financial crisis, in the face of a mostly macro-finance driven oil price shock. Turning to results for the euro area, we argue that the available empirical evidence, neglecting that ECB monetary policy is currently working at the zero lower-bound, is of no guidance concerning the prediction of the effects of the oil price slump. We find strong evidence of asymmetric real effects of oil price shocks for the euro area, with recessionary effects triggered not only by oil price hikes, but also by oil price slumps in some cases, likewise for the most recent episode. The latter oil price slump also contributes to raising deflationary risk, as well as financial distress. Concerning the ECB response to the oil price shocks, the observed increase in real money balances is consistent with the progressive deepening of the expansionary stance during 2014, eventually culminated with the introduction of Quantitative Easing in January 2015. As nominal interest rates are currently at the zero lower-bound, the real short term rate increase brought about by the deflationary effects of the oil price slump might then account for its recessionary bias observed so far. Overall, our findings have a key policy implication. In so far as Q.E. failed to generate inflationary expectations within the expected environment of soft oil prices, the case for a much more expansionary use of fiscal policy than in the past would become even more compelling, in order to counteract the deflationary and recessionary threats to the euro area.
D5.5) Morana, C., Conrad, C., Baillie, R.T. Zumbach, K.U. and Cho, D., “The US$/€ Exchange Rate: Structural Determinants and Properties”
In the first part of the research we specify and estimate an econometric model grounded on the asset pricing theory of exchange rate determination. In the latter theoretical framework current exchange rate fluctuations are determined by the entire path of current and future revisions in expectations about fundamentals. In this perspective, the research innovates the literature by conditioning on Fama-French and Charart risk factors, which directly measure changing market expectations about the economic outlook, as well as on new financial condition indexes and a large set of macroeconomic variables. The macro-finance augmented econometric model has a remarkable in-sample and out of sample predictive ability, largely outperforming a standard autoregressive specification neglecting macro-financial information. We also document a stable relationship between the US$/€-Charart momentum conditional correlation and the euro area business cycle, potentially exploitable also within a system of early warning indicators of macro-financial imbalances. In the second part of the research we analyze whether the communication of European politicians with respect to the sovereign debt crisis affects the US$/€ exchange rate as well as the European stock and bond markets. Results show that positive communication regarding the periphery countries or the EA as a whole leads to a significant appreciation of the US$/€. Further, the stock markets of the core European countries (Germany, France and Belgium) as well as the periphery countries (Greece, Ireland, Italy, Portugal and Spain) instantaneously increase in response to positive communication regarding the stance of the economy in the periphery countries or positive communication with respect to the EA as a whole. Finally, in the third part of the research, we further explore the role of nonlinearity in the determination of the US$/€ exchange rate. In particular, the research focuses on the so called forward premium anomaly and the apparent failure of the theory of Uncovered Interest Rate Parity for the US$/€ exchange rate, as well as for other seven different currencies considered for comparison. Our results clearly indicate the futility of trying to classify forward premium series as being stable, time invariant processes. Rather, the evidence strongly suggests that persistence substantially changes across regimes. Moreover, we also find evidence of unstable anomaly over time, both in magnitude and sign, actually even showing a reversal for the US$/€ exchange rate, after the financial crisis of 2008.
D5.6) Conrad, C. and Hartmann, M., “Cross-sectional evidence on the relation between macroeconomic conditions, stock market volatility, monetary policy, and low-frequency inflation uncertainty”
We examine how financial market volatility and the interaction between monetary policy and macroeconomic conditions affect inflation uncertainty in the long-term. Moreover, the direct and indirect influences of stock market volatility on inflation and output growth are examined. The unobservable inflation uncertainty is quantified by means of the slowly evolving long-term variance component of inflation in the framework of the Spline-GARCH model (Engle and Rangel, 2008). For a cross-section of 13 developed economies, we document that long-term inflation uncertainty is high if central bank governors are perceived as less inflation-averse, if the conduct of monetary policy is ad-hoc rather than rule-based and during times of heightened volatility in financial markets. Moreover, we find that financial market volatility has a direct effect on both the level of inflation and output growth and an indirect influence on these variables which is transmitted through its relation to low-frequency inflation uncertainty.
