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Chapter 1 Comparing the peak and trough

F i g u r e 1



7 reveals that during the crisis a

drop of 55 percent occurred.

Similar figures hold for basically

all major stock market indexes

around the world. After having

experienced a drop of 50 percent

during the crisis, they have all

gained about 40 percent by the

end of last year, thereby reducing

the fall to approximately 30 per-

cent. Furthermore, overall vola-

tility in stock markets – as for

example measured by the implied

volatility on the S&P 100 and

which has become known as the

financial “fear factor” – has

F i g u r e 1



8 4

decreased substantially.

Not only were bond and stock

markets in turmoil during the cri-

sis, but also exchange rates were

quite volatile during that period.

Whereas the euro sharply depre-

ciated against the US dollar dur-

ing the crisis, it regained much of

its strength again during the

course of last year (see Fig-

ure 1.28). The historically strong

euro is reducing international

competitiveness of its member

countries and shifting at least

part of the burden of the eco-

nomic crisis on to euro area.

F i g u r e 1



9 Also within Europe exchange rates

moved quite a bit during the year.

The depreciation of the currencies

of EU member countries against

the euro has helped cushion the

crisis in those economies. The cur-

rencies which had clearly given

way during the crisis, i.e. the Czech

crown, Hungarian forint, Polish

zloty, Romanian leu, and the UK

pound, partly made up for their

losses during spring and summer

last year (see Figure 1.29). Still all

of them remain at values below

those observed shortly before the

crisis. On the one hand, this will

STOXX 50 improved by 47 percent since its trough in

March and has reduced its gap to its highest level 4 See Bloom and Floetotto (2009) and

reached in June 2007 to 35 percent (see Figure 1.27). on this.


EEAG Report 2010 Chapter 1

many firms have improved, however, after often hav-

benefit their competitiveness. On the other hand, for ing reached historical lows. The huge fiscal stimulus

the eastern European countries, whose debt is largely measures and expansionary monetary policy stance

denominated in euros, it also implies a higher foreign have prevented an even worse outcome. Industrial

debt burden. production has started its recovery after its sharp fall

and also the normalisation of world trade is under-



3 T h e m a c r o e c o n o m i c o u t l o o k way. The latter is also due to the improved trade

finance possibilities which were severely constrained

1.3.1 The global economy during the crisis.

In the course of 2009, most countries in the world However, the world economic recovery will only tem-

moved out of recession or at least witnessed a stabili- porarily turn out to be stronger than in autumn last

sation of their economies. Coming from mostly his- year. Structural problems, which suppress economic

torical lows, expectations of the Ifo World Economic growth, continue to be large. For instance, credit

Survey have skyrocketed in all major regions of the supply of banks will remain restrictive. A credit

world economy and even reached a historical high in crunch in the light of the increased demand for

Asia (see Figure 1.30). Given the tremendous fall – external funds is becoming more likely. However, the

which can only be partly reflected in these kinds of strong under utilisation of production capacities will

surveys due to the bounded nature of the answering continue and thereby keep the demand for net invest-

categories – many participating experts have realised ments comparatively low. Furthermore, the labour

that their economies have hit rock-bottom and that market situation will not only remain depressed, but

factually anything else than an improvement of the will slightly deteriorate further, dampening private

situation is becoming more and more unrealistic. consumption.

Furthermore, it is likely that they have also updated

their beliefs about what could be the worst state of the Furthermore, uncertainties, mistrust and panic-

world. Hence, given the relative nature of these survey stricken reactions all around the world during the

questions and the changed focal point, one has to be peak of the crisis have triggered a general de-lever-

careful not to draw too strong conclusions from them aging process throughout the economy and have led

in the present situation. Nevertheless, it is safe to say 5

to a surge in liquidity demand.

that experts around the world increasingly tend to To generate liquidi-

agree that the economic recovery will continue in the ty, many firms were forced to reduce inventories sub-

months to come. stantially. Stabilisation also implies that this process

of reducing inventories has been stopped and for the

Although not all problems have been solved, the time-being even reversed. Such inventory cycles,

uncertainty concerning future business cycle develop- however, are generally not long-lived and the cur-

ments has diminished – although remaining high in an rently observed positive impulses are bound to end

historical perspective – and the sales prospects of anytime soon. Finally, policy impulses, i.e. addi-

