NEW ECONOMIC MODEL OF THE EUROZONE SUGGESTS THAT IT CAN BE
SUCCESSUL
Countries in the eurozone can become more closely aligned and the single currency
can work to their benefit, according to a new way of looking at the eurozone economy
outlined by Marcus Miller and colleagues in a study to be presented at the Royal
Economic Society’s 2012 annual conference.
The study presents a simplified model of the European economy in a bid to make its
problems easier to understand. It shows that integration between a highly indebted
region (such as Southern Europe) and a lower-debt region (such as Northern Europe)
can be successful in the long run, leading the economies to become closer aligned,
especially if the North saves too much and the South borrows too much.
But the authors add that giving highly indebted Southern member countries access to
international capital markets is a ‘double-edged sword’. It gives them the chance to
borrow money from countries other than the Northern countries, allowing them to take
on more debt than it can sustain. This, they argue, has led to the current debt crisis.
The rules of the eurozone explicitly exclude capital market intervention to prevent big
debt expansion by the South. Nevertheless, the emergence of sovereign spreads can
have much the same effect – where a country like Greece, facing spreads of over 20%,
is effectively unable to access European capital markets for years to come.
More…
How much sovereign debt can a country sustain on its own? And what happens when
capital markets become integrated? This research shows first how the debt capacity of
a closed economy is limited by the need to maintain its capital stock. Then how this limit
can be raised by international capital market integration – essentially by transferring
some of the debt to partner countries who have issued less.
It is shown specifically how integration between a highly-indebted region (like Southern
Europe) and a lower-debt region (like Northern Europe) leads to long-run ‘convergence’
in output, interest rates and capital; and how both regions stand to benefit – especially if
the North was prone to over-saving while the South was prone to under-saving. A
fascinating finding is that, in the end, the North actually winds up with a higher debt-tooutput ratio than the South.
What if the differing debt endowments reflect different – and persistent – policy
preferences? In that case, giving highly-indebted Southern member countries access to
international capital markets in a eurozone is a double-edged sword: it increases the
maximum sustainable government debt in those countries, but it opens up the
possibility of further debt issuance on their part. This can lead to policy conflict and a
debt crisis of the type recently observed.
To avoid a repeat, the eurozone is looking to tightening external controls on national
fiscal policies: but stripping local sovereigns of their fiscal powers is a risky step at
times of low aggregate demand and financial fragility. In designing rules for the fiscal
authority – as in choosing targets for central bank monetary policy – it is vital that the
aim to check ‘free-riding’ be tempered by a realistic appreciation of shocks to which the
economy is subject.
The framework used to discuss these issues is the ‘overlapping generations’ model of
Peter Diamond, where it is the young who have to pay the taxes needed to finance the
burden of sovereign debt. To make things stark and simple, the researchers assume
further that in isolation the South issues its maximum sustainable debt, while the North
issues none. Thus, after capital market integration, more than half Southern debt is
transferred to the North.
The logic behind this result is that while national output, interest rates and capital stocks
converge, national incomes will differ as interest payments follow debt across national
frontiers. Being better off as the recipient of the interest income, the North will hold a
greater stock of bonds.
The gains to integration are more pronounced if the high-saving region was
‘dynamically inefficient’ in isolation – accumulating so much capital that its rate of return
falls below the rate of depreciation – while the heavily-indebted region faced the
opposite problem of deficient savings and capital decumulation.
The policy conflict that may arise if there are domestic pressures for issuing debt that
differ between the participants is analysed as a non-cooperative game where the South
wishes to ‘free-ride’ fiscally but the North may choose to protect itself by reversing
capital market integration – which the researchers model as imposition of taxes on
capital inflows from the South .
There is no pure strategy equilibrium to this ‘discoordination game’; but there is a mixed
strategy Nash equilibrium where the North reverts to autarky with probability half and
the South fiscally free rides with probability half.
This opens up the prospect of a debt crisis where big debt expansion by the South
leads to closure of capital markets. The rules of the eurozone do, of course, explicitly
exclude such capital market intervention.
Nevertheless, the emergence of sovereign spreads can have much the same effect –
where a country like Greece, facing spreads of over 20%, is effectively unable to
access European capital markets for years to come.
ENDS
Contact:
Marcus Miller
Email: marcus.miller@warwick.ac.uk
07775 901322