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First, on the austerity itself, when we talk about austerity, we’re assuming some level of effort in terms of raising taxes and cutting expenditure to achieve deficit reductions.  In 2009 in Ireland, the year that steep cuts began, the deficit was about 12 percent of GDP.  In 2010, with previous cuts now implemented and new ones added, the deficit was, er, about 12 percent of GDP.   In 2011, with 2 years of cuts to build on and more to come, the deficit is projected to be, drum roll please, 10 percent of GDP.

So what’s going on?  First, some of the fiscal effort has gone in preventing even worse outcomes if no cuts had been made.  That’s how bad the cratering of the Irish public finances is.  But another conclusion is inescapable: the cuts themselves have been contractionary and have made deficit reduction harder to achieve, both in terms of higher unemployment benefits and lower tax revenues.  Our department of finance is now clever enough to set revenue projections that can be achieved, but that doesn’t disguise the fact that revenue is down even on 2009 levels, when the decline in growth was at its worst.  In other words, Krugman is right: this is a plain old contractionary fiscal contraction that is working against its own side effects to achieve its objectives.  The road is falling, not rising to meet us.

Let’s now return to Krugman’s broad question of why markets think that there is more Irish fiscal risk.   The simple answer: bank sector strategy.  There are two issues here.  The first is that, leaving aside deficit numbers, the government has taken on new risk in its approach to the banking sector.  The National Pension Reserve Fund, which was supposed to ring fence money for public sector pensions from 2025 onwards, is now a major equity investor in the walking wounded of the Irish banking sector.  Equity positions in banks are a tad risky.  Even when it’s public money.

Furthermore, the toxic property stuff from these banks has been dumped into the National Asset Management Agency (at a knockdown price) and paid for with borrowed money.  If a private fund was borrowing to invest in distressed banking assets, it would be seen as potentially profitable but risky proposition.   No reason why the markets should view a public entity doing the same thing any differently.

But wait, there’s more.  Up above we mentioned a 2010 Irish budget deficit of 12% of GDP.  Well the European Commission took another look at those numbers and decided that it should have been 14%.  And that relates not to the above interventions, which are in Eurostat accounting terms neutral, because any public money went to buy actual assets (equity stakes or loans).  No, the revision was due to the money that is going into a hole, to meet the obligations of dead banks/building societies whose liabilities are guaranteed by the Irish government.  It is past payouts for those purposes that Eurostat got classified as outright public expenditure for 2010, and there have been more of those payouts in 2010 already, and more to come.  In total, it will be about €25 billion.

Now, we have our New York Times/IMF accredited expert on Spain right here on this blog in the form of Edward.  So maybe he can tell us that the Spanish fiscal and banking stew is as poisonous as Ireland’s.  But I doubt it.  Instead, the bottom line on Krugman’s comparative question would be: Yes, Irish austerity has not worked, but it hasn’t worked both for the standard Keynesian reasons and because it is being swamped by quasi-sovereign risk from the banking sector.  Maybe, just maybe, if you avoid the bottomless pit coming from the latter, standard fiscal austerity might have a chance.  Here’s looking at you, Lithuania.

UPDATE: National Review’s Stephen Spruiell says Krugman is presenting the CDS comparison selectively and that Ireland’s CDS spread doesn’t look so bad given the size of its deficit.  But of course the size of the deficit makes it more difficult to argue that the austerity is effective.  And Karl Whelan notes that bond spreads — which is where debt dynamics are actually being determined — have deteriorated significantly for Ireland in the last few weeks.

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Migration Flows and Long Term Economic Capacity and Sustainability: The Baltic Case

Authors: Claus Vistesen and Aapo Markkenen

The World Bank has recently drawn attention to the level and extent of migration flows in Eastern and Central Europe whilst at the same time attempting an initial assessment of some of the longer term economic consequences of such flows (World Bank, 2007).