D5.7) Conrad, C., and Loch, K., “Macroeconomic expectations and the time-varying stock-bond correlation: international evidence”
The article explains the time-varying correlation between stock and bond returns by survey expectations on the future macroeconomic development. A modified DCC-MIDAS specification allows to relate daily changes in the correlation to monthly expectations data. For a cross-section of countries, the authors show that the stock-bond correlation is mainly determined by expectations regarding the future course of monetary policy as well as stress in financial markets. From a European perspective, the asymmetry in the response of the stock-bond correlation to heightened stock market volatility in the UK, Germany and France on the one hand, and Italy on the other hand is of high policy relevance.
D5.8) Morana, C., Karanasos, M., Baiardi, D., Koutroumpis, P., Karavias, Y., and Arakelian, V., “Nominal and Real Convergence in the Euro Area”
The research yields innovative contributions along several perspective. For instance, concerning within country real income convergence, we innovate by introducing a new specification of the Kuznets curve (KC), where turning point per capita income is conditioned to the level of financial development. We then use the latter model to study euro area (EA) income distribution inequality since the mid-1980s, with a special focus on the subprime cum sovereign debt financial crisis period. We find strong empirical evidence in favor of a steady-state financial Kuznets curve (FKC) for the EA and of ongoing convergence across EA members towards a common per capita income turning point level, also resilient to the financial crisis. By means of a counterfactual analysis, we then find a sizable worsening in income inequality not only for the countries that were most severely hit by crisis, i.e. Cyprus, Ireland, Spain, Portugal, Greece and Italy, but also for core EA countries, Austria, Belgium, Luxemburg, Finland, France and Germany, which were little affected by the sovereign debt crisis. Concerning nominal convergence, we study the convergence properties of EA inflation rates since the early 1980s. By applying recently developed panel unit root/stationarity tests we are able to accept the stationarity/convergence hypothesis. This means that some differentials are stationary and therefore there might be clubs of countries which have been in the process of converging absolutely or relatively. We detect three absolute convergence clubs in the pre-euro period, which comprise early accession countries. In particular, Luxemburg clusters with Austria and Belgium, while a second sub-group includes Germany and France and the third The Netherlands and Finland. We also detect two separate clusters of early accession countries in the post-1997 period: a sub-group with Germany, Austria, Belgium and Luxemburg, and one with France and Finland. For the rest of the countries/cases we find evidence of divergent behaviour.
D5.9) Morana, C., “Divided we Fall: Early Warning Signals of Macro-Financial Distress in the Euro Area”
The article proposes a new framework for the setting up of an Early Warning Indicator System for the euro area, which directly includes, among other indicators, risk factors and measures of real, nominal and financial divergence. In particular, the author develops a measure of stock market uncertainty/risk aversion based on the cross-sectional dispersion of stock market returns; the latter, by embedding both cross-sectional and temporal dimensions is likely to provide a more accurate measurement than indicators exploiting the temporal dimension only. The analysis is also innovative in terms of the econometric methodology employed, as it is performed by means of a time-varying parameter model for the euro area, cast within the framework of the semiparametric dynamic conditional correlation model (SPDCC) of Morana (2015a). The author provides clear-cut evidence of leading indicator properties of the proposed stock market uncertainty/risk aversion measure for the episodes of financial and economic distress that have hit the euro area since 1999. In particular, higher stock market divergence/uncertainty might accurately signal a worsening in the expected economic outlook, by pointing to higher financial instability, lower stock returns (financial busts) and economic growth (recessions); by rising bond market divergence, the latter signal would also be reflected in a positive momentum factor, consistent with the stronger resilience of firms with good fundamentals during recessions. A direct linkage of stock market divergence with momentum is also detected; the latter would however hold only when the economic downturn is expected to be sizable.
