Can Structural Reforms Help Europe? ∗ Gauti Eggertsson Andrea Ferrero Andrea Raffo Brown Oxford Board of Governors BoI/CEPR/MNB Workshop on “Growth, Rebalancing, and Macroeconomic Adjustment after Large Shocks” Budapest—September 20, 2013
Crisis in Europe Large output losses during the 2008-9 global financial crisis ◮ Different speed of recovery (or lack thereof) between core and periphery Real GDP 104 102 100 Index (=100 in 2008Q3) 98 96 94 92 90 88 2008 2008.5 2009 2009.5 2010 2010.5 2011 2011.5 2012 2012.5 2013 Germany Greece Ireland Italy Portugal Spain EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 2 / 24
Crisis in Europe Periphery troubles: Debt crisis but also fundamentals ◮ Large external imbalances pre-crisis ◮ Significant inflation differentials (real exchange rate misalignments) Current Account Real Exchange Rate (relative to Germany) 10 116 114 5 112 0 110 Index = 100 in 2000Q1 108 % of GDP −5 106 −10 104 102 −15 100 −20 98 2000 2002 2004 2006 2008 2000 2002 2004 2006 2008 Germany Greece Ireland Italy Portugal Spain EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 2 / 24
Policy Options for the Periphery Traditional policy options limited/unavailable: ◮ Exchange rate depreciation not an option due to common currency ◮ Fiscal expansion not an option because of debt crisis ◮ ECB monetary easing limited by zero lower bound (ZLB) EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 3 / 24
Policy Options for the Periphery Structural reforms recommended by various agencies to address competitiveness gap and boost income prospects “...the biggest problem we have for growth in Europe is the problem of lack of competitiveness that has been accumulated in some of our Member States, and we need to make the reforms for that competitiveness. ...to get out of this situation requires...structural reforms, because there is an underlying problem of lack of competitiveness in some of our Member States.” Jos´ e Manuel Dur˜ ao Barroso President of the European Commission Closing Remarks following the State of the Union 2012 Strasbourg, September 12, 2012 EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 3 / 24
Source of Competitiveness Gap Labor/Product market inefficiencies 4.6 IRE 4.4 Labor market efficiency index (1 = min, 7 = max) 4.2 FIN NET 4 AUT GER CORE 3.8 FRA POR BEL 3.6 3.4 SPA PERIPHERY GRE 3.2 ITA 3 3.5 4 4.5 5 5.5 6 Product market efficiency index (1 = min, 7 = max) Source: World Economic Forum (2011) EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 4 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? In the long run? 1 In the short run, when the ZLB binds? 2 Nominal Interest Rate (MRO) 4.5 4 3.5 Annualized percentage points 3 2.5 2 1.5 1 0.5 2008 2008.5 2009 2009.5 2010 2010.5 2011 2011.5 2012 2012.5 2013 EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? Machinery: Off-the-shelf two-country DSGE model of a currency union, where monopoly power gives rise to price and wage markups EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? Machinery: Off-the-shelf two-country DSGE model of a currency union, where monopoly power gives rise to price and wage markups Experiment: Permanent reduction in periphery’s non-tradable markups by 10 percentage points (close gap with core) EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? Machinery: Off-the-shelf two-country DSGE model of a currency union, where monopoly power gives rise to price and wage markups Experiment: Permanent reduction in periphery’s non-tradable markups by 10 percentage points (close gap with core) Results: Long-run: Union-wide output increases by about 2.5% 1 EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? Machinery: Off-the-shelf two-country DSGE model of a currency union, where monopoly power gives rise to price and wage markups Experiment: Permanent reduction in periphery’s non-tradable markups by 10 percentage points (close gap with core) Results: Long-run: Union-wide output increases by about 2.5% 1 Short-run: Output increase crucially relies on monetary accommodation 2 EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? Machinery: Off-the-shelf two-country DSGE model of a currency union, where monopoly power gives rise to price and wage markups Experiment: Permanent reduction in periphery’s non-tradable markups by 10 percentage points (close gap with core) Results: Long-run: Union-wide output increases by about 2.5% 1 Short-run: Output increase crucially relies on monetary accommodation 2 ⋆ In times of crisis (ZLB), ambitious reforms are contractionary! ⋆ Temporary reforms involve even larger short-run output costs EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Questions and Results What are the aggregate effects of structural reforms in the periphery? Machinery: Off-the-shelf two-country DSGE model of a currency union, where monopoly power gives rise to price and wage markups Experiment: Permanent reduction in periphery’s non-tradable markups by 10 percentage points (close gap with core) Results: Long-run: Union-wide output increases by about 2.5% 1 Short-run: Output increase crucially relies on monetary accommodation 2 ⋆ In times of crisis (ZLB), ambitious reforms are contractionary! ⋆ Temporary reforms involve even larger short-run output costs Key intuition: At ZLB, deflationary impact of reforms raises real interest rate and depresses output EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 5 / 24
Roadmap One-sector, closed economy model: ◮ Basic intuition and some analytical results Two-country, two-sector model of a currency union: ◮ Calibration ◮ Long-run effects of reforms ◮ Short-run effects of reforms in normal times and in a crisis ◮ Disentangling the effects of reforms EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 6 / 24
Textbook New Keynesian Model ˆ E t ˆ Y t + 1 − σ − 1 ( i t − E t π t + 1 − r e AD: = t ) Y t κ ˆ AS: π t = Y t + β E t π t + 1 + κψω t EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 7 / 24
Textbook New Keynesian Model ˆ E t ˆ Y t + 1 − σ − 1 ( i t − E t π t + 1 − r e AD: = t ) Y t κ ˆ AS: π t = Y t + β E t π t + 1 + κψω t ω t ≡ wedge between first-best and flexible-price output due to: ◮ Firms’ market power ◮ Markups in labor market EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 7 / 24
Textbook New Keynesian Model ˆ E t ˆ Y t + 1 − σ − 1 ( i t − E t π t + 1 − r e AD: = t ) Y t κ ˆ AS: π t = Y t + β E t π t + 1 + κψω t ω t ≡ wedge between first-best and flexible-price output due to: ◮ Firms’ market power ◮ Markups in labor market Suppose monetary policy implements a strict inflation target ( π t = 0, ∀ t ): EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 7 / 24
Textbook New Keynesian Model ˆ E t ˆ Y t + 1 − σ − 1 ( i t − E t π t + 1 − r e AD: = t ) Y t κ ˆ AS: π t = Y t + β E t π t + 1 + κψω t ω t ≡ wedge between first-best and flexible-price output due to: ◮ Firms’ market power ◮ Markups in labor market Suppose monetary policy implements a strict inflation target ( π t = 0, ∀ t ): ◮ Equilibrium output (short-run=S; long-run=L) ˆ ˆ Y S = − ψω S and Y L = − ψω L EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 7 / 24
Textbook New Keynesian Model ˆ E t ˆ Y t + 1 − σ − 1 ( i t − E t π t + 1 − r e AD: = t ) Y t κ ˆ AS: π t = Y t + β E t π t + 1 + κψω t ω t ≡ wedge between first-best and flexible-price output due to: ◮ Firms’ market power ◮ Markups in labor market Suppose monetary policy implements a strict inflation target ( π t = 0, ∀ t ): ◮ Equilibrium output (short-run=S; long-run=L) ˆ ˆ Y S = − ψω S and Y L = − ψω L ◮ Structural reforms: ω t ↓⇒ ˆ Y S , ˆ Y L ↑ EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 7 / 24
Textbook New Keynesian Model at the ZLB Dynamics dramatically change at the ZLB Consider a negative shock to r e t ( r e S < 0) such that: ◮ Large enough to force i S = 0 ( π t < 0): ◮ Reverts back to (absorbing) steady state w/ prob. 1 − µ in each period Short-run equilibrium: + σ − 1 µ 1 − µπ S + σ − 1 ˆ ˆ 1 − µ r e AD: = Y S Y L S ���� = − ψω L κ κψ ˆ AS: = Y S + π S 1 − µβω S 1 − µβ EFR (Brown-Oxford-Board) Structural Reforms in Europe September 20, 2013 8 / 24
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