In particular the report highlights the rather substantial nature of migration in Central and Eastern Europe as well as the steady and continuing population drift from Central Asia towards the west. If we exclude movements between the countries themselves, such flows now account for approximately one third of total world immigration. In terms of the direction of the flows the major part of all Eastern European migration (42%) is now directed towards Western Europe, with notably Germany and the UK being the main recipients in numerical terms.

Within this general context the EU’s ‘inner sea’ (the Baltic) provides an interesting case study where some of the longer term implications of these processes can be examined. Despite the fact that their economies have been growing rapidly in recent years, young citizens of the three Baltic states of Estonia, Latvia and Lithuania still appear to find life more attractive somewhere else, at least this is the conclusion which may reasonably be drawn from their manifest willingness to out- migrate. However the differences which are to be found between migration patterns in each of these countries may well be just as important as the common trend. Lithuania, for example, has become – in relative terms – been the biggest source of intra-European migration, with more than 400.000 of its 3.4 million population out-migrating since the country joined the EU in 2004. During the same time period Estonia has seen a mere 1% of the total population leave.

What is interesting and instructive about the present migration patterns is how different they are from the traditional migration flows which have been observed both historically in other parts of Europe as well as increasingly today in many parts of the developing world (Williamson and Hatton, 2002). Traditionally migration could be thought to form part of a demographic transition process, and has largely tended to take off as countries achieve an initial growth impetus whereby development towards a modern growth regime occurs, under conditions where employment opportunities still do not increase rapidly enough to absorb all the young entrants to a labour market which is nevertheless expanding. Classically this migration process has to some extent been associated with the phenomenon known as the demographic dividend, insofar as an initial increase in living standards seems necessary to initiate the process.

Now the literature on the demographic dividend is normally at pains to emphasise that the dividend itself is far from automatic, and it would seem that the Eastern and Central European societies as a group provide one of the clearest indications of just how path dependent the whole demographic dividend and development process really is. By and large Eastern and Central European societies experienced a long term and sustained fertility decline without a concomitant increase in life expectancy to West European levels, and, even more significantly, without the arrival (due to the specific characteristics of the institutional structure which was in place) of a modern economic growth regime. By and large then these societies have commenced the second stage of their demographic transition in association with the institutional transformation which has accompanied the EU accession process, and rapid economic growth rates are now being experienced together with a slow and steady increase in life expectancy towards West and North European norms.

However this move towards the modern growth regime has been accompanied by a very dramatic decline in fertility to levels which may be considered to be in the lowest-low category (1.2/1.3 Tfr). It is precisely this ‘trifecta’ combination (very low fertility, steadily rising life expectancy, and ongoing out-migration of the young and well-qualified) which should be sounding the alarm bells as regards the medium-term sustainability of the growth process in these countries as labour supply and human capital constraints begin to exert themselves.

One theory that might be considered to throw some light on the case of the Baltic Countries, is that of relative deprivation. (Stark & Taylor 1991.) This theory argues that economic growth in and of itself may not be sufficient to stem emigration if the benefits of growth are not distributed equally; that is if income levels within a community increase, but the impact of the increase remains distribution-neutral – and thus existing income differences are maintained or even widen – then the incentive for the relatively less well off to move away can possibly increase too. Such groups may in fact be slightly better off than previously, but they may perceive themselves to have become relatively poorer in comparison to their wealthier counterparts, and as a consequence the incentive to move may be considered to have increased.

Worthy of note is the fact that Stark and Taylor postulate that even if economic growth does involve some redistributional element it may still encourage migration outflows – especially when the availability of credit is not uniform – since households that have to some extent benefited from rising living standards may attain a theoretical threshold which makes it economically possible to leave to seek their fortune elsewhere.

Another factor which may be operative in current Baltic migration is a kind of generational ‘gridlock’, as the weight of earlier generations, and the ‘insider’ character of their employment situation effectively serves to frustrate younger and often better qualified labour market entrants who find themselves either unable to advance sufficiently rapidly, or to obtain a salary level which they feel to be commensurate with their true economic worth.

