Chapter

Annex II Implications of Structural Reforms Under EMU

Author(s):
International Monetary Fund
Published Date:
October 1997
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This annex builds on the discussion in Chapter III and further explores the implications for Europe and the rest of the world of alternative assumptions about labor market reform, fiscal adjustment, and product market liberalization under EMU. While necessarily speculative in nature, the resulting scenarios are meant to illustrate the profound impact that EMU can have on macroeconomic performance depending on progress in these three policy areas.1

The potential effects of structural reforms under EMU are analyzed using a version of the Fund’s multicountry model, MULTIMOD. This version includes a model for each EU member country, except that Belgium and Luxembourg are modeled jointly. It is assumed that all present EU member countries participate in EMU from the start2 and that the European Central Bank will use a monetary aggregate as an intermediate target. It is assumed that the credibility of monetary policy is established, and the focus is on the impact of structural reforms—or the lack thereof—with EMU firmly in place. Thus, the scenarios start in 2000, the baseline being an unchanged-policy scenario that extends the present World Economic Outlook database beyond its present horizon.

The basic structure of MULTIMOD3 has been preserved for this exercise except for the incorporation of EMU and a new treatment of labor markets. First, a modified Phillips curve was incorporated4 This nonlinear Phillips curve was estimated separately for most countries in the model. It captures the differential impact of large and small shocks on unemployment and inflation, while allowing for hysteresis effects. Second, an equation was added to capture the business cycle dynamics of unemployment around the natural rate. The natural rate itself feeds into the calculation of potential output, providing a direct channel for the impact of structural reforms in the labor market on long-term output and investment.

Alternative Reform Scenarios for EMU

This section expands on the discussion of the two alternative scenarios for fiscal consolidation and labor and product market reforms discussed in Chapter III. Box 10 summarizes the main assumptions underlying the simulations. It will be recalled that in the first scenario, EMU provides a positive impetus for structural reforms in Europe. With far-reaching labor market reforms, structural unemployment falls substantially. Moreover, it is assumed that government expenditures are reduced, leading to lower debt levels, and that product market reforms raise total factor productivity.

The results for Scenario I are presented in the top panel of Table 13 in Chapter III. For “EMU members.” all variables refer to EU-wide aggregates and averages. As is to be expected, the drop in structural unemployment and the improved fiscal position provide a powerful boost to the EU economy. Potential GDP expands by almost 3 percent by 2010; with a rise in the marginal productivity of capital and some decline in interest rates, investment expands significantly, and the increase in income provides a boost to consumption. The reduction in government spending allows the tax rate to be reduced despite a lower target level of debt: the long-run expansionary impact of the structural reforms, coupled with lower government spending, provides sufficient room for simultaneously reducing the debt ratio and the general level of taxation. After an initial decline, the EU trade surplus increases, relative to baseline, from some $14 billion (0.1 percent of GDP) in 2001 to about $28 billion (0.2 percent of GDP) in 2010.

These structural reforms in the EU have modest positive effects on the rest of the world. Potential GDP increases by 0.1 percent in the non-European G-7 countries, and by somewhat more in the smaller in dustrial countries outside the EU. The decline in the world stock of debt leads to a worldwide decline in interest rates, which boosts investment. Developing countries also benefit from these developments and their GDP increases by ¼ of 1 percent. While the increase in productivity and the decline in structural unemployment boost supply in the EU more than in non-EU countries, fiscal consolidation dampens demand initially; equilibrium in the goods market is restored in part through an initial moderate depreciation of the euro, resulting in an increase in net exports from the EU and a corresponding deterioration in the trade balance of non-EU industrial countries.

Box 10.Scenario Assumptions

Scenario 1: EMU as a Catalyst for Change

  • Policies are introduced that reduce both the persistence of unemployment and inflation inertia, partly by increasing the responsiveness of inflation to unemployment in the short term. More specifically, inflation is modeled as a nonlinear function of the deviation of unemployment from its natural rate and incorporates a weighted average of lagged and expected future inflation as well. Increased labor market flexibility is captured through an increase in the parameter on unemployment by around one-third of the level currently observed. In addition, an increase in the weight of expected inflation captures a reduction in the inertia of the inflation process.1

  • As a result, from 2000 onward, structural unemployment is reduced by 0.125 of 1 percentage point annually, stabilizing in 2007 at 2 percentage points below the baseline.

  • Government expenditures are cut by ½ of 1 percent of GDP annually during 2000–2003 and kept constant at 2 percentage points below the baseline from 2003 onward. The average rate of taxation is cut by ½ of 1 percent of GDP during 2000–2010 and the target level of debt is reduced by 10 percent of GDP.

