Cyclical Convergence and Divergence in the Euro Area Presentation by Val Koromzay, Director for Country Studies, OECD to the Brussels Forum, April 2004 1 1
I. Introduction: Why is the issue important? II. Measuring convergence and divergence: general considerations III. Explaining divergence: A) potted history of a decade s experience with EMU B) The analytical framework - Asymmetric shocks versus differential responses to a given shock IV. The dynamic transmission of a demand shock: what matters? - A key result - Policy implications V. Differential transmission mechanisms of monetary policy within the euro area: endogenous divergence? - Need for further work 2 2
II. General considerations: what is the policy-relevant measure of divergence? a) International comparisons b) The ECB position c) OECD evaluation in the Economic Outlook and the Country Surveys d) A simple Taylor Rule illustration -- Qualifications 3 3
Chart I. Inflation differentials in the Euro Area, United States and Canada (Standard deviation) % 2.0 1.8 1.6 Euro area US regions Canadian provinces % 2.0 1.8 1.6 1.4 1.4 1.2 1.2 1.0 1.0 0.8 0.8 0.6 0.6 0.4 0.4 0.2 1997 1998 1999 2000 2001 2002 2003 Source: US Bureau of Labour Statistics, CANSIM-Statistics Canada and OECD. 0.2 4 4
Chart II. Taylor rule for euro-area countries (2000) IRL PRT ESP NLD FIN ITA BEL AUT EURO GRC FRA DEU Euro area short-term interest rate 0 2 4 6 8 10 12 1. The Taylor rule computes the short-term interest rate that would be recommended by a simple monetary policy rule. It is based on the equilibrium interest rate level and the extent to which inflation rises above (falls below) its target or the output gap turns positive (negative). The weights attached to inflation and the gap are 1.5 and 0.5, respectively. The assumed inflation target is 1.8 per cent and the assumed equilibrium interest rate is 2.8 per cent. Source: OECD. 5 5
III. Explaining divergence A) A potted history of a decade s experience with EMU 1) A core versus periphery model: much can be explained by the asymmetric shock of euro-creation per se 2) But there are also country-specific puzzles 3) And more recently 6 6
7 7 Chart III. Changes in output gaps for euro-area countries: 1995-96 to 2000 Source: OECD, Analytical database. 0 1 2 3 4 5 6 7 8 9 10 % 0 1 2 3 4 5 6 7 8 9 10 % Ita Ger Aut Nld Fra Prt Bel Esp Fin Ire
Chart IV. Changes in output gaps for euro-area countries: 1995-96 to 2000 and from 2000 to 2004 % 10 8 6 Changes between 1995-96 and 2000 Changes between 2000 and 2004 % 10 8 6 4 4 2 2 0 0-2 -2-4 -4-6 -6-8 Ita Ger Aut Nld Fra Prt Bel Esp Fin Ire Source: OECD, Analytical database. -8 8 8
III. Explaining divergence (continued) B. The analytical framework 1) A crude typology: a) Asymmetric shocks 1) country-specific (domestic) shocks 2) external source, but with variable impacts due to countryspecific difference in economic structure b) Differentiated dynamic responses to a given shock: 1) persistent demand shock 2) an interest-rate shock : differing transmission mechanisms 2) Heart of this presentation: - re (a1, 2): little new to offer - re (b1): a significant result - re (b2): a worthwhile question mark 9 9
IV. The dynamic (domestic) transmission of a demand shock: what matters? 1. The basic mechanisms: interest-rate crowding-out versus competitiveness induced crowding-in: 2. Large versus small economies 3. Issues for discussion: a) How big is the real interest rate effect: contrarian views b) Interest-rate exogeneity? c) Is there an endogenous economic cycle? 1010
Chart 5. Simulated effects of a sustained demand shock France and Ireland Reference 1 Simulation 2 France Ireland 0.60 Real gross domestic product, level 0.60 Real gross domestic product, level 0.40 0.40 0.20 0.20-0.20-0.20-0.40-0.40-0.60-0.60-0.80-0.80-0.80 Real total domestic demand, level -0.80 Real total domestic demand, level -1.00-1.00-1.20-1.20-1.40-1.40-1.60-1.60-1.80-1.80-2.00-2.00-2.20-2.20 1111
Chart 5. Simulated effects of a sustained demand shock France and Ireland (continued) Reference 1 Simulation 2 France Ireland 0.80 0.60 0.40 0.20-0.20-0.40-0.60-0.80-1.00 Inflation rate 0.80 0.60 0.40 0.20-0.20-0.40-0.60-0.80-1.00 Inflation rate Government net lending as a % of GDP Government net lending as a % of GDP 0.20 0.20 0.10 0.10-0.10-0.10-0.20-0.20-0.30-0.30 1212
