Francesco Giavazzi

Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries

According to conventional wisdom, a fiscal consolidation is likely to contract real aggregate demand. It has often been argued, however, that this conclusion is misleading as it neglects the role of expectations of future policy; if the fiscal consolidation is read by the private sector as a signal that the share of government spending in GDP is being permanently reduced, households will revise upward the estimate of their permanent income, and will raise current and planned consumption. Only the empirical evidence can sort out which of these two contending views about fiscal policy is more appropriate-i.e., how often the contractionary effect of a fiscal consolidation prevails on its expansionary expectational effect. This paper brings new evidence to bear on this issue drawing on the European exercise in fiscal rectitude of the 1980s, and focusing, in particular, on its two most extreme cases-Denmark and Ireland. We find that at least in the experience of these two countries the expectations view has a serious claim to empirical relevance.

Macroeconomic Effects of Regulation and Deregulation in Goods and Labor Markets

Product and labor market deregulation are fundamentally about reducing and redistributing rents, leading economic players to adjust in turn to this new distribution. Thus, even if deregulation eventually proves beneficial, it comes with strong distribution and dynamic effects. The transition may imply the decline of incumbent firms. Unemployment may increase for a while. Real wages may decrease before recovering, and so on. To study these issues, we build a model based on two central assumptions: Monopolistic competition in the goods market, which determines the size of rents; and bargaining in the labor market, which determines the distribution of rents between workers and firms. We then think of product market regulation as determining both the entry costs faced by firms, and the degree of competition between firms. We think of labor market regulation as determining the bargaining power of workers. Having characterized the effects of labor and product market deregulation, we then use our results to study two specific issues. First, to shed light on macroeconomic evolutions in Europe over the last twenty years, in particular on the behavior of the labor share. Second, to look at political economy interactions between product and labor market deregulation.

Current account deficits in the Euro area : the end of the Feldstein Horioka puzzle?

Both Portugal and Greece have been running large current account deficits, and these are expected to continue in the future. Yet, financial markets do not appear to be worried. Starting from this observation, we document that Portugal and Greece are in fact representative of a broader evolution: Increasing goods and financial market integration is leading to an increasing decoupling of saving and investment within the European Union, and even more so within the Euro area. In particular, it is allowing poorer countries to invest more, save less, and run larger current account deficits. The converse holds for the richer countries.

Immediate challenges for the European Central Bank

This paper discusses a number of issues that the newly constituted Board of the ECB will face early on. We show how conducting a European monetary policy is very different from living under the protective umbrella of the Bundesbank. We discuss voting on the ECB Board and argue that the ability to communicate to the public will be a critical factor for the success of the new institution. We also ask how a single monetary policy -- a common change in the interest rate controlled by the ECB -- is transmitted to the economy of the member countries. We show that the monetary process differs significantly inside EMU: initially disinflation episode could thus fall very unequally on a few member countries because they have a combination of financial structure that spreads a monetary contraction widely structure that is relatively inflexible. This process, moreover, is sure to evolve of the financial industry restructuring that is already underway and will be accentuated by the common money. Furthermore, as the Lucas principle suggests, the wage-price process itself will adapt to the changing focus of European monetary policy.

Limiting exchange rate flexibility : the European monetary system

Events of recent years have exacerbated the dissatisfaction with the performance of flexible exchange rates, and prompted a number of proposals to limit exchange rate fluctuations among industrialized countries. This book provides the first in depth analysis of the European Monetary System (EMS), the only lasting experiment of this kind.The books careful blend of theory and empirical analysis supports the view that, in Europe, nominal exchange rate targets have had significant real effects. Its detailed description of European economic institutions shows why exchange rate fluctuations are perceived as especially harmful.Giavazzi and Giovannini explain the institutional features of the EMS and describe how central banks run the system in practice. They offer an illuminating analysis of European capital controls and show how such regulations have guaranteed the survival of the EMS in a period characterized by unprecedented dollar fluctuations.The authors point out the lessons to be drawn from this experience with the EMS for the more general problem of reforming the international monetary system. Their forceful arguments are backed by analysis of such important issues as the determinants of international capital flows and international portfolio diversification, and the role of credibility and expectations in disinflation.Francesco Giavazzi is Professor of Economics at the University of Bologna. Alberto Giovannini is Associate Professor at the Columbia University Graduate School of Business.

