EMU Imbalances in a Two-Country Overlapping Generations Model

The present sovereign debt crisis in the Economic and Monetary Union of the EU (EMU) is partly attributable to the pronounced increase in external imbalances across northern and southern euro zone countries during the years running up to 2007 (Lane and Milesi-Ferretti, 2011). While the behavior and extent of external imbalances during the pre-crisis period is empirically well documented (e.g. Lane and Pels 2012) it remains an open theoretical question how the evolution of the observed external imbalances can best be reproduced within an intertemporal general equilibrium model of the EMU. Fagan and Gaspar (2008) compare in a two-good, two-country Yaari (1965)-Blanchard (1985) overlapping generations (OLG) pure exchange model without government debt the pre-euro financial autarky steady state to euro-related financial integration between northern and southern euro countries (called core and periphery, respectively). They find that the evolution of intra-EMU external imbalances can be traced back to North-South differences in time preference. While the neglect of production and capital accumulation may be justified by the similarity of northern and southern GDP growth rates in the pre-crisis period the rather huge private capital movements from core to periphery over this period suggest a two-country overlapping generations model with production and private capital accumulation in order to check whether the observed EMU external imbalances can be attributed to differences in economic fundamentals within this model framework, too. In addition, we introduce government debt into our basic model in order to investigate whether in view of the pre-crisis time-stationarity in the debt to GDP ratios of both EMU core and periphery the observed external imbalances can be traced back to which economic fundamentals. Thus, there are two main objectives of the paper: First, to present stylized facts regarding the intra-EMU macroeconomic data running up to the financial crisis 2007 in order to motivate the model set-up. Secondly, to develop a two-zone OLG model with production, capital accumulation and government debt in order to figure out how EMU’s North-South external imbalances can be attributed to financial integration due to the common currency. To pursue the second objective, a one-good, two-country Diamond (1965)-Buiter (1981) OLG model with time preference and technological differences across countries (e.g. EMU’s North, South) and time-stationary debt to GDP ratios will be developed. It will be used (i) to see how the pre-euro real interest differential between EMU South (periphery) and EMU North (core) can be depicted in the proposed model and (ii) whether the observed external imbalances (net foreign asset positions) can be referred to the euro-related interest rate convergence between EMU core and periphery. Both countries in the model economy are interconnected through free international trade in commodities, real capital and bonds emitted by national governments. The objective of this highly stylized model is to figure out major economic mechanisms triggering the observed intra-EMU imbalances in the run-up towards the global financial crisis. This is clearly the first step to set up a dynamic applied general equilibrium model along the lines of Fagan and Gaspar (2008). The author finds that the pre-euro real interest differential can be attributed to a relatively high time preference, low total factor productivity and high capital production share in the periphery. Exactly these differences in economic fundamentals cause the pre-crisis evolution of the external imbalances among EMU core and periphery.