F i g u r e 1



0 tional policy measures, which so

far have not only stabilised but

also revived the world economy,

will become weaker during our

forecasting horizon. Especially

fiscal policy stimulus will fade

and even turn negative. The fiscal

balance situation in most coun-

tries has worsened dramatically

and will continue to do so in the

years to come. If they have not

already done so, governments

must inevitably develop strategies

5 Chapter 2 discusses in more detail the

role trust plays in financial markets.

33 EEAG Report 2010

Chapter 1 to reduce fiscal deficits and sub- F i g u r e 1




sequently implement them. This

will retard the recovery process

further. Hence, the world econo-

my will start lose momentum

during 2010.

After an unprecedented drop

since World War II of minus

2.3 percent last year, we expect

world GDP to increase by

2.5 percent in 2010. Hence, world

economic growth will stay below

6 Combined

its long-run average.

with a usual increase in labour

supply and further technological

progress, this will not prevent

unemployment rates from con- sumers have been living beyond their means for too

tinuing to rise. Inflation will accelerate somewhat, but long. To allow for a way back to sustainable growth,

also stay well below its long-run average. US consumers are in a process of curtailing their con-

sumption. This process has already set in but needs to

Despite the economic crisis in Japan, the only region continue during our forecasting horizon. However, it

that still managed to contribute to economic growth should ultimately not be compensated for by an

positively last year was Asia (see Figure 1.31). Its 7

increase in public deficits – as presently is the case.

growth contribution this year will reach almost pre- Furthermore, although the worse seems to be over for

crisis levels again. The two regions that remain well- the banking industry, a continuation of write-offs – as

below their potential are North America and Europe. predicted by the IMF (2009) – is highly likely and gov-

Of the four major regions in the world, it is evident ernment interference in the banking and real estate

that none of them will reach pre-crisis levels again this sectors will consequently remain high. On top of that

year (see Figure 1.32). – and as discussed in more detail in Chapter 3 – fiscal

sustainability is a new issue that will stay on the agen-

1.3.2 United States da for the years to come.

Although the recession has ended, the US economy The fiscal stimulus package will unfold its biggest

still has to conquer its structural problems. US con- influence on the deficit in fiscal 2010 when about

400 billion US dollars of the

estimated 787 billion US dollars

F i g u r e 1



1 becomes effective. On top of

that, rising social expenses, par-

ticularly in areas related to the

labour market and the health

sector, will hardly result in a low-

ering of the budget deficit in fis-

cal 2010 despite the reduction in

expenses related to banking sec-

tor. Therefore, the debt-to-GDP

ratio will surpass 90 percent this

year. This will further limit the

6 This figure is based on market prices. If

instead purchasing-power-parity adjusted

weights were used – and therefore emerg-

ing markets would receive higher weights

– our growth forecasts would be 3.2 per-

cent in 2010 (see Figure 1.2).

7 See Chapter 4 on this.


EEAG Report 2010 Chapter 1

room for manoeuvre of the US government in the construction investments and investments in equip-

years to come. ment and software. Credit constraints and subdued

domestic developments will prevent fixed capital for-

Many banks are still not willing to add mortgage mation from taking a lead in the US recovery.

loans onto their own balance sheets. Consequently,

approximately 95 percent of all new mortgage loans Although both exports and imports will continue to

are currently issued and securitised by the government grow, the weak dollar and the constraints on domestic

supported enterprises, Fannie Mae, Freddie Mac and demand will allow net exports to contribute positive-

Ginnie Mae. These mortgage-backed securities are ly to economic growth. Consequently, the current

mainly bought by the Federal Reserve. Hence, termi- account deficit will continue to be reduced – albeit at

nating this kind of monetary assistance – as scheduled a slower pace than last year.