Given the fact that economic growth in all three Baltic Countries – and particularly in Latvia – has to date been largely concentrated in the more dynamic capital cities (Basarova & Titova, 2004), the possibility clearly exists that the inability of labour markets in provincial cities and rural areas to generate sufficient employment opportunities with the appropriate human capital element have lead these areas to become the greatest losers from out-migration, since seeing their capital-based compatriots reaping comparatively more substantial benefits from economic growth, they have decided to leave in search of better pay and improved life expectations in the United Kingdom, Ireland or Spain.

In this context the relatively better performance of Estonia in retaining a higher proportion of its more educated young people seems to be important. The present paper will examine institutional and generational factors in the transition in Estonia which may have contributed to its comparative success in this area, and will suggest institutional and other policy measures which may help to address the issues outlined.

Finally it will be argued that the directional and value component which is implicit in the current migration flows is quite simply unsustainable. Unless the Baltic States address the underlying issues of low fertility in the context of rapid ageing and to some extent reverse the ‘brain flight’ which has been so far associated with this, then absence of a sufficient supply of adequately qualified labour will in the space of a decade or so lead to a significant slowdown in the steady sectoral transition in economic activity and place a break on employment expansion in such a way that the economic growth process will either stagnate or even enter decline.

Bibliography

Basarova, Julia and Nellija Titova, “Distribution of Economic Activity In the Baltic States: Concentration and Specialization Patterns”, University of Southern Denmark 2004.
Stark O. and J.E. Taylor, “Migration Incentives, Migration Types: The Role of Relative Deprivation”, Economic Journal, 101 (1991): 1163-1178.

Williamson, Jeffrey and Timothy Hatton. What Fundamentals Drive World Migration? NBER paper 9159. 2002.

World Bank. Migration and Remittances, Eastern Europe and the Former Soviet Union. 2007.

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There then followed several days of political and financial chaos which saw market valuations rocking across the globe till finally the government issued a series of new measures designed to try and bring the country’s fiscal deficit problem back under control. Thus ended a brief and ill-fated experiment in alternative anti-crisis measures - one which in fact lasted for just under a month (the month we lived dangerously, aka suddenly last spring). Hungary’s new prime minister Viktor Orban has now sharply changed course, and said his government will cut public wages, overhaul the tax system and ban mortgage lending in foreign currencies in an attempt to reassure nervous investors he can contain the country’s budget deficit.

After a sweeping victory in April’s elections, which saw the victorious FIDESZ party elected with a two-thirds majority, the incoming government unveiled a program which departed dramatically from that of the previous caretaker Socialist cabinet that had been following the outline of an IMF Programme introduced after the country narrowly avoided economic meltdown in 2008. Initially the party had pledged to cut taxes and create jobs in an attempt to stimulate the growth the country evidently badly needs to tackle its heavy debt burden, although such moves would obviously threaten targets agreed under the country’s 20 billion euro European Union/International Monetary Fund bailout.

In fact Hungary has - for anyone who looked hard enough - been in an unsustainable fiscal position for some time now (try this article of mine in January, Is Hungary Another Greece?). It was obvious that the deficit was going to be higher than the 3.8% objective - indeed I personally clashed publicly with the Finance Minister (see his reply to me here) on exactly this issue back in January - and that the provisional figures coming out for growth from the statistics office were just a bit too good to be true. Furthermore, the underlying “cashflow” deficit (as in Spain, see charts below) was in fact higher because of the need to fund the losses of state companies and others (like the hospitals and other public entities where the previous government was simply funding the losses by classifying them as unpaid short term debts). Hungary had been lucky until the election in that the financial markets had been too busy with Greece, Southern Europe and the Eurozone to pay the country too much attention. Now that state of grace is well and truly over.

