Sudden stops and the EMU

Economic Models: from theory to application n.1

The European Economic Community, the ancestor of the European Union (EU) as we know it today, was founded to maintain peace and to bring stability and prosperity to its members. As the union grew, and with it a desire for greater integration, many challenges arose, leading it to seek stability and cooperation on many levels. In particular, the building and consolidation of a reliable economy has been a great challenge due to the accession of countries with diverse cultures and economies.

The Economic and Monetary Union (EMU) was discussed among European nations for many years before its implementation at the end of the 20th century. Initially introduced as a 3-step implementation plan, the EU EMU was intended to provide stability and resilience within Member States through the use of control and stabilisation mechanisms, monetary cooperation and ultimately the adoption of a common currency, the Euro. By adopting such structures, member countries of the Eurozone abandoned their sovereignty over monetary policy, depriving them of a tool of great value when it comes to mitigating the adverse effects of an economic crisis.

Down the line, the idea behind the Eurozone is that the stability induced by such cooperative union would mitigate the effects of economic crises. It was thought by many that developed countries and especially the European EMU would resist – or at least reduce – the negative impact of a sudden halt of foreign lending; but such beliefs proved unfounded, thus bringing into question the real usefulness of a monetary union in facing a financial crisis.

The theoretical impact of sudden stops

What are sudden stops?

Sudden stops are situations in which foreign capital lending stops flowing into a country following a drop in the confidence of creditors in the host country. That is, as foreign investors come to doubt a country’s ability to repay the debt, they stop sending capital to this country, thereby stopping capital inflows. Such an abrupt halt in lending may have many consequences on a country’s economic performance.

The impact of sudden stops

We will now introduce a basic model to understand how a stop in foreign capital inflows impacts a country’s economy.

This model aims to describe the behaviour of open large economies. It studies the behaviour of the interest exchange rates faced by the country, the consumption of both tradable and non-tradable goods, as well as the quantities in which they are produced and their relative prices. Tradable goods are goods which may be found in international trade, such as fruits or commodities. Non-tradables, on the other hand, are goods that cannot be traded due to transportation issues, such as services – haircuts for instance – or immovable goods such as real estate. This model makes valuable predictions when it comes to analysing how a credit crisis propagates in a country.

Put simply, a cessation in capital inflows can be modelled by an increase in interest rate r. Indeed, the interest rate can be interpreted as the cost of a loan; for each €1 loan, you have to repay €(1+r), thereby making the interest rate a cost. When foreign lenders lose confidence in a country’s ability to repay its debts, the interest rate increases; as lending to the country becomes riskier, investors pull out their capital and become willing to lend money only at a higher cost. Therefore, a sudden stop is followed by a capital outflow and an increase in the interest rate.

When a country faces a sudden stop, and therefore an increase in interest rate, the following happens:

  • Consumption of both traded and non-traded goods decreases as the interest rate increases. Indeed, savings become more appealing as the return on savings – the interest rate – is now higher. Therefore, consumption decreases.

  • A surplus of non-traded goods appears as the demand decreases, but production does not decrease immediately, and the goods cannot be sold abroad. Therefore, to clear the market, the price of these goods decreases.

  • Since the price of non-traded goods decreases, but the price of traded goods remains unaffected, the production of traded goods becomes more attractive. In theory, a sudden-stop should induce a shift of activity towards traded-good industries.

  • As this shift is not always feasible since it might require substantial structural changes, there is a surplus production of non-traded goods. Since prices are falling, firms aim to reduce their costs, either by lowering wages or by employing fewer workers. Therefore, the final effect of a sudden stop is increased unemployment.

In conclusion, sudden stops affect a country by lowering consumption, decreasing the price of non-traded goods, and creating unemployment.

The Case of the EMU