D5.10) Bagliano, F.C. and Morana, C., “It ain’t over till it’s over: A global perspective on the Great Moderation-Great Recession interconnection and transition to the euro area sovereign debt crisis”
A large-scale model of the global economy is used to investigate the determinants of the Great Moderation and the transition to the Great Recession (1986-2010) and euro area sovereign debt crisis. Beside the global economy perspective, the model presents the novel feature of a broad range of included financial variables and risk factor measures. The results point to the relevance of various mechanisms related to the global monetary policy stance (Great Deviation), financial institutions’ risk taking behavior (Great Leveraging) and global imbalances (savings glut), in shaping aggregate fluctuations. The paper finally contributes to the literature on early warning indicators, assessing the information content of risk factor innovations for the prediction of real activity dynamics during the Great Recession and the early phase of the euro area sovereign debt crisis.
WP6 Towards a revised economic governance: in search of stability
D6.15) Villa, M. and Villafranca, A., “New policies and institutions to escape the fate of recurring crises”
Building on RAstaNEWS research, the deliverable draws substantive policy recommendations for the Eurozone as a whole. While the EU (and the EMU in particular) has been reformed to shelter the currency union from the likelihood and impact of future crises, the EMU is still not an optimal currency area. Within and across countries, asymmetries and disequilibria abound, demanding constant monitoring and extensive policy action. RAstaNEWS partners believe that, in the short term, it would be possible and advisable to support the ongoing nascent (but still tentative) Eurozone economic recovery through bolder action on both the monetary and fiscal side. At the same time, the EMU governance should be reformed by making fiscal rules more flexible in times of crisis and more rigid in good times (in order to force Member States to undertake the necessary adjustments to safeguard their economies from future idiosyncratic crises). Decision making processes should be depoliticized, especially with regards the Excessive Deficit Procedure, the Macroeconomic Imbalance Procedure, and ECB monetary policy decisions. Moreover, a coherent push in favor of public investment would be advisable both for those core countries that tend to focus on fiscal discipline too early in the economic recovery, and for periphery countries that need to support their own recovery and close the competitiveness gap with the rest of the Eurozone. The ECB should be allowed to undertake bolder measures, which would support the domestic recovery, bring inflation closer to the official target, and increase the external competitiveness of the EMU by indirectly lowering the real effective exchange rate. Meanwhile, much closer coordination of national fiscal policies would be strongly advised. In the medium run, the preferred outcome should be to enforce rigid budgetary rules for each Member State, while at the same time making discretionary fiscal spending more and more supranational (and flexible). This would allow for collective decisions on fiscal readjustments for the whole of the EMU, while substantively decreasing moral hazard in the single Eurozone economies and, possibly, increase a sense of common destiny in each Member State and its national policymakers.