But beyond the immediate, headline-catching, story there lurk a number of issues with implications which stretch well beyond the frontiers of the small central European country. The first of these is the high preponderance of forex loans which have been taken out by Hungarian families (largely in CHF, they constitute over 85% of total mortgages). The presence of these loans has been a massive aggravating factor in Hungary’s ability to conduct an effective monetary policy in a context of high inflation and low growth. Swiss franc loans are attractive in Hungary, since they are much cheaper than forint denominated ones, since while interest rates determined by the National Bank of Hungary are still over 5%, at the Swiss National Bank they are effectively near to zero.

The second issue is the failure of the current IMF programme to return the economy to a sustainable growth path. The Hungarian economy contracted by 7% last year, and even while it grew slightly in the first three months of this year, the level of Hungarian PIB is still likely to fall again in 2010. A 5% increase in VAT last July, and increasing reluctance to take out more loans means that domestic consumption is still contracting, while the public sector has been in an ongoing adjustment process since 2006. This leaves the economy – like its Spanish equivalent – completely dependent on exports to obtain growth. Yet while Hungary now has both a trade and current account surplus, the heavy level of international indebtedness means that the burden of interest payments is heavy, and the capacity to generate export lead growth insufficient.

Of course, since Hungary is not a member of the Euro Group the country could devalue its currency, but the high level of external debt makes this very difficult, since the proportion of non performing loans the banking system would have to handle would rise sharply.

Finally, we have the political lessons. Having seen the experience of Greece, and now that of Hungary, it must be very clear to all that the traditional ploy of those who win elections against unpopular governments – of blaming their predecessors for the disastrous state of public finances – is now no longer open. The financial markets are indifferent to who is responsible, they simply want to know how the extra debt being made public is going to be paid. So the lions share of their anger inevitably falls on the incoming government.

Also, this kind of situation demands a high level of responsibility from opposition parties. This responsibility was not shown by the FIDESZ party. Indeed in 2008 they organised a succesful referendum against the constitutionality of a number of cost saving measures in the health system (see my post on this at the time), only to find that they themselves will have to introduce similar (if not identical) measures. The only casualty here is democracy. Countries facing problems which can lead to national bankruptcy need the maximum political unity and consensus in seeking a way out, and not short term political gests which can only bring more problems in the longer run. If pensions need to be cut, they need to be cut, if the only way to finance them is to issue more debt at a time when markets are tired of buying so much of it. The sooner politicians find the courage to recognise this the better, whether we are talking about Hungary, or other (let them be nameless) countries on Europe’s periphery in similar difficulties.

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So, the Second Congo War. To make a long story short, this happened because the victors of the First Congo War — that is, Congolese rebel commander Laurent Kabila, and his Rwandan backers — fell out among each other. The Rwandans, for their own reasons, had given Kabila a small army and (more importantly) logistical support and intelligence, allowing him to grow rapidly from a bandit leader to a formidable force. Over several months, he and his troops marched methodically across the country, pushing the dictator Mobutu’s crumbling armed forces out of the way almost at will. In May 1997 they took the capital; Mobutu fled, and Kabila became the new leader of the Democratic Republic of Congo.

Just fifteen months later — August 1997 — Kabila turned on the Rwandans and ordered them out of the country. They did not take this well. The result was the Second Congo War. It would last for years, suck in half a dozen neighboring countries, and become by some measurements the deadliest conflict since the Second World War.

But the question remains: why did Kabila turn so quickly against his Rwandan backers?

Part of the reason, of course, is that Kabila was a thug and a brute, and more than a little paranoid. Another reason is that Congolese nationalism was outraged by the obvious presence of foreigners around their new President. Kabila’s new government was shaky enough; being perceived as foreign puppets wasn’t helpful. But even taking that into account, the split between Kabila and the Rwandans happened so fast — and was handled so badly — that it’s still a bit mysterious.

This recent post on the excellent Congo Siasa blog offers an interesting additional explanation:

From the moment [Kabila] arrived in Kinshasa, he began thinking that Rwanda was going to get rid of him, egged on by his own coterie of wizened rebels who had little love for the Rwandans. His secretary, personal bodyguard and many security officers were Rwandans.