IV. The dynamic (domestic) transmission of a demand shock: what matters (continued) 4. What determines differential adjustment? a) Role of wage/price flexibility - theory and evidence - implications b) Integration effects dominate the results: - policy implications c) Role for fiscal policy: automatic stabilizers and active stabilization: - Stabilizers slow adjustment, but reduce the present value costs of demand shocks - Activism is probably not helpful, though uncertainty remains 1313
Chart 6. Adjustment dynamics when only trade integration matters Reference 1 Simulation 2 France Ireland 0.60 0.40 0.20-0.20 Real gross domestic product, level 0.60 0.40 0.20-0.20 Real gross domestic product, level -0.40-0.40-0.60-0.60-0.80-0.80-0.50 Real total domestic demand, level -0.50 Real total domestic demand, level -1.00-1.00-1.50-1.50-2.00-2.00-2.50-2.50-3.00-3.00 1414
Chart 6. Adjustment dynamics when only trade integration matters (continued) Reference 1 Simulation 2 Inflation rate Inflation rate 0.50 0.50-0.50-0.50-1.00-1.00-1.50-1.50 0.20 Government net lending as a % of GDP 0.20 Government net lending as a % of GDP 0.10 0.10-0.10-0.10-0.20-0.20-0.30-0.30 1515
Chart 7. Fiscal multipliers: how model-specific? QUEST NIGEM OECD Revenue Expenditure Expenditure Expenditure Austria 0.1 0.5 0.6 0.4 Belgium 0.1 0.5 0.5 0.5 Finland 0.3 0.4 0.7 0.9 France 0.1 0.5 1.1 0.6 Germany 0.2 0.4 1.6 1.2 Greece 0.1 0.5 -- -- Ireland 0.1 0.4 0.5 0.3 Italy 0.1 0.5 0.8 0.9 Netherlands 0.1 0.4 0.9 0.6 Portugal 0.0 0.7 0.6 0.6 Spain 0.1 0.5 1.1 0.4 Source: EC (2001) and Barrel and Pina (2000). 1616
V. Differential transmission mechanisms of monetary policy within the euro area: is this an endogenous source of cyclical divergence? 1) The exchange-rate channel: how diverse are the economic impacts of a given change in the euro/dollar parity? 2) The domestic-demand channel: a closer look at housing markets and housing finance 1717
Chart 8. Changes in effective exchange rates for a 10 per cent depreciation of the euro Per cent 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 IRE FIN DEU NLD BEL ITA FRA GRC AUT ESP LUX PRT 0 Note: Based on the 1999 trade weights from OECD database, which includes the 30 OECD member countries and 12 nonmember countries. Source: OECD. 1818
Chart 9. The weight of extra euro-area trade in GDP Per cent of GDP 60 60 50 50 40 40 30 30 20 20 10 10 0 IRE LUX NLD BEL FIN AUT GRC DEU FRA ITA ESP PRT 0 Source: OECD. 1919
V. Differential transmission mechanisms (continued) B. The Housing and House-finance channel 1) General idea: when comparing the United Kingdom, the United States and Australia to the larger euro-area countries, there is an incapable sense that monetary policy is simply much more powerful in the former than the latter. The housing channel plays a double role: - Impact of interest rates on residential construction activity (United States/Australia) - Impact of housing prices on consumer demand due to induced wealth effects and liquidity effects via home-equity withdrawal. / 2020
V. Differential transmission mechanisms (continued) 2) Within the euro area, various indicators suggest that the housing channel may be relatively more important in some smaller countries especially the Netherlands, but also Ireland, Finland and Spain than in core Europe 3) But the more one looks at it, the more complex the linkages appear. OECD work, still inconclusive, focuses on trying to explain the structural determinants of house-price movements and their differential impact (via wealth effects) on consumer demand. We are well short of understanding the interaction of such structural influences with monetary conditions so as to be able to quantify properly a housing channel, and how it is affected by structural policy. 2121
4) In this context, I want to provide a summary of three, incomplete sets of evidence bearing on the following points: a) What is the cyclical sensitivity of house prices relative to an overall price index? b) More generally, what determines the relative volatility of real house-prices movements? c) What are the inter-country differences in the propensity to consume out of changes in housing wealth; and what factors might explain such differences? 2222
