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
Before the 2008 crisis, it was thought that the EMU would not be affected by sudden stops. With the creation of the EMU, many European countries formerly seen as “riskier” by investors saw an increase in capital inflows as foreign lenders felt that the creation of the EMU was mitigating the risks associated with these countries. Yet, these countries faced an abrupt decrease in foreign lending following the crisis, demonstrating that the EMU was not immune to sudden stops.
Sudden stop and consumption in the EMU
A study by D. Gros and C. Alcidi compared EU countries inside and outside of the EMU in order to determine its mitigatory ability. Using measures of the countries’ current account, which grasps the consumption, investment, trade balance and other components, and interest rate data, they found that countries within the EMU were likely to experience a smaller loss in consumption than countries outside of it, but the economic recovery was in turn slower than in countries that did not use the common currency. Countries outside the EMU were also found to adapt with greater ease towards increasing exports than EMU periphery countries.
Figure 1: Current Account Change, D. Gros and C. Alcidi
Differences in consumption loss could be explained by the fact that countries within the EMU enjoyed lending from the ECB, allowing banks to maintain low interest rates and therefore mitigate the fall in consumption. On the other hand, countries outside the EMU did not enjoy this safety net and had to adapt more quickly, therefore greatly decreasing their consumption.
Figure 2: Consumption adjustment, D. Gros and C. Alcidi
Sudden stop and unemployment in the EMU
Another challenge arising from sudden stops is unemployment. When the need to decrease production costs arises, and if policy makers want to prevent unemployment, wages must decrease. Such reductions can be operated through a wage cut in absolute terms, or in relative terms by depreciating the exchange rate.
EMU countries and EU member states more broadly do not have these options. Undoubtedly, Euro countries do not have any sort of sovereignty over the exchange rate, as it is fixed by the European Central Bank (ECB). Likewise, EU member states that have not yet joined the Euro have their currency pegged to the Euro with the intention of one day adopting the common currency. Therefore, a depreciation of the exchange rate in order to mitigate the unemployment induced by sudden stops is not an option for EU member states. Finally, these countries are often endowed with strict labour laws protecting wages and preventing them from any abrupt reduction. Therefore, sudden stops induce unemployment in EU countries, as found by the study.
In all, the European EMU is not a strong shield against sudden stops and may even induce a slower recovery, as was found in Europe following the 2008 crisis. Sudden stops have had contrasting impacts on European economies; while the decrease in consumption is less harsh than it would be without the ECB, this false sense of security probably played a role in the delayed action of governments, and thus deferred recovery. Overall, the EMU may represent a great opportunity for European countries but comes with the cost of a limited policy toolbox for member states. The EMU appears to mitigate the expected impact of a sudden stop, albeit such mitigation might come with a cost of slower adjustment.
Based on the work of Gros, D., & Alcidi, C. (2013). Country adjustment to a “sudden stop”: Does the euro make a difference? Available at Link (European Commission)