On the Rwandan side, they began watching him suspiciously, wondering what he would do. The people to take the first step were probably the Congolese Tutsi who had arrived with Kabila and were almost immediately marginalized. By March 1998 - only ten months after they took power - Moise Nyarugabo and Deo Bugera had (by their admission) begun planning to replace him, although allegedly without Rwandan support. They were mostly just frustrated that they had been marginalized and that Kabila had mismanaged his initial months in power.

The Rwandans probably didn’t really get involved in trying to get rid of Kabila until later, although the facts are murky. Given that the guy - Commander David - who held his pen and pad and stood outside his room at night well into 1998 was a Rwandan, it’s hard to believe that they wanted to get rid of him until much later. But the Congolese insist that the Rwandans mounted several assassination attempts in June and July 1998, just after Laurent Kabila asked them all to leave the country. By then, the Rwandan intelligence was reporting that Kabila had begun recruiting the very ex-FAR soldiers that the AFDL had initially set out to defeat…

But what came first? Kabila’s paranoia and recruitment of the ex-FAR, or Rwandan attempts to get rid of him? Intelligence services from both sides hyped up these possibilities - that was their job. They also had a bunch of over-eager Congolese spies they had hired, who wanted to ingratiate themselves with their higher-ups. Perverse incentives.

That last paragraph really made me sit up. Here’s the thing: when he fled, Mobutu left behind a huge internal security network. The whole country was larded with government spies. It was like East Germany on the equator. There were spies all through the military, spies in every government agency, spies in private businesses and next to foreign investors, spies to spy on spies. It’s been fifteen years since Mobutu fell and Congo is still crawling with them.

Okay, this wasn’t unique to Congo. Half of Europe had much the same problem after 1989. The new, post-Communist governments had to deal with decades-old, well entrenched internal security systems. It wasn’t easy. Many of the problems born of that era are still around today.

But in Europe, the new governments were (1) mostly perceived as legitimate, and (2) were made up of people who were reasonably familiar with the security agencies — if some cases because the new MPs and ministers had themselves had been their targets. In Congo, Kabila was running a rickety new government, installed by force, with little legitimacy beyond everyone being sick of Mobutu. And he and his “wizened rebels” had spent more than thirty years in the bush. So it was difficult for him to understand the system he’d taken over, never mind control it. And it was all too tempting for the spies to start feeding him (and the Rwandans!) “valuable” information whose real purpose was to increase their own value.

– Okay, it’s not quite irrelevant to Europe. I can think of at least two examples where post-Communist spy networks got out of control. One is Albania, where the Sigurimi security service converted itself almost overnight into the Mediterranean’s newest criminal organization. The other is Serbia, where — oddly enough — the spymaster that Milosevic inherited from 1980s Yugoslavia was often trying to work against him. (He didn’t succeed, but it’s interesting that he tried.)

That said, there’s no recent European example of internal security successfully starting a war. Thank goodness.

So, not that relevant to Europe. Just, interesting. No?

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Demographics and the Macroeconomic Environment
A theoretical model to asses some macroeconomic implications of population ageing

Authors: Claus Vistesen and Edward Hugh

Despite the rather distinct and specific characteristics in the ageing process across the EU countries, population ageing is in fact a global phenomenon. The specificities of the European ageing process are a legacy of the fact that it was in Europe that the process known as the demographic transition was first initiated. Two important points need to be kept clearly in mind about the population ageing process in a macroeconomic context. Firstly the process of the demographic transition is an ongoing one, with no evident end point. As such the trajectory of the process is associated with a considerable degree of uncertainty, and this kind of uncertainty presents important problems from a forecasting point of view, problems which most conventional models find it hard to address. However, as will be argued in this paper, some of these problems may be reduced if we simply focus on the evolution of the process in the short and medium term, since, from a macroeconomic point of view, some important structural features of the population ageing process are already becoming evident.

