Why is output volatility falling for the euro area?

By: Eurointelligence Publication Review

In the Quarterly Report on the Euro area Vol 6, published this week, the European Commission had an interesting article on reduced volatility of output growth in the euro area.

 

It is well known that volatility of output growth declined since the 1970s in OECD countries. Compared to the US, the decline has been less sharp for euro area but volatility was and remains lower in the euro area than in the US. Within the euro area, the decline in volatility since the 1970’s is observed for all member countries although some member countries (Germany, Finland, Spain and Greece) experienced a reemergence of output growth volatility in the late 1980’s and early 1990’s due to country specific shocks.  German unification and the collapse of the Soviet Union generated boom-bust cycles that temporarily reversed the downward trend in volatility.

 

What are the reasons behind this declining trend in volatility? Though the decline is broad-based in the across GDP components, the biggest contribution to the decline in the euro area came from inventories. Based on covariance estimates the Commission finds that inventories have accounted for nearly 70% of the decline in GDP volatility since the 1970’s. Better inventory management and production technologies allowed for just-in-time delivery helped to reduce output volatility significantly.  Also, the restructuring of the economy from production to services explained about 10% of the decline in GDP volatility. The aggregate data though hides huge differences among member countries, with contributions of 30% in Germany and only 3% in France. So far, this is common sense although we are less certain how far the latter argument can be stretched to the future. Service sector activities might no longer enjoy the domestic shelter; some services - such as the financial sector - are exposed to competition internationally, its activities can become as disruptive to the economy as the production sector or even more.

 

The interesting part starts where the Commission argues that in contrast to the US there seem to be less contribution from financial markets. The strong contribution of both private consumption and housing indicating a key role of financial markets to the decline in volatility in the US is not evident for the euro area. Reduced private consumption in the euro area is attributed to lower volatility in the disposable income. The argument now is that since there is no evidence that labour income volatility contributed to this lower volatility in the disposable income, it can only be attributed to non-labour income and government transfers and taxes. The Commission now concludes that this is a-priori consistent with a more stabilizing role of fiscal policy. Two comments on this line of arguments. First, it is hard to believe that financial integration played no role for consumption smoothing amid the surge in residents’ credits since 2002 and booming housing markets in Spain and Ireland. Our suspicion is that the data set suffers from loss of information through aggregation (euro area figures are aggregated from six member countries - DE, ES, FR, IT, NL and FIN) and the short sample period (sample ends in Q3 2003). Second, non-labour income includes investment and inheritance income and is therefore an implicit measure of the contribution of financial markets. Since the data does not allow to distinguish between non-labour income and government transfers it is not clear to us at all whether it is fiscal policy rather than financial markets that provide the smoothing. 

The Commission highlighted another difference with respect to the US namely the contribution of macroeconomic policy to the reduction of output volatility. According to their analysis discretionary fiscal policy was less pro-cyclical since the start of EMU – at least in bad times. Furthermore, the increased size of the government expenditure as percentage of GDP led the Commission to conclude that the size of the automatic stabilizers also increased and improved the smoothing of cyclical fluctuations.

 

Monetary policy is also believed to have contributed to the reduction in output volatility. EMU entailed a significant change in the monetary regime for its member countries. Member states which have experienced the largest fall in the level of inflation since the 1070s are also those which have experienced the largest fall in GDP volatility. Since 1999, the ECB has been successful to stabilize inflation expectations. The Commission argues that the anchoring of inflation expectations is an important contribution to stability since it reduces the risk that short term inflation could entail an adjustment in long term inflation expectations.

 

Is reduced output volatility a matter of good luck or a permanent feature of our economy? Empirical studies for the US suggest that the main reason for reduced output volatility since the 1970’s is due to smaller shocks rather than the changes in the structure of the economy. But the Commission remains upbeat that structural issues together with a better macroeconomic management in the euro area are there to stay and ensure that high output volatility is a phenomenon of the past. Only time will tell whether the euro area is really as immune to financial market disruptions as the data of the past suggest.

 

email: mundschenk@eurointelligence.commundschenk(at)eurointelligence.com

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