D6.16) Villa, M. and Villafranca, A., “Monetary Policy and Prudential Regulation: In Search of a New Normal”
This deliverable focuses on: proposals to reform EMU macro-prudential policies, improving the functioning of the Banking Union as a way to enhance convergence of economic conditions and a smoothing of the business cycle, all the while serving as prudential tools at the EMU level that shelter the monetary union from a renewed negative feedback loop of financial crises and inter-country contagion. While recognizing that monetary policy and prudential regulation are characterized by intertwined transmission mechanisms and reciprocal spillovers, we advocate an operational separation between the two. The rationale for this separation is essentially the fact that the sign, size and time dimension of the effects of changes in monetary policy (e.g. a change in the policy rate) on financial institutions are too uncertain to justify the assignment of a financial stability objective to monetary policy. The assessment is more nuanced as to the effects of prudential policies on the output and inflation gaps. Adequate macro-prudential policies can often (but not always) improve the trade-off faced by monetary policy, enlarging its policy space. However, the goal of macro-stabilization cannot be reasonably assigned to prudential policy. In the end, therefore, we would (i) stick to the dual mandate for monetary policy, and (ii) assign a financial stability objective to prudential policies. Operational separation implies that interest rate setting should be employed to preserve monetary stability, while capital and liquidity requirements should be used to preserve financial stability. We also advocate the centralization of both monetary and prudential policy to a single institution: the central bank. In this way, the central bank can exploit the obvious synergies between the two spheres mentioned above. Going deeper into the institutional arrangement of prudential policy, we emphasize the limits of the current situation where macro-prudential supervisory decisions are delegated to the national authorities, with the ESRB and the ECB playing a quite limited (mainly advisory) role. The institutional design should be streamlined and centralized. As far as the euro area is concerned, it seems reasonable to attribute the responsibility of macro-prudential supervision to the SSM. This is an issue that needs to be further analysed and discussed by policy-makers.
D6.16) Villa, M. and Villafranca, A., “The Green Book”
This Green Book collects final policy recommendations that originated from the research of the RAstaNEWS consortium. The Green Book was presented during the Final Dissemination Conference and amended taking into account feedback from policy makers, scholars and experts. In the years following the launch of the RAstaNEWS project in early 2013, the Eurozone crisis seems to have somewhat subsided. However, the recent Greek crisis and the negotiations leading to the country’s third bailout program in August 2015 reminded us of the effects that unsustainable debt levels and dangerous macroeconomic imbalances can still have on the stability and resilience of the Eurozone.
Meanwhile, economic growth levels in the Eurozone are still a far cry from the relatively healthy recovery recorded in other advanced economies, above all the United States. Recent data suggests that the euro area may have grown by 1.5% in 2015, markedly lower than the US economy (2.5%; IMF 2016). Such sluggish growth prospects have endured since the end of the Great Financial Crisis, so much so that euro area real GDP is still below the pre-crisis peak, while the US exceeded it already in 2010 and is now almost 10% above those levels. Stymied growth prospects have translated in much lower job-growth rates and very low inflation. At the policy level, EU Institutions and Eurozone national governments have painstakingly taken a number of important steps in the direction of reforming EMU policies and the overall EMU governance framework, often at the cost of long debates and deep political divisions. However, EU Institutions have mainly focused on fiscal policy sustainability, over which they enjoy greater latitude since the formalization of debt and deficit rules within the Stability and Growth Pact (SGP).
In light of the persistent need to rebalance the Eurozone, the challenge for the RAstaNEWS consortium has been to single out what is still missing from the EMU policy framework – something the consortium has consistently referred to as “holes in the cheese” – in order to spot weak points and propose desirable policy solutions. Drawing from current ongoing RAstaNEWS research, the consortium partners present here a multi-pronged strategy to reform EMU macroeconomic policies and avoid the fate of recurring crises. In the short-to-medium term, the strategy includes the following elements:
1. A revamped Juncker plan;
2. Much closer coordination of national fiscal policies at the supranational level, making room for the possibility to define a euro-area fiscal stance;
3. An even more accommodating monetary policy, implemented until macroeconomic conditions change significantly in the Eurozone periphery;
4. A true euro-area wide implementation of macro-prudential policies, which should also account for potential contagion effects between different financial institutions.