In the second place, it is important to take clear note of the fact that the demographic transition itself – and hence population ageing - is far being a uniform and symmetric process. Thus, while it may well be possible to postulate a theoretical ‘end-state’ limit towards which all OECD countries may be progressing, the duration and transition dynamics of the process are far from clear, and the presence of important feedback loops and significant path dependence components only serve to complicate the problem even further for analysis given that important differences exist in the speed of transition, and the fact that the very presence of such differing velocities and current states produces a certain dynamic interaction between macroeconomic performance, migration flows, fertility levels and life expectancy patterns both within and between countries, an interaction which is hard to both grasp and model.

In its most general terms , the demographic transition process is already a familiar one, and as such relatively uncontroversial. It is also relatively well accepted that the whole transition process is associated with (and indeed could easily be defined by) a steadily rise in population median ages. What have been much less well-explored to date are the structural macroeconomic consequences of such changes in median ages, in particular given that the pace and pattern of the associated age structure changes differ widely across OECD countries. As will be argued in this paper, cross-border transmissions arising from differing national demographic evolutions significantly modify national macroeconomic growth rates and levels of social welfare (Bryant 2006) . In particular the asymmetric character of the demographic transition may be thought to already be having notable effects on exchange rates, domestic demand and saving-investment shares in GDP in the highest median age countries, as well as on current account balances and imbalances, and, hence, on global liquidity and net capital flows.

Clearly at any given time, there are a variety of processes at work in the global economy (geopolitical shocks, technological changes, sectoral shifts, institutional devopements, etc) many of which are either totally unrelated to demographic trends, or at best only indirectly connected to such trends. Such processes and shocks have consequences for global macroeconomic interaction which may well be, and especially in the short term, much more powerful than the impact of the ongoing transition. Demographic processes are by their very nature slower-moving and cumulative, however over the medium and long term demographic forces can and do exert powerful effects, and it is to some of these that this paper will address itself.

At the individual country level when we talk of median ages, two countries immediately stand out - Germany and Japan – since they currently hold the somewhat dubious honor of being the oldest societies on earth in median age terms. Examining the recent economic performance of these two countries from a macroeconomic perspective, it is evident that some common structural features immediately stand out: weak domestic consumption; consequent strong dependence of export shares of GDP; relatively high savings rates; declining real trade-weighted exchange rates; demographically related labour market tightening which does not provoke domestic wage inflation. Starting from such common structural patterns this paper will develop a simple theoretical model which seeks to explain the consequences and effects of ageing on the macroeconomic environment via the impact on median age. The paper will draw on country-level evidence from Japan, Germany, and Italy. It will be argued that there are both sound theoretical reasons (Modgiliani’s life cycle saving and consumption model, as applied to populations) for anticipating, as well as clear empirical evidence to confirm, the idea that as population median age passes the 40 year mark an ongoing process of weakening in domestic consumption can be identified (as evidenced by the declining GDP consumption share as societies move forward) and, as a consequence, a growing dependence on exports becomes the key structural driver of economic growth. Having intitially examined the Japanese, German, and Italian cases, the model will then be extended to take into account recent experience in Switzerland, as well as in Scandinavia (specifically the Swedish and Finnish cases).

In conclusion, two points seem to be important here. In the first place the implications of this growing export dependency of the most ‘elderly’ societies needs to be explored in a global context, and in particular in the context of the so-called ‘macroeconomic imbalances’. Clearly the demographic transition is far from its end point, and meanwhile the impact of the uneven pace of the transition continues to make its presence felt. Globally the net sum of trade deficits and surpluses needs to be zero, so logically some societies will need to sustain substantial current account deficits to compensate for the ongoing export dependency of some of the currently richest economies. Without attempting any generalised solution to this issue at the theoretical level, a brief examination of the problem and of the most probable short-term scenarios will be presented.