  • Total factor productivity grows by ¼ of 1 percent a year faster than in the baseline scenario in 2000–2001 and remains at ½ of 1 percent above the baseline thereafter.

Scenario 2: EMU Without Structural Reforms

  • The natural rate of unemployment increases by ¼ of 1 percentage point a year from 2000 until 2007 when it stabilizes at 2 percentage points higher than the baseline value.

  • Government expenditure rises by ¼ of 1 percent of GDP a year during 2000–2003, after which it stabilizes at 1 percent of GDP above the baseline,

  • The target level of debt is raised by 10 percent of GDP from 2000 onward.

  • The euro’s risk premium rises by 10 basis points annually during 2000–2003; after 2003, the risk premium is kept constant at 40 basis points.

1 For details, see Peter B. Clark and Douglas Laxton, “Phillips Curves, Phillips Lines and the Unemployment Costs of Overheating,” IMF Working Paper 97/17 (February 1996); and Guy Debelle and Douglas Laxton, “Is the Phillips Curve Really a Curve? Some Evidence for Canada, the United Kingdom and the United States,” Staff Papers, IMF. Vol. 44 (June 1997), pp. 249–82.

In an alternative, “reform fatigue” scenario (Scenario 2), EMU goes ahead and inflation remains low, but labor and product markets do not become more flexible. The natural rate of unemployment rises gradually by 2 percentage points in all EU countries, that is, to about the current levels of actual unemployment in the EU, contributing to rising government spending, widening fiscal deficits, and increasing government debt. A risk premium on the euro starts to emerge, gradually growing to 40 basis points vis-à-vis instruments denominated in U.S. dollars.

The results are summarized in the second panel of Table 13 in Chapter III. Unemployment rises gradually during 2000–10, and potential output declines. The resulting decline in household income and wealth reduces consumption. Interest rates rise by about 1.5 percentage points in the first five years, partly because of the increase in the risk premium but, more importantly, because of the increase in government deficits and debt. The trade balance improves slowly during 2000–10, as domestic demand weakens and the euro depreciates.

The effects on output in other industrial countries arc quite small. The increase in EU deficits and debt raises the world interest rate and has a negative impact on output in the rest of the world. However, this is counterbalanced by effects emanating from the increase in the euro risk premium, which drives a wedge between the interest rate in the euro area and the rest of the world, leading to lower interest rates abroad while pushing up interest rates in the euro area. On balance, the risk premium effect marginally dominates the effect of the lack of fiscal consolidation in Europe, and interest rates in the rest of the world decline moderately. This contributes to a small rise of output in the rest of the industrialized world. This result is very sensitive, however, to the specification of the risk premium. In developing countries, the weakening of industrial country demand and rise in world interest rates lead to a decline in GDP of about ¼ of 1 percent over the medium term.

Sensitivity Analysis I: Aggregate Demand Shocks Under EMU

Structural reforms in the euro area will have a critical impact on the ability of the EU economy to absorb business cycle fluctuations. Under the reform Scenario 1, there generally will be sufficient room for the automatic fiscal stabilizers to operate during a typical business cycle downturn. Moreover, the enhanced flexibility of the labor market will reduce price and wage inertia and keep the economy closer to its long-term growth path.

Table 32 reports the results of an illustrative business cycle shock. The shocks—modeled as negative shocks to consumption and investment—are calibrated to illustrate business-cycle-type swings in GDP and unemployment: the ultimate impact of these demand shocks obviously depends on the degree to which structural reform is being implemented in the EU.5 In the reform Scenario 1a, the EU economy copes relatively well with this downturn. GDP falls by 2.1 percent (relative to baseline) up to the low point of the downturn and recovers gradually afterwards. The drop in investment leads to a decline in long-term real interest rates. Government transfers rise to cope with the increase in unemployment, which contributes to a fall in net revenue, as shown in Table 32. The general government balance worsens correspondingly, falling to 1.0 percent of GDP below the baseline in 2001. Spillover effects from the downturn in the euro area lead to falling output in industrial and developing countries alike. Their trade balance worsens to accommodate a larger decline in investment than in saving in Europe.