for the first quarter this year – will put a substantial

burden on the mortgage market. Besides increases in Driven by extensive monetary and fiscal policy as well

mortgage interest rates and a further rationing of as cyclically-determined inventory investments, over-

mortgage supply, it is quite possible that this will trig- all production will still noticeably expand during this

ger further reductions in real estate prices. Also to winter half-year. However, as the impact of these sup-

alleviate this, the Federal Reserve will continue its portive elements will weaken and the heavy burdens

zero-interest rate policy throughout this year. on private consumption will remain, GDP growth will

lose its momentum. After a decline of 2.6 percent last

Although monthly data on private consumption give year, GDP will expand by 1.9 percent this year. The

a relatively upbeat impression of the fourth quarter of unemployment rate will reach an average of 9.5 per-

last year, consumer sentiment surveys, on the other cent this year.

hand, indicate that consumer confidence remains low.

In particular, the persistently tense labour market sit- After the recession and the fall in energy prices caused

uation is responsible for this. The sharp rise in unem- inflation in the US to even turn negative last year,

ployment is increasingly restraining income develop- consumer prices will start to increase again at very

ments of households. The increase in nominal wages moderate rates. For this year, we expect annual infla-

has already slowed down noticeably and real wages tion to equal 1.6 percent.

will be under pressure more and more especially now

that the negative base effect on inflation caused by the 1.3.3 Japan, China, India and other Asian countries

drop in energy prices last year has ended. Due to Although will continue its recovery in the

falling interest and dividend income, real disposable Japan

short run, the medium-term expectations are quite

income – the most important determinant of private bleak. Whereas both private consumption and

consumption – already fell during the third quarter of exports allowed for relatively positive developments

last year. during the last three quarters of 2009, it is to be

expected that only the latter will remain the main

Reducing the indebtedness of households will increas- driver of growth this year. The Japanese export

ingly restrain consumption. Saving rates have already economy benefits from its geographical proximity to

increased from approximately 1 percent in early 2008 Asian emerging markets, which are experiencing a

to around 4.5 percent at the end of last year. This surge in domestic demand.

process is likely to continue as is also shown by

reduced lending to households, in particular with Especially the slack in private consumption will sup-

respect to credit card loans. Consumer loans have press the domestic economy. As most of the con-

already sunk nine months in a row up until October sumption-oriented stimulus packages are expected to

last year. With the expiration of state support in the be phased out in the first half of 2010, a setback in

course of 2010, private consumption will hardly consumption growth is likely. With the prolonged

expand anymore. duration of the under-utilisation of production

capacities, both employment and wages are expected

Investment will stop declining. Although the situation to decrease. Furthermore, the persistent deflation will

on the real-estate market remains fragile, residential attenuate private demand. Although exports will

construction already stopped falling during the sec- remain the main pillar for economic growth based on

ond half of last year. More stable business conditions the surge in demand from China, the strong yen –

will induce the same with respect to non-residential 35 EEAG Report 2010

Chapter 1 reaching a 14-year peak against the US dollar at the last year, it will stay below 3 percent this year.

Furthermore, according to official statistics, the

end of November last year – will nevertheless restrain unemployment rate in urban regions remains low.

the export-dependent Japanese economy. Also from the exchange rate side no negative impuls-

es are to be expected. In spite of criticism from

The Japanese authorities take these risks seriously abroad, the Chinese government appears to be

and have – contrary to other governments in the retaining its policy of keeping a fixed exchange rate

Asian region – initiated new measures to stimulate to the US dollar, thereby continuing to subsidise its

the economy. At the beginning of December last export-oriented economy via a strongly undervalued

year, the Japanese government launched an addi- renminbi.

tional stimulus package of 7.2 trillion yen (54 billion

euros) directed towards domestic demand to prevent In principle, the room to manoeuvre for the Chinese

the menacing drop in consumption. The Bank of government remains large. The success of the stimulus

Japan has announced intentions to stick to its low- packages have induced larger than expected govern-

interest rate policy for the time being and has once ment revenues. Thus, the fiscal deficit reached only

again provided liquidity of more than 10 trillion yen around 3 percent of GDP last year and the public