Secondly, whilst it is clear that in the medium term, societies with median ages over 40 will tend to have a growing savings (and hence declining consumption) GDP share, it is far from clear that this net increase in saving will continue indefinitely as median ages approach the 50 mark and beyond (it is not even clear at this point whether median ages will stabilise at this level or continue to rise). There are theoretical reasons for anticipating a growing tendency to dis-saving at some point (although this depends on the relative ‘thickness’ of succeeding cohorts and their respective income levels as the population pyramid evolves). The problem will be outlined theoretically, although no attempt will be made to evaluate the levels of probability associated with each of the scenarios presented, since, in the opinion of the authors, the complete absence of empirical data makes such an exercise impossible in practical terms (and rather dubious in theoretical ones) at this point.

Finally it should be underlined that the theoretical aim of this paper is to outline ongoing macroeconomic impacts of ageing, independently of institutional changes and without reference to cultural specificities. This approach is not taken as a result of the authors’ belief that institutions and culture have no bearing on the macroeconomic environment but rather because of the paper’s fundamental assumption that ageing has a marked effect on macroeconomic variables which goes beyond and transcends the evident differences which exist on the institutional, structural and cultural levels. The paper thus situates itself in the long established tradition of partial analytics and our main purpose is to isolate the effects of ageing as they occur ‘other things being equal’. It is our contention that having established a consensus on this level, a much more substantial platform would then exist upon which the various ‘path dependency’ issues which inevitably arise could be explored.

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Monetary Policy and Eurozone Imbalances - The Demographic Transition and Asymmetric Shocks

Authors: Paula Silli and Edward Hugh

It is by now part of our received wisdom as economists that the single greatest difficulty envisaged for an optimum currency area as the idea was originally conceived by Robert Mundell would be the issue of adapting a ‘one size fits all’ monetary policy (especially given the associated absence of exchange rate flexibility) to the need to adjust to the presence of asymmetric shocks. Now whilst methodologically it may be somewhat questionable to attempt to address Europe’s differential demography in terms of shocks since the demographic transition may be far better conceptualised as a process than as a series of ongoing shocks (a process which most notably occurs with differing intensity and at different velocities from one country to another), the problem of the asymmetric impact of such changes on the different member countries which presently constitute the eurozone is a real enough one. Surprisingly, to date, this topic has received comparatively little attention in the literature. This short paper will be an attempt to address this other ‘imbalance’, to summarise the issues which are involved, and to initiate the much needed reflection process on the policy implications of the continuing presence of such asymmetries.

In order to begin this reflection process it may well be worth asking ourselves a number of key questions. Firstly, just what Eurozone imbalances are involved here? Secondly, assuming such imbalances exist, what are the underlying reasons for, and the structural drivers of, the imbalances? Thirdy, in the light of the above, should we be asking ourselves the question as to whether it is really appropriate to continue to speak of the Eurozone as one single economy (or structural entity) as conceptualised under the ECB’s two pillar monetary framework? These three issues represent the pivotal points of this paper.

At the present time the concept of internal Eurozone imbalances is normally operationalized by drawing attention to the notable differences which exist between the external balances of the various member country economies. Perhaps the most telling example here is to be found in the difference between two of the zone’s largest countries: Germany and Spain. The former country exited 2006 with a current account surplus close to 6% of GDP while the latter was running a current account deficit of just over 8% of GDP. Another approach to the same issue has been to try and think about imbalances in the Eurozone in terms of ongoing divergences in real exchange rates (Breugel, 2006). Now in fact such divergences in real-exchange rates occur as a result of differences in the domestic inflation rate and of varying rates of growth in domestic demand. Put another way, the transmission mechanism for monetary policy seems to vary from one zone member economy to another, and the big question is why should this be?