The rationale for such expansionary policies should be cast in the perspective of the “jobless growth” phenomenon, a persistent feature of the global business cycle. This means that unconventional monetary policy should last sufficiently long to allow for the dissipation of recessionary and deflationary trends not only at the euro area level, but also at the Member State level, in order to allow for the unemployment rate to come down considerably, and that an important role could and should be played by fiscal policies. In this regard, it is also crucial to reverse cumulated competitiveness imbalances as soon as possible during the correction and stabilization phases. In the longer run, RAstaNEWS partners consider that there is a need to set out a new course for EMU policies and governance. Such new course should have the following objectives as priorities:
1. A full, conscious shift from fiscal to full macroeconomic surveillance with a renewed emphasis on growth enhancing reforms. It should also be acknowledged that faster nominal income growth is crucial to obtain fiscal consolidation that are both sustainable and socially acceptable. In this regard, it would be crucial to re-evaluate the “contractual” dimension of intra-EMU bargaining, as proposed in the 2012 Van Rompuy report, whereby EMU member states may be awarded some fiscal room to support growth in the short term by binding themselves to enact detailed structural reforms within a certain time horizon. As it is right now, the concession of flexibility by the Commission takes place within a sanctions-waiver, ex post scheme. Establishing the flexibility allowance more firmly would allow to greatly reduce short-term uncertainty that risks stifling the effects of flexibility on aggregate demand;
2. The creation of a proper euro-area fiscal capacity. The EU budget currently amounts to around 1% of GDP and 2% of total member state governments’ expenditure. This is clearly insufficient in order to give the EU and the euro area sufficient room to agree upon and enact credible countercyclical policies;
3. The setting of a differentiated, politically-consensual, EMU-wide fiscal stance, with a Eurogroup that is tasked with deciding upon what the EMU’s overall fiscal stance should be, while also agreeing upon temporary relaxations (or strengthening) of Member States’ fiscal positions, according to country-specific cyclical conditions;
4. A “depoliticized” ECB and strengthened macro-prudential regulation at both the EMU and EU level
Potential Impact:
RASTANEWS intends to enhance knowledge base, at both theoretical and applied level, on many aspects of the future of macro-economic and monetary integration in Europe, paving the way to a revised governance of the EMU, and in the wake of the debt crisis. The results are meant to contribute to reshape the way in which these issues and other related topics are addressed in the literature.
At a normative level, RASTANEWS undertakes pioneering research at the frontiers of new thinking in economics on macro-risk assessment, new early warning systems and links to stabilization policies. In our view, these activities are key elements in securing progress towards a stable monetary union. Once more, we wish to emphasize here that in our view monetary policy in the near future should respond to a set of indicators and policy objectives and openly interact with the fiscal policymakers in a way which would have been unthinkable in the pre-crisis era. To this aim, our research raises big questions with a view to avoiding a future crisis and prompting sustainable growth in the framework of a stable EU financial system. Clearly, this is no modest agenda, as the final evaluation of RASTANEWS’s impact will stand or fall by its ability to contribute to European theoretical understanding and policy practice towards a stable and successful EMU.
RASTANEWS considers its ability to disseminate its findings to be an essential component for the overall success of the project. The development of an extensive and targeted dissemination strategy is key to accomplish the above mentioned task. The spotlight is not only on the dissemination of RASTANEWS’s scholarly work and its more applied, policy focused work to the scholarly community, but also to the wider public and private sector policy communities particularly interested in RASTANEWS’s research. In addition, RASTANEWS researchers provide both analysis and policy recommendations targeted to civil servants and political leaders, both at the EU and national levels.
What is crucial in our view is to put in place a sufficiently wide range of beyond state-of-the-art research and high level dissemination activities so as to ensure that if not all are successful then at least some of the initiatives find their target publics. The other key issue is to allow research consortium will have the opportunity to share views and present/discuss research findings and policy recommendation with target-publics. To this aim, it is necessary for target-publics to feel some sense of ownership of the project. RASTANEWS has put in place a range of activities which genuinely wishes to achieve this result. Indeed, RASTANEWS has constantly tried to have a significant impact on decision-making processes through a dissemination strategy whose main components are:
- engage and raise awareness through a preliminary mapping of all the stakeholders to be involved (also as target-groups) in RASTANEWS ;
- synchronize activities with the main ongoing decisions taken at the EU level and be coherent with the most relevant EU policies in the fields and period covered by this project;
- translate research analysis/findings in policy recommendations;
- design an overall economic governance of the EMU and EU as a whole
RASTANEWS researchers have ensured that much of the activities were not only of a high scientific quality but also provided useful insights to the wider public, and significant policy recommendations to civil servants and political leaders. In order to do so, dissemination activities have been targeted not only at institutional actors at various levels (especially the EU Commission and the ECB) but also at non-institutional actors (managers, journalists, experts etc.).