(76 billion euros) to the banking sector to boost debt remains modest. Nevertheless, economic policy

credit supply. is increasingly putting a burden on the Chinese econ-

omy by aggravating unbalanced economic develop-

Consequently, these measures will further increase ments. Already during the past years gross capital for-

public deficit and debt as a percentage of GDP this mation, at a share of more than 40 percent, was

year. The latter will surely surpass 200 percent this extremely high – even larger than the share of private

year. Although the public finance situation is unlikely 8 As a clear focus of

consumption (about 35 percent).

to be sustainable in the long run, the situation in the economic stimulus package is to support invest-

Japan is – in an international comparison – quite ment activity of large, often state-controlled, enter-

unique. Although the public sector has been dissaving prises, their weight will even increase further. In the

for decades, the savings rate of the private sector more medium term, many of these investments may prove

than compensates for this. Japan for years has already to be misdirected, unprofitable and may lead to over-

been a net creditor to the rest of the world. Hence, it capacities in some sectors. Furthermore, the strong

has at least thus far been relatively easy for the increase in credit growth has induced a boom in both

Japanese government to finance its debt domestically stock and real-estate markets which might turn out to

at low cost – the 10-year government bond yield hov- be bubbles.

ers at around 1.3 percent presently. Approximately

90 percent of Japanese government debt is owned by Also has to a large extent been able to remain


Japanese individuals. close to its long-run growth path throughout the cri-

sis. The outlook for this year remains favourable and

In 2010, the positive impulses from the world econ- its growth rate is bound to remain robust. We expect

omy, and in particular from China, will prevail over an increase of GDP by about 6.8 percent.

the domestic problems. All in all, economic growth

will amount to 1.0 percent (after – 5.3 percent last In light of this, both government and central bank

year). have announced that they will terminate their stimu-

lus measures. At the end of last year, the government

The short-term economic prospects for China remain announced that it would reduce its funds to support

quite positive. This can especially be traced back to the economy this year. This was not only triggered by

government policy which succeeded – with a massive the improved economic situation, but also by the esti-

stimulus program – in strengthening its economy mated large budget deficits of 7 percent of GDP both

without relying on outside impulses. The program is last and this year. Also at the end of last year, the

scheduled to run out by the middle of this year and central bank of India announced its aspiration to

will not be fully compensated for by impulses from the raise interest rate in the first quarter in 2010 again.

rest of the world. As a consequence, GDP growth will Among the central banks in Asia, it thereby takes the

equal 8.5 percent this year. lead. Higher inflation forecasts have probably been

This optimistic view is not clouded by an increase in 8 In a typical developed country, these figures are around 20 percent

inflation. After having been partly negative during and 65 percent, respectively.


EEAG Report 2010 Chapter 1

decisive for this decision. Due to low precipitation sions fell back relative to wages in recent years, they

already in October last year, food prices have surged. are scheduled to increase substantially this year. As

The inflation rate is likely to increase to beyond 5 per- a downside of these measures, the public finance

cent this year. situation has already worsened substantially last

year –the budget deficit rose to 7 percent of GDP in

In the remaining emerging economies of Asia, i.e. the first half of 2009 as compared to a surplus of a

similar magnitude the year before. It is bound to

Indonesia, Malaysia, the Philippines, Singapore, South

and the recovery will contin- deteriorate further, albeit at a slower pace. Parts of


Korea, Taiwan

ue. Although domestic demand will also pick up, the the deficit are and will be financed by withdrawals

region will mainly benefit from economic develop- from the stabilisation fund that is fed by raw mate-

ments in China. Hence, the current account surplus of rial proceeds. Its size, however, is shrinking quickly.

the region will – after having been reduced last year – Whereas it amounted to 16.2 percent of GDP on

increase again. GDP of these East Asian countries average in 2008, it was only 12.7 percent in Au-

will grow by a moderate 3.5 percent this year. gust 2009.