Table 32.Simulation Results for Euro-Area Demand Shock

(Deviations from respective baselines; in percent, unless otherwise noted)1

20002001200220032010
Scenario 1a: EMU with Additional Fiscal Consolidation and Labor Market Reforms
EMU members
Real GDP-0.8-2.1-1.3-0.6-0.2
GDP deflator-0.6-1.5-2.2-2.4-0.6
Long-term real interest rate-0.9-1.3-1.5-1.3-0.1
Unemployment rate0.20.50.50.30.1
General government balance (in percent of GDP)-0.5-1.0-0.40.20.1
Net revenue-0.40.9-0.10.30.1
Expenditure0.10.10.10.1
General government debt (in percent of GDP)1.33.63.83.1-0.4
Trade balance (in billions of U.S. dollars)11.648.947.841.51.0
Non-European G-72
Real GDP-0.1-0.20.20.1
Trade balance (in billions of U.S. dollars)-9.5-36.9-34.9-29.4-1.7
Other industrial countries3
Real GDP-03-0.6-0.30.10.2
Trade balance (in billions of U.S. dollars)-3.9-9.1-9.3-7.9-1.4
Developing countries4
Real GDP-0.1-0.3-0.10.1
Trade balance (in billions of U.S. dollars)1.8-2.9-3.6-4.22.1
Scenario 2a: EMU with Neither Additional Fiscal Consolidation Nor Labor Market Reforms
EMU members
Real GDP-1.3-2.9-1.4-0.5-0.6
GDP deflator-0.5-1.3-2.0-2.4-0.3
Long-term real interest rate-0.9-1.3-1.5-1.4
Unemployment rate0.30.80.60.30.2
General government balance (in percent of GDP)-0.3-0.7-0.30.3-0.2
Net revenue-0.6-1.3-0.20.4-0.5
Expenditure-0.3-0.60.10.1-0.4
General government debt (in percent of GDP)1.43.63.32.5-1.1
Trade balance (in billions of U.S. dollars)17.658.241.933.9-0.2
Non-European G-72
Real GDP-0.2-0.30.10.20.2
Trade balance (in billions of U.S. dollars)-13.6-42.6-30.1-24.3
Other industrial countries3
Real GDP-0.4-0.7-0.20.20.2
Trade balance (in billions of U.S. dollars)-4.5-10.5-8.9-7.1-1.0
Developing countries4
Real GDP-0.2-0.40.2
Trade balance (in billions of U.S. dollars)0.5-5.1-2.9-2.51.2

The baselines in Scenarios 1a and 2a refer to panels 1 and 2 in Table 13 in Chapter III. It is assumed that all current EU member countries participate in EMU from the start and that all participants adhere to the Stability and Growth Pact.

Canada, Japan, and the United States.

Australia, New Zealand. Norway, and Switzerland.

Rest of the world excluding transition economies.

The baselines in Scenarios 1a and 2a refer to panels 1 and 2 in Table 13 in Chapter III. It is assumed that all current EU member countries participate in EMU from the start and that all participants adhere to the Stability and Growth Pact.

Canada, Japan, and the United States.

Australia, New Zealand. Norway, and Switzerland.

Rest of the world excluding transition economies.

The second panel reports the results for a shock of the same magnitude for the reform fatigue scenario in Europe, so that Scenario 2 above serves as the relevant baseline. In this scenario, many countries in the euro zone have deficits in the baseline close to 3 percent. When experiencing the downturn, they thus have less room to allow automatic stabilizers to operate; in fact, as revenues fall in the business cycle downturn, several countries have to cut expenditures to satisfy the Stability and Growth Pact. Correspondingly, the fall in output is substantially larger than in the previous scenario. The Stability and Growth Pact limits the government deficits to 3 percent of GDP, and the overall EU deficit rises by only 0.7 percent of GDP in 2001. It is assumed that, to stay within the 3 percent limit, government expenditures are adjusted; and they drop by over 0.6 percent of GDP during the downturn. While the long-term impact on the rest of the world of a downturn in the euro area is not significantly different from that in the reform scenario, the immediate negative effect is somewhat larger reflecting the larger decline in EU output.

Sensitivity Analysis II: Asymmetric Demand Shocks Under EMU

As a further illustration of the importance of structural reforms in the euro area, Table 33 reports the effects of a demand shock of similar magnitude but only in part of the euro area.6 In this scenario, the lack of structural reforms—as evidenced by the differences between Scenarios 2a and 2b—has an even larger impact on the countries facing the adverse negative shock since EU monetary policy is geared toward euro area conditions and takes the asymmetric shock only partly into account. Hence, interest rates fall less than in the case of a symmetric shock. This adverse effect is, however, partly offset by the positive impact of declining interest rates in the rest of the euro area, which does not experience a downturn. On balance, GDP in the part of the euro area facing the downturn drops 1½ percentage points more in the reform fatigue scenario than in the scenario with structural reforms. While fiscal policy is able to cushion, via the automatic stabilizers, the effects of the downturn in the structural reform scenario, this is largely precluded in the reform fatigue scenario where the limits imposed by the Stability and Growth Pact result in declining government expenditures during the downturn.