More specifically, the RASTANEWS dissemination strategy aimed at communicating and engaging interactively with five target groups: 1) policymakers, 2) academics, 3) media, 4) business, and 5) the general public. Our overall aims for engaging with these groups were to:
- Create greater awareness of the aims and results of the RASTANEWS project;
- Improve understanding of how the RASTANEWS approach can contribute to insights into macro-risk assessment, stabilization policies and early warning systems;
- Increase involvement of key actors in the RASTANEWS research program and application of its results;
- Get feedback and constructive critiques on the RASTANEWS program;
- Create the basis for long-term impact on the policymaking community, in support of the FP7 grant objectives;
The following sections provide further details on these objectives and our channels/tools for achieving them. Specific attention is devoted to the character, quantity and timing of different communication activities specifically designed for the above-mentioned target groups.
--Objectives--
Dissemination activities commenced at the start of the project and were be carried out during its entire duration. They aimed specifically at:
a) engaging policymakers, particularly from central banks, EU Institutions and finance/economic ministries, in the design of the RASTANEWS models, reviewing and criticizing the work, and in proof-of-concept applications to policy design;
b) working with private sector institutions who can contribute both expertise and experience to the substantive issues of the project (e.g. banks and other private financial Institutions);
c) disseminating the results of the project within the academic community to build support for further research, build an on-going community around this work, and to broaden the impact of the project on economics as a field and its application to improving policymaking;
d) engaging the broader public, both directly (e.g. the Annual Conferences) as well as through the media (including the website, the newsletter, social networks etc.).
--Target groups--
Dissemination was carried out using a variety of channels and tools adapted to different target audiences. In this respect all the consortium partners concentrated on the users’ and stakeholders’ needs and their preferred communication tools. An important outcome we strived for in the project was to create partnerships with key institutions that could help further develop and propagate RASTANEWS after project completion.
We worked with the Directorate General for Economic and Financial Affairs (DG ECFIN) of the Commission, the ECB, national central banks/Ministries of finance to provide a contribution to their modelling and policy support tools.
The target audience consisted of 5 main target groups:
- Policymakers: senior principal decision makers, as well as the staff and advisors that support them. Key institutions: European central banks, EU Institutions, finance and economic ministries.
A number of such institutions have already agreed to engage in the project. The International Advisory Board (IAB) has been a primary vehicle for creating a community of interest in the policymaker and in the scientific community. The ambition for the senior policymakers in the IAB is to see RASTANEWS as representing a new way of understanding the economy and supporting policy decisions. We expect that many IAB members will continue to serve as ambassadors for the project after it completes, working with members of the RASTANEWS team to create on-going engagement with senior policymakers.
The RASTANEWS team also sought to build broad policymaker interest through events, publications, and a media strategy that will lead to continued engagement after completion of the project
- Academics (from the economics, finance, and policy research communities, as well as from the complexity science and computer science communities). The academic members of RASTANEWS have long-standing research interests in the topics covered by RASTANEWS and will likely continue to pursue those interests and utilize the model, data, and findings of RASTANEWS. These individuals publish widely, are regular lecturers and speakers, and are well networked in the academic community – including those institutions and working groups with specific interests in RASTANEWS topics.
- Business (Financial sector private institutions) have been asked to contribute to the research through suggestions and feedbacks on the preliminary research findings of RASTANEWS, but, above all, through comments on the policy recommendations provided by RASTANEWS.