1.3.4 The rest of the world 1.3.5 Assumptions, risks and uncertainties

The present recovery of the global economy and its This forecast rests on the technical assumption that

subsequent slow-down will also affect Latin America oil price will move around 75 US dollars per barrel

and Russia. and the euro exchange rate stabilises at around

1.45 US dollars. World trade is expected to increase

For the Latin American countries of by 5.0 percent this year, after having dropped by


and 11.0 percent in 2009.


Brazil, Chile, Colombia, Mexico

sound economic conditions assure that its recovery

can continue to be largely driven by domestic fac- Although the banking crisis appears to be under con-

tors. Consequently, the current account deficit which trol and the world economy is slowly recovering,

has emerged during the crisis – and reflects the uncertainty about economic prospects remains high.

buffering function of this region for the world econ- Whereas the maximum spread between forecasts of

omy during the crisis – will remain negative through- (approximately 25) different institutes in the US, as

out our forecasting period. GDP having shrunk by measured by its 95 percent confidence interval, has

2.2 percent last year, the region will expand by been around 70 basis points for the years 2005 until

3.1 percent in 2010. 2007, it increased to approximately a 100 and

150 basis points for 2008 and 2009, respectively. For

Not all countries in this region will recover at the 2010 the largest amount of uncertainty amongst pro-

same speed. Whereas growth will remain compara- fessional forecasters was registered in early 2009; the

tively strong in Brazil as a result of the robust domes- spread even reached 185 basis points (see Figu-

tic demand, it will be much weaker in Mexico. The lat- re 1.33). In the latest data we have seen a reduction to

ter continues to suffer from its proximity to and there- 96 basis points, which is historically still large. For the

by dependence on the US economy. Some of the euro area a similar picture emerges, albeit its peak

countries benefit from the recent increase in raw mate- with respect to the forecast disagreement for 2010 was

rial prices. in August 2009.

will only increase gradu-

Economic activity in In our forecast the economies of industrialised


ally. GDP growth is expected to rise by only 1.5 per- countries and especially the US will only recover

cent this year, after having fallen by 8.0 percent in slowly. However, several leading indicators have

2009. Especially the recovery of investment will be improved substantially in recent months. In our

slow. The worldwide increase in demand for raw mate- view, besides the technical problems with many of

rial – and in particular from China, the second most these survey-based indicators mentioned in Section,

important trading partner of Russia – will, on the this is largely due to the extraordinarily expansion-

other hand, be supportive. ary economic policies carried out by government

and monetary authorities around the world. Its

Private consumption will be stimulated by expan- stimulus impact could be much stronger if the mul-

sionary fiscal policy. For instance, whereas pen- tipliers are bigger than we expect. In that case, the

37 EEAG Report 2010

Chapter 1 capital ratios of banks continue to

F i g u r e 1



3 erode as a consequence of further

massive write-offs. According to

calculations of the IMF (2009), still

pending write-offs continue to

jeopardise financial market stabili-

ty. The fragility of financial mar-

kets became apparent at the end of

last year as seen by the reaction of

stock markets to financial difficul-

ties in Dubai and Greece. An inten-

sification of the banking crisis as a

result of other shocks could send

financial markets into a downward

spiral. This would undoubtedly

have negative consequence on the

world economic climate.

Another risk for the world econo-

my lies in the challenge for policy-

makers to reverse their expansion-

ary course appropriately. Phasing

out expansionary policy should

ideally occur when the economy –

in particular private domestic de-

mand – has stabilized and is able to

revive gradually without further fis-

cal or monetary impulses. However,

if governments decide to cut back

their stimulus measures too early,

many economies would fall back

into recession. This holds both for

monetary policy as well as fiscal

policy. The latter could be tempted

to limit the massive expansion of

private economies would not only stabilise but also budget deficits by introducing consolidation measures

go into a sustainable and self-supporting upswing. too quickly. Indeed, also waiting too long before

reducing stimulus measures contains considerable

Furthermore, our US scenario is based upon the idea risks; it could easily cause a drop in confidence in the

that private consumption will have to remain subdued sustainability of monetary and fiscal policy. Should

until structural problems of the US economy are central banks maintain their expansionary course

overcome. If, on the other hand, US consumers do much longer, this could lead to an increase in inflation

not increase their saving rates by as much as we expectations. Also the likelihood that a new bubble

assume, the US economy might perform – from a emerges somewhere in financial markets would be

business cycle perspective – better than expected. By high as a result of a persistent increase in liquidity.