Table 33.Simulation Results for Asymmetric Demand Shock in the Euro Area.

(Deviations from respective baselines: in percent, unless otherwise noted)1

20002001200220032010
Scenario 1b: EMU with Additional Fiscal Consolidation and Labor Market Reforms
EMU members: Group 12
Real GDP0.20.30.1
GDP deflator0.10.20.30.5-0.5
Long-term real interest rate-0.5-0.6-0.5-0.3-0.1
Unemployment rate-0.1
General government balance (in percent of GDP)0.20.3-0.1
Net revenue-0.10.20.3-0.1
Expenditure
General government debt (in percent of GDP)-0.1-0.1-0.5-1.0-0.7
Trade balance (in billions of U.S. dollars)-14.7-26.7-20.4-13.6-4.7
EMU members: Group 23
Real GDP-0.8-1.9-1.7-1.3-0.1
GDP deflator-0.6-1.4-2.2-2.6-0.1
Long-term real interest rate-0.2-0.5-0.8-0.8
Unemployment rate0.20.40.40.3
General government balance (in percent of GDP)-0.4-0.9-0.6-0.30.1
Net revenue-0.4-0.8-0.5-0.20.1
Expenditure0.10.10.1
General government debt (in percent of GDP)1.53.84.74.80.5
Trade balance (in billions of U.S. dollars)19.547.239.429.04.4
Non-European G-74
Real GDP-0.1-0.10.1
Trade balance (in billions of U.S. dollars)-4.0-16.1-14.4-11.3-0.3
Other industrial countries5
Real GDP-0.1-0.2-0.10.10.1
Trade balance (in billions of U.S. dollars)-1.5-3.5-3.7-3.0-0.4
Developing countries6
Real GDP
Trade balance (in billions of U.S. dollars)0.7-0.9-0.9-1.11.0
Scenario 2b: EMU with Neither Additional Fiscal Consolidation Nor Labor Market Reforms
EMU members: Group 12
Real GDP-0.2-0.40.60.60.1
GDP deflator0.10.10.3-0.7
Long-term real interest rate-0.6-0.6-0.5-0.2
Unemployment rate0.1-0.1-0.20.1
General government balance (in percent of GDP)-0.1-0.10.40.5-0.3
Net revenue-0.1-0.10.40.5-0.3
Expenditure
General government debt (in percent of GDP)0.20.4-0.6-1.2
Trade balance (in billions of U.S. dollars)-21.4-39.1-8.8-0.2-2.5
EMU members: Group 23
Real GDP-1.5-3.4-1.5-0.7-0.3
GDP deflator-0.5-1.3-2.0-2.40.6
Long-term real interest rate-0.2-0.5-0.7-0.80.1
Unemployment rate0.30.80.60.3
General government balance (in percent of GDP)-0.30.10.1
Net revenue-0.7-1.5-0.30.2-0.3
Expenditure-0.7-1.50.1-0.4
General govemment debt (in percent of GDP)1.53.52.82.2-1.6
Trade balance (in billions of U.S. dollars)31.767.916.02.3-3.2
Non-European G-74
Real GDP-0.1-0.20.10.1
Trade balance (in billions of U.S. dollars)-7.7-21.0-5.7-2.13.4
Other industrial countries5
Real GDP-0.3-0.50.20.1
Trade balance (in billions of U.S. dollars)29.663.113.61.0-2.6
Developing countries6
Real GDP
Trade balance (in billions of U.S. dollars)-0.5-3.00.91.31.7

The baselines in Scenarios 1b and 2b refer to panels 1 and 2 in Table 13 in Chapter III. It is assumed that all current EU member countries participate in EMU from the start and that all participants adhere to the Stability and Growth Pact.

Austria, Belgium, Denmark, Finland, Germany, Greece, Ireland, Luxembourg, the Netherlands, Sweden, and the United Kingdom.

France, Italy, Portugal, and Spain.

Canada, Japan, and the Uniled States.

Australia. New Zealand, Norway, and Switzerland.

Rest of the world excluding transition economies.

The baselines in Scenarios 1b and 2b refer to panels 1 and 2 in Table 13 in Chapter III. It is assumed that all current EU member countries participate in EMU from the start and that all participants adhere to the Stability and Growth Pact.

Austria, Belgium, Denmark, Finland, Germany, Greece, Ireland, Luxembourg, the Netherlands, Sweden, and the United Kingdom.

France, Italy, Portugal, and Spain.

Canada, Japan, and the Uniled States.

Australia. New Zealand, Norway, and Switzerland.

Rest of the world excluding transition economies.

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