Chart 10. The sensitivity of house prices to the business cycle differs a lot across countries; but the differences are not easy to explain perhaps for good reason Timing of maximum correlation Output gap Output gap lagged Output gap lagged contemporaneous or 1-2 years 3-4 years lagged > 1 year Intensity of correlation Strong Denmark, Finland Spain Ireland, United Kingdom Average Japan Canada, France, Sweden Australia, Germany, Switzerland Weak New Zealand Norway, United States Belgium, Italy, Netherlands Note: Correlations are between de-trended real-house price levels and the output gap. They are calculated for the period 1970-2002, based on semi-annual data. Countries are ranked according to the value of the maximum of correlations and of the lags at which these are found. The intensity of correlation is indicated as strong if the maximum correlation coefficient is above.65 if between.50 and.65 weak if below.50. Source: OECD. 2323
Chart 11. Real house price variability and selected explanatory variables A : Tax wedge on mortgage interest 12 Standard deviation of annual real house price changes (1971-2002) Italy Spain Finland United Kingdom 10 Netherlands Austria B : Price elasticity of housing supply 12 Standard deviation of annual real house price changes (1971-2002) United Kingdom 10 Netherlands 8 Denmark 8 Denmark 6 4 Ireland Sweden Belgium R2 = 0.353 France 6 4 France R2 = 0.852 2 Portugal Germany 2 United States Germany 0-2 -1 0 1 2 Tax wedge 0 0.0 0.5 1.0 1.5 2.0 2.5 Price elasticity of housing supply Note : The tax wedge is defined as the difference between the after-tax and the pre-tax real interest rate on mortgage loans. It is defined to also incorporate the effect of property taxes. Thus, a low or negative tax wedge indicates a more favourable tax treatment of mortgage interest. Sources : Real house prices: BIS; Tax wedge on mortgage interest is from Van den Noord, 2004; Price elasticities of housing supply is estimated by Swank, Kakes and Tieman, 2002. 2424
Chart 12. Correlations of private consumption growth and real house-price changes 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Italy Belgium Denmark Spain Japan Australia Ireland Finland New Zealand Germany France Norway United States Canada Sweden Netherlands Switzerland United Kingdom Average Notes: Contemporaneous correlation coefficients, calculated from annual data, 1971 to 2002. House prices are deflated using the private consumption deflator. Source : BIS, OECD. 2525
Chart 13. Importance of leverage and housing-equity withdrawal in explaining the MPC out of housing wealth A : Mortgage debt ratios 0.09 MPC out of housing wealth 0.08 Netherlands 0.07 Australia United Kingdom 0.06 Canada R2 = 0.534 0.05 United States B : Housing equity withdrawal 0.10 MPC out of housing wealth 0.08 0.06 Netherlands Australia United Kingdom Canada United States 0.04 0.04 R2 = 0.848 0.03 0.02 0.01 Italy Spain Japan 0.02 Spain Italy Japan France,Germany France Germany -0.01 0 20 40 60 80 100 Mortgage debt 2002 (in% of GDP) -0.02-10 -5 0 5 HEW average level 1990-2002 (in % of disposable income) Sources : United States Federal Reserve Board, Japanese Annual National Account, United Kingdom Office for National Statistics, Bank of Canada, Bank of France, Statistics Canada, The Netherlandsche Bank, Bank of Spain, European Central Bank, Reserve Bank of Australia, OECD. 2626
Chart 14. Effects of Mortgage-market completeness on MPC and on HEW 0.9 0.8 A : on consumption sensitivity to changes in real house prices Contemporaneous correlation (1971-2002) United Kingdom 2 0 B : on housing equity withdrawal HEW average level (in % of disposable income) since 1990 Netherlands United Kingdom 0.7 Netherlands Denmark 0.6-2 R2 = 0.696 0.5 Spain Denmark France -4 Spain 0.4 0.3 Portugal R2 = 0.688-6 Italy Germany France 0.2 Germany -8 Italy 0.1 40 50 60 70 80 90 Synthetic indicator of mortgage market completeness -10 40 50 60 70 80 90 Synthetic indicator of mortgage market completeness Note: The synthetic indicator of mortgage market completeness is presented in Annex Table 3. (for additional information see Mercer, Oliver, Wyman, 2003). For Portugal, the contemporaneous correlation between consumption and real house price change is calculated over the period 1989-2001, due to limited data availability. Sources : United States Federal Reserve Board, Japanese Annual National Account, United Kingdom Office for National Statistics, Bank of Canada, Bank of France, Statistics Canada, The Netherlandsche Bank, Bank of Spain, European Central Bank, Reserve Bank of Australia, OECD. 2727