Web Essays and Comments

The French labour market reforms of 2005-2006 and their ensuing public protests made headlines around the world. While students took to the streets and politicians wrangled over the airwaves, two renowned French economists took the time to carefully evaluate the effects that the new labour contracts were expected to have.

The essay below uses a model capturing the chief characteristics of the French labour market to estimate the impact on unemployment, employment and aggregate welfare of the newly proposed labour contracts. The creation of new jobs is weighed against the deterioration of job-seekers welfare. To close, the authors suggest a more comprehensive reform package that could increase both job creation and welfare.

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So what is the impact of a common currency on trade? Rose's provocative essay in Economic Policy 2000, continues to stir discussions. Is the "Rose effect" only valid for poor, dependent countries? The creation of the EMU is seen by many as an ideal "natural experiment" to study the effects of a common currency on trade patterns within developed economies. Micco, Stein, Ordoñez and Barr, for instance, in Economic Policy 2003, find that the adoption of the Euro increased trade by 4-16 percent over the last four years of available data. The "Rose effect" is therefore alive and kicking.

But Berger and Nitsch take a step back to evaluate this apparently strong result with the perspective of time. They show a clear trend of gradually increasing trade among European and especially "to-become" EMU countries over a period of over half a century, due to the consecutive adoption of policies fostering integration, but not directly related to a monetary union. Surprisingly, the famous "Rose effect" disappears once this trend is controlled for.

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In a prominent article in Economic Policy 37 (2003), Honohan and Lane argued that the strength of the US dollar in 1999-2001 had an important impact on inflation divergence within the EMU and in particular the surge in Ireland's inflation to over 7 per cent.

Since writing, the hypothesis has been subjected to a grueling out-of-sample test: would the dollar's subsequent weakness contribute to inflation convergence and in particular to a fall in Irish inflation?

In this online commentary, the authors show that the theory passed the test with flying colours. Irish inflation stopped dead in its tracks: consumer prices were unchanged between May and November of 2003. Regression analysis on quarterly inflation data across EMU members 1999.1-2004.1 confirms the importance of the exchange rate channel, although pinning down the exact dynamic specification will require a further span of data, suggest the authors.

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Andrew Rose's article in Economic Policy 30 (2000), "One Money, One Market: the Effects of Common Currencies on Trade", quickly became a classic. It's results were topical and new. But especially, they were laid out so simply and elegantly, and were so unexpected yet so robust, that the profession was shocked. Immediately, economists, researchers, graduate students and journalists tried to refute the paper's conclusions. A whirlwind of attempts to reproduce Rose's methodology, adopt new econometric techniques, find new data, impose other assumptions quickly encircled the paper. But to date, no-one has authoritatively proven Rose's conclusions wrong. A common currency still increases trade "a lot"!

While other researchers were trying to challenge the paper, Rose remained very cooperative. His data has been available on his site and he has kept a careful log of all the major papers written in response to his. Some confirm his strong results, others find a significant yet smaller effect (like Torsten Persson, published in Economic Policy 33, 2001), and a few still remain convinced that Rose went wrong somewhere. But whatever the contending paper's conclusion, Rose often followed it with a rebuttal of his own. This collection of articles as well as Rose's replies can be found on Andy Rose's website.

It is becoming increasingly clear that the European Stability and Growth Pact is excessively rigid and arbitrary. Some even argue it dampens growth and may not be politically enforceable. Eminent economists have proposed various alternatives. For instance, some favor the consideration of structural deficits over the very cyclical and volatile actual deficits. Others have proposed setting standards for debt to GDP levels, not percentages. More recently, the idea has emerged of creating an independent committee to manage government spending, or of having markets monitor fiscal policy.

But rewriting the Stability and Growth Pact from scratch would not be easy, as it would entail formulating an entirely new treaty and having it ratified by all member states.

On the contrary, Blanchard and Giavazzi make a clever case in favor of reform. In particular, they argue for the Pact to be applied only to budgets including interest payments and depreciation, but excluding net investment. This would correct an accounting mistake in the Pact, but also allow governments to engage in investment projects yielding a high enough social return, stimulate the economy when needed and become more accountable to citizens through greater transparency. Finally, the authors present a bold new idea to create an agency to finance and manage public investment projects.

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Macroeconomic exchange rate models based on narrowly defined "fundamentals" are notoriously poor at explaining actual data, especially at horizons of less than two years. This has led to the famous Meese-Rogoff puzzle on which a series of well-respected authors have commented. It would seem like macro variables cannot account for exchange rates empirically. Instead, Lyons argues that micro models based on order flows have much higher explanatory power. The trading process per se is important, argues Lyons, to determine currency prices. The question is why. What is driving order flows? What information do order flows reflect?

Lyons believes that order flows may be determined by varying discount factors (reflecting the subjective evaluation of risk), but more plausibly by heterogeneous beliefs of how a currency will evolve, signals sent by market players of varying reputation and at times contradictory interpretations of macro-economic variables.

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This well crafted paper reads like a history book. It relates a first hand account of the shocking realization that exchange rates are better forecasted by a random walk specification than by any structural macro-economic model.

Rogoff and Meese were two young economists at the US Federal Reserve when they came across this stunning result that their superiors and advisors refused to believe for some time. The two young researchers entered the professional world just as excitement was stirring about the first well formulated macro-economic models of exchange rate dynamics. These models argued authoritatively that income, money supply, interest rates and capital accounts were at the heart of exchange rate movements. Although elegant, these models were strongly refuted by the data, found Rogoff and Meese. The macro models were built on assumptions of purchasing power parity and inexistent transaction costs - two factors which Rogoff later showed were responsible for leading the models' predictions astray. To date, argues Rogoff, despite significant improvements in theory and data collection, a random walk model continues to be the best predictor of exchange rates (at least in the short-medium run).

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