1. Europe’s Stability and Growth Pact in the Context of a Global Economic Slowdown Warwick J McKibbin ANU Centre for Applied Macroeconomic Analysis (CAMA) Presented at the ANU Conference on Fiscal Policy and Financial Markets, ANU, October 2003

2. Stability and Growth Pact  Agreed in July 1997 based on Maastricht convergence criteria for a single currency in Europe.  Member states commit to a medium term objective of budgetary balance.  Will take action no later than the year following the identification of “excessive fiscal deficit” which is in excess of 3% of GDP  The European council is “always invited” to impose sanctions if the member state fails to take necessary steps to bring deficits under control

3. Results Based on: “Optimal Fiscal and Monetary Policy Responses to Global Risk Shocks” by Warwick J McKibbin Centre for Applied Macroeconomic Analysis (CAMA) at ANU Mathan Satchi Oxford David Vines Oxford, ANU and CEPR

4. Background  Two broad views of the current global economic slowdown The result of weak aggregate demand that can be offset through appropriate adjustments to monetary policies The results of a reduction in aggregate supply resulting from  A downward revision in productivity growth in the OECD  The collapse of the “new economy” bubble  An increase in risk since September 11 and the war on terrorism

5. Goals of the Paper  In a previous paper we explored the global adjustment to Changes in Equity Risk premia and the role for monetary policy  In this paper we extend the analysis to explore the optimal response of fiscal and monetary policy to equity risk shocks

6. Questions to be addressed  What is the optimal response of fiscal and monetary policies in countries experiencing a rise in equity risk?  How does the existence of the European Central Bank (ECB) affect the response of European fiscal authorities relative to countries with floating exchange rates?  How does the existence of the Stability and Growth Pact affect the optimal fiscal policy response?

7. Some Answers  The optimal response to a rise in equity risk is a loosening of monetary policy and a fiscal expansion in the short run to manage demand but a long term fiscal consolidation to manage supply;  The smaller the country, the more reliance on fiscal policy for a demand stimulus;  The existence of a single currency in Europe causes individual countries within Europe to expand fiscal policy more than if they were floating  The Stability and Growth Pact inhibits the optimal European response – indeed it works in reverse in the medium run.

8. Attempt to Quantify the Key Issues using a global model Use the MSG3 model version 50o www.gcubed.com

9. The G-Cubed Model  Key features Based on explicit intertemporal optimization by households and firms in each economy in a dynamic setting Substantial sectoral dis-aggregation with macroeconomic structure Explicit treatment of financial assets with stickiness in physical capital differentiated from flexibility of financial capital Short run deviation from optimizing behavior due to stickiness in labor markets, myopia Short run “New Keynesian” Model with Neoclassical steady state

10. G-Cubed Model  12 sectors production in each economy Plus a capital good producing sector Plus a household durable production sector (I.e. housing)  Estimation of KLEM technology in production and consumption  Tracks flows of international trade at the sectoral level  Tracks flows of international capital  Distinguishes between relatively traded and non trade goods (all goods are potentially tradeable)

11. Derivative Models We aggregate the full G-Cubed model by sectors and countries to create models suitable for particular purposes: G-Cubed (Asia Pacific) G-Cubed (Agriculture) G-Cubed (Environment) MSG3 (macro)

12. Sectors: Energy Non – Energy Capital goods producing sector Household capital sector The MSG3 Model

13. Countries:Exchange rate Regime: United Statesfloat Japanfloat Australiafloat Canada float United Kingdomfloat GermanyEuro (floating) Austria Euro (floating) France Euro (floating) Italy Euro (floating) Rest of Euro Zone Euro (floating) Rest of OECDfloat Chinapeg to $US non Oil Developing countriespeg to $US Eastern Europe and Russiafloat OPECpeg to $US The MSG3 Model

14. The Results

15. The Simulations  1) Baseline 2000 Assumptions about  population growth by country  Productivity growth by sector catching up by 2% per year to US leading sector  Given tax rates, monetary growth rates etc in all countries Solve for rational expectations equilibrium for the global economy  2) apply the change in equity risk premium Equity risk increase across the OECD

16. The Equity Risk Premium (μ) Excess return on equities relative to the return on government bonds

17. How to think about the Temporary Shock?  The way to interpret the shock depends crucially on the nature of the baseline.  The equity risk premium fell sharply to 1999 and suppose it was expected to gradually rise back towards 5% over a decade.  The temporary risk shock can be interpreted as a return to long term 5% more quickly than was expected in 2000 so that the steady state is the same but the path towards it is shifted.

19. Rise in OECD wide Equity Risk: Germany

21. Risk Shock without a policy response  The desired capital stock falls, real wages need to fall, potential output falls, real interest rates fall.  Capital tends to flow into the large country away from small countries  Employment falls by more in a small country and prices rise by more in a small country relative to a large country

22. Optimal Policy Response Policy makers choose a vector of instrument (monetary policy and fiscal spending) to minimize the discounted expected future squared deviation of targets from desired values

23. Policy optimization  Countries have weights of: 2 on output price inflation; 1 on employment (log); 1 on fiscal deficits.  Instruments are: Monetary policy Fiscal spending on workers

24. Fiscal Policy Lessons  A fiscal stimulus in a large country Raises world interest rates permanently Crowds out home and foreign investment Crowds out net exports through an appreciation  A fiscal stimulus in a small country Raises home interest rates (temporarily) Crowds out home investment Crowds out net exports through an appreciation  Relatively more crowding out of investment in a large country and net exports in a small country

25. Putting the shock and the policy Response together

30. Conclusion  Shocks to equity risk premia have significant effects on the real economy  Both aggregate demand and supply are affected.  Monetary and fiscal policy can help in the short run to smooth the adjustment but it can do little to completely offset the underlying shock  The optimal fiscal response is a fiscal expansion followed by a long term fiscal consolidation  The existence of the Euro implies more fiscal activism in Europe would be optimal given a global risk shock  The Stability and Growth Pact constrains the optimal response

31. Background Papers www.gcubed.com www.sensiblepolicy.com