Data will be presented to illustrate how those countries experiencing fairly high rates of domestic demand growth generally have seen their real exchange rate rise relative to the countries which have had an ongoing weakness in domestic demand and which have become structurally dependent on leveraging exports in order to achieve respectable rates of GDP growth (and hence, indirectly, sustain that other imbalance, the government deficit one). In particular it is noteworthy how Germany - the zone’s largest economy - has developed a very complex series of relationships with the other Eurozone countries in terms of both the notable depreciation of its real-exchange rate since the 1990s, and the presence of systematic capital flows out of Germany into other member countries. These flows are associated with the relatively high savings rate which is to be found in Germany.

A variety of explanations are of course possible for the occurrence of such imbalances but few of those adanced to date seem able to account for the apparently systematic nature of the imbalances and the precise mix which is to be found. The differences which are to be found in the recent economic performance between the French and German economies would be a clear case in point. In an influential paper Duval and Elmeskov (2005) drew attention to the way the single interest rate policy might produce differential outcomes at the individual country level based on the character of the institutional response and degree of structural reform. However it is widely accepted that the structural reform process has gone much further in Germany than it has in France, and in the light of this the relatively robust performance of the French economy in recent years should certainly be considered puzzling. A similar argument could be made about the impact of globalisation and the so called ‘global labour arbitrage’ process. From the perspective of the more conventional narratives it is hard to see why domestic demand should be more robust to this impact in France than it is in Germany.

Now all of this begins to assume some importance when we return to the theoretical starting point for Mundell’s idea of optimum currency areas which assumed that a fixed exchange rate regime was the right choice for a group of countries which were tightly integrated through international trade and factor movements. It was always anticipated that asymmetric shocks would to some extent be in evidence as a result of an initial adjustment process among and between the economies which constituted the zone, and the contents of Maastricht Convergence criteria, as well as the growth and stability pact, obviously reflect just this awareness. Such initial shocks were normally conceptualised in terms of the well-known Balassa-Samuelson effects on relative prices. However the apparently endemic and ongoing character of the imbalances now begins to suggest that the process may be more than simply transitory, and that other factors may well be at work.

The present paper will therefore seek to develop the idea that the cause, nature, and crucially the future path, of the internal macroeconomic imbalances in the Eurozone may be best addressed by modifying the original theory of optimum currency areas to incorporate the presence of ongoing endogenous shocks experienced in the context of a fixed exchange rate regime as participating countries proceed through the demographic transition from different starting points and most importantly with considerable variance in tempo.

In particular this paper will formally expand on and develop the theoretical framework advanced by Ralph Bryant (Bryant 2006), who argues that cross-border transmissions arising from demographic processes which occur with differing velocities and outcomes significantly modify national macroeconomic performance, with the respective demographic transitions having particularly important effects on exchange rates (notional or otherwise), saving and investment ratios, current account balances and, hence, net capital flows.

The focus of the paper will be on the specific case of the Eurozone and the ECB’s single interest rate policy. We will suggest (and data will be presented to indicate) that the ECB’s monetary policy may inadvertantly have become a vehicle for transmitting systematic asymmetric shocks across the whole range of Eurozone economies.

Taking Modigliani’s idea of a life cycle saving and consumption pattern as applied to populations as a first approximation, and using movements in population median ages as a convenient proxy for a whole gamit of underlying processes, a simple model will be presented which it will be argued does a reasonably satisfactory job of accounting for the structural differences which are to be found across the various national economies in the zone, and at the same time offers a plausible framework for attempting to examine possible forward-looking scenarios.

Bibliography

Ralph C Bryant. Asymmetric Demography and Macroeconomic Interactions Across National Borders. Paper presented to the Demography and Financial Markets G20 Workshop organised by the Reserve Bank of Australia. 2006.

Duval, Romain and Jørgen Elmeskov. The Effects of EMU on Structural Reforms in Labour and Product Markets. Paper presented to the ECB conference “What effects is EMU having on the euro area and its member countries?”. 2005.

R.A. Mundell, “A Theory of Optimum Currency Areas,” American Economic Review, November 1961.
Bruegel, The Euro: Only For The Agile, Bruegel Policy Brief. 2006.

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