The U.S. Current Account and the Dollar

There are two main forces behind the large US current account deficits. First, an increase in the US demand for foreign goods. Second, an increase in the foreign demand for US assets. Both forces have contributed to steadily increasing current account deficits since the mid-1990s. This increase has been accompanied by a real dollar appreciation until late 2001, and a real depreciation since. The depreciation has accelerated recently, raising the questions of whether and how much more is to come, and if so, against which currencies, the euro, the yen, or the renminbi. Our purpose in this paper is to explore these issues. Our theoretical contribution is to develop a simple portfolio model of exchange rate and current account determination, and to use it to interpret the past and explore alternative scenarios for the future. Our practical conclusions are that substantially more depreciation is to come, surely against the yen and the renminbi, and probably against the euro.

Is the international propagation of financial shocks non-linear?: Evidence from the ERM

Abstract This paper tests for the presence of non-linearities in the propagation of devaluation expectations among the countries that were members of the Exchange Rate Mechanism of the EMS. We show that whenever it is possible to estimate a model for financial interdependence, a full-information technique to detect such non-linearities is more efficient than the limited-information estimator proposed, in a similar context, by Rigobon (2000) . This happens, in particular, when the periods of market turbulence are relatively short. Our evidence suggests that non-linearities in the propagation of devaluation expectations were a general phenomenon in the ERM. Normally the non-linearity amounts to a stronger effect in the same direction, but sometimes, as in the Dutch case, it implies a significant effect in the opposite direction: evidence of flight-to-quality.

Rebalancing Growth in China: A Three-Handed Approach

Our paper is an attempt to define the contours of the right macroeconomic strategy for China. In a nutshell, we believe that the package includes a decrease in saving, with a focus on private saving, an increase in the supply of services, in particular health services, and an appreciation of the RMB. This is why we refer to this strategy as a three-handed approach: action on the fiscal and budgetary front, accompanied by currency revaluation. We start by asking how the Chinese economy got to where it is - what the strategy has been since the beginning of the reforms, and what the main characteristics of the economy are today. We then ask what is the desirable path for the future, and which are the main policy tradeoffs implied by such a path. Finally, we put the various pieces together to describe what we believe is a consistent policy package.

Adjustment and Growth in the European Monetary Union

The Maastricht Treaty, signed in December 1991, set a timetable for the European Communitys economic and monetary union (EMU) and clearly defined the institutional policy changes necessary for its achievement. Subsequent developments have demonstrated, however, the importance of many key issues in the transition to EMU that were largely neglected at the time. This volume reports the proceedings of a joint CEPR conference with the Banco de Portugal, held in January 1992. In these papers, leading international experts address the instability of the transition to EMU, the long-run implications of monetary union and the single market for growth and convergence in Europe. They also consider the prospects for inflation and fiscal convergence, regional policy and the integration of financial markets and fiscal systems. Attention focuses on adjustment mechanisms with differentiated shocks, region-specific business cycles and excessive industrial concentration and the cases for a two-speed EMU and fiscal federalism.

International Investors, the U.S. Current Account, and the Dollar

Two main forces lie behind the large U.S. current account deficits: an increase in U.S. demand for foreign goods and an increase in foreign demand for U.S. assets. Both have contributed to steadily increasing current account deficits since the mid-1990s, accompanied by a real dollar appreciation until late 2001 and a real depreciation since, which accelerated in late 2004. This paper explores whether and how much more depreciation is to come, and against which currencies: the euro, the yen, or the renminbi. The paper develops a simple model of exchange rate and current account determination based on imperfect substitutability in both goods and asset markets and uses that model to interpret the past and explore alternative future scenarios. The paper concludes that substantially more depreciation is to come, surely against the yen and the renminbi, and probably against the euro.