- Media (including traditional, electronic, and social) have been a key channel for shaping opinion leadership and general public opinion. While there is limited interest in technical academic topics, there is a high level of interest in new insights into the financial and euro crisis and an appetite to debate possible solutions. Through the media we hoped to show the relevance of this project to those debates and to improving policymaking in a way that betters peoples’ lives.
- Civil society and the general public. Although the project’s subject matter is fairly technical, there is a very strong interest in civil society and the general public around the crisis, instabilities in the financial system, and avenues for creating a more robust, economically productive, and fairer system.
Target-groups and, more generally, institutional and non-institutional actors were identified through a preliminary Political Context Analysis (PCA) which will allow to identify stakeholders and key policy-makers (the most relevant institutional and non-institutional actors, including individuals and groups at both the EU and national levels) who can influence or affect policy processes.
In addition, RASTANEWS’ activities were synchronized through a Functional Calendar (FC) which took into account the main steps of the European policy processes (agenda-setting, decision-making, implementation and evaluation) for the period covered by the project; dissemination activities were then developed, as much as possible, to cohere with this Calendar and to enhance the potential for the impact of the dissemination. The Functional calendar allowed partners to synchronize as much as possible research and dissemination related activities within the RASTANEWS network with the main political and economic events taking place in the Eurozone. In order to maximize relevance and the probability that high-level officials would take part in RASTANEWS dissemination activities, ISPI also took constant care to identify event dates that would match the agenda of relevant EU and national stakeholders. The Functional calendar also allowed RASTANEWS partners to decide upon which content to prioritize first in terms of policy outcomes and recommendations. Indeed, coming just a few months after the ECB’s announcement of its quantitative easing programme and the publication of the Five Presidents’ Report, the First Annual Report focused on expansionary monetary policies and the possibility of a step-by-step establishment of a Eurozone fiscal capacity. The Second Annual report, timed with ongoing discussions on completing the Banking Union, focused on macro-prudential policies and on ways to make financial institutions more resilient to shocks.
A particular feature of RASTANEWS was to organize ‘Executive Briefings (EBs), i.e. meetings with the appropriate senior officials in Brussels and at the major EU capitals in order to secure a formal agreement from them to participate in these innovative feedback-input processes.
All these actions aimed at assuring the highest level of visibility and impact to RASTANEWS activities. In particular, building on the results of the Political Context Analysis and Functional Calendar, a multidimensional dissemination strategy was pursued involving a range of means (Events and Publications) and a number of activities (Conferences, Workshops, On-line Publications etc.) depending on the specific target group RASTANEWS intended to reach.
--Channels/Tools--
Work package 7 was entirely dedicated to impact and dissemination. In addition to PCA and FC, it had 4 key components:
a) Website and Newsletter
RASTANEWS Website hosted all the information about the consortium and listed all the research and dissemination activities (including video-recording of the main RASTANEWS events). The electronic Newsletter ‘RASTANEWS’ has been issued four times per year, informing on all the initiatives promoted by RASTANEWS partners and circulating preliminary research outcomes. The Newsletter was sent to the stakeholder database built upon PCA and to the electronic mailing lists of the Partners (over 30,000 contacts all over Europe It was also available for download on the Website of the project.
b) Scholarly and Policy Focused Publications
Our research products concentrated less on edited collections and more on high quality peer-reviewed work in international journals . Our ‘Policy Focused Publications’ were a series of electronic policy briefs, circulated to the available mailing list. These products translated preliminary research findings in policy recommendations
c) Annual Dissemination Conferences and Executive Briefings
The dissemination of results via the active participation of RASTANEWS scholars in the annual conventions of the disciplines represented in the project (mainly economics and politics) have been complemented by attendance at the 3 Annual Conferences: each event brought together project partners with 6-7 stakeholders from the EU, including outstanding representatives of the political and economic communities, especially thanks to the great expertise and networks by ISPI and PISM (two of the most prestigious think-tanks in Europe ). These events –held in Milan, Brussels and Warsaw – were meant to raise awareness, promote debate and disseminate preliminary research outcomes. The video of these events is also available for download on the project website, and the link for the download was also included in the Newsletter in order to involve a broader audience. The three Annual Conferences were the biggest RASTANEWS public events, gathering outstanding international personalities and scholars (such as the Nobel Prize in Economics Prof. Michael Spence and the former President of the European Commission Romano Prodi) and European and national policy makers and civil servants (among others: an ECB Vice-President, two Italian Ministers of Economy and Finance, a Member of the European Parliament, and representatives from the European Commission’s DG ECFIN, the European Stability Mechanism, and the Single Resolution Board). Speakers were invited to discuss RASTANEWS research – especially policy outcomes and recommendations – and the current predicament of the European economy, and to reflect upon reform proposals on the Eurozone economic governance. The Annual Conferences were live streamed and their recordings remain available online. On the sidelines of these Conferences, Scientific Workshops allowed experts and scholars to join RASTANEWS partners in order to discuss the network’s preliminary and final research findings, all the while allowing for a fruitful debate and cross-fertilization between different research fields. Another event – the conference ‘EU Economic Governance in the Making – the CEE Perspectives’ – was organized by PISM in Warsaw and brought together high-ranking personalities, scholars and experts to discuss on the specific role and contribution of Central and Eastern Europe (CEE) countries to the EMU In addition, a special edition of the PISM Quarterly on “Eurozone crisis and the Visegrad countries experience: performance and perception” has been issued, including contributions from scholars/experts in Poland, the Czech Republic, Slovakia and Hungary.
The audience of the 2 ‘Executive Briefings’ included at least 30 policy-makers at both national and international levels and other stakeholders, including business and civil society actors (preliminarily identified thank to PCA). These meetings had an informal consultation character and were relevant in sharing both research results and their practical implications. In particular RASTANEWS partners had the opportunity to meet about 25 stakeholders (also identified in the Political Context Analysis), present and discuss research outcomes with a policy-oriented focus. In addition, it is also important to note that many RASTANEWS partners organized scientific workshops/seminars in their to discuss/present preliminary scientific findings with other scholars/experts.
d) Annual Reports and ‘Green Book’
The Consortium provided 3 Annual Reports which will allow to list the activities promoted by RASTANEWS partners every year and the most significant scientific findings. These Reports will be circulated to the scientific community in Europe and abroad. Users will also be able to download them from the official project Website.
The ‘Green Book’ was the third and final report of the entire project. It plays a central role in RASTANEWS as it translates all the main scientific findings of the project in concrete policy recommendations.
--Most significant results. --
Throughout the three years of the project, dissemination and communication activities allowed RASTANEWS partners to reach a very wide range of stakeholders. Among the latter were EU and national policymakers and civil servants, scholars, experts, and the public at large. The three Annual Conferences were attended by an average of 240 people each, while Executive Briefings were attended by over 30 participants each. This allowed for fruitful discussions among policy experts and for a broad dissemination of RASTANEWS scientific findings and policy recommendation (especially in the case of the Final RASTANEWS Green Book).
The Website and the Newsletter allowed people from outside the network to stay informed about the project’s activities; the RASTANEWS newsletter, in particular, kept people engaged throughout the whole length of the project, reaching over 40,000 contacts for each issue.
All events were timed so as to maximize attendance of policy makers, civil servants and the public at large. The Calendar served to ensure that the topics discussed at events were highly relevant to stakeholders engaged in the reform of the Eurozone economic governance. The involvement of important scholars in economics from outside the network also allowed RASTANEWS partners to disseminate further their research findings.
Finally, the internal peer-review process was not only crucial to safeguard the quality of the network’s scientific output, but also served as a first foray through which preliminary research findings could be disseminated to high-level scholars.
List of Websites:
http://rastanews.eu/