bringing our US forecast closer to what is currently Already now it cannot be ruled out that the recovery

the consensus, this would also uplift our forecast for on financial markets is unsustainable.

the rest of the world. For fiscal policy, high public deficits could also result

However, there is also the risk that the world economy in a credibility problem by which the room to

will slip into recession again especially if the credit manoeuvre would be seriously limited. In case gov-

supply by banks should be restricted more and longer ernments do not succeed in communicating their con-

than expected. This would above all happen when solidation efforts credibly, this would seriously reduce


EEAG Report 2010 Chapter 1

trust and lead to an increase of F i g u r e 1




the capital market interest rates.

This would, in turn, increase the

interest burden of public finance.

1.3.6 The European economy

The cyclical situation

The deep economic recession has

moved from a stabilisation phase

mid-2009 into a moderate recov-

ery. Coming from historical lows,

consumer and producer confi-

dence are on the mend and point-

ing upward. The recovery is like-

ly to continue in the coming

quarters. It is still doubtful

though whether it will turn into a

self-supporting upswing. Several F i g u r e 1




restraining factors remain. Credit

supply is bound to become more

restrictive also because the past

recession will for the time being

continue to create additional

write-offs. Capacity utilisation

rates will – after their severe drop

during the crisis – only slowly

move away from their historically

low levels. Consequently, the situ-

ation on the labour market will

continue to deteriorate. Hence, as

soon as stimulus measures and

impulses from the inventory cycle

wear off, the European Union is

likely to fall back to a phase of

low growth. After having sunk by

4.0 percent last year, GDP will

rise to 1.0 percent this year (see

Figure 1.34).

Of the demand components, only

gross fixed capital formation will

continue to contribute negatively

to economic growth this year (see

Figure 1.35). Investments will

first continue to fall, but during

the course of the year increase

moderately. A combination of

low profits, tougher financing

conditions and low growth pros-

pects will continue to put a bur-

den on firms’ willingness to in- 39 EEAG Report 2010

Chapter 1 vest. Although machinery and F i g u r e 1




equipment investment is likely to

pick up somewhat during the

year, the large fall in 2009 will

prevent annual rates from turn-

ing positive. Despite the first

signs of stabilisation on housing

markets, residential investment

continues to shrink, albeit at a

slower pace. Also non-residential

construction will continue to

report negative growth. Stimulat-

ed by fiscal measures, only infra-

structure investment will show

moderate growth this year.

A relatively strong impulse will

come from investment in invento- Employment, sectoral output and inflation

ries. Whereas during the crisis the speed at which

inventories were emptied out was extraordinary (to On account of its lagging characteristics with respect

increase firm liquidity), it was also clear that this to the business cycle, the labour market situation will

process was not sustainable. In the meantime invento- further deteriorate in Europe. After having declined

ries are still falling, albeit at a slower pace. Already the by a – considering the depth of the crisis – moderate

reduction in the rate of decline is creating a positive 1.9 percent last year, the number of employees will

impulse for economic growth. The decline in invento- continue to decrease by another 1.4 percent this year

ries is bound to turn into an increase. Therefore, the (see Figure 1.36). As a near mirror-image, the unem-

positive impulses will remain during the first half of ployment rate will continue to rise reaching an average

this year. Once inventories have been restored, their of 10.3 and 9.9 percent in the euro area and the

cyclical influence is likely to diminish again. European Union, respectively (see Figure 1.37).

The largest demand component, i.e. private con- Developments of individual sectors throughout the

sumption, will deliver only a small positive contribu- crisis have been quite different. Their prospects also

tion to economic growth in the European Union. It vary substantially. Fiscal stimulus packages almost

will expand only moderately as a result of the pre- always have – for political reasons – a focus on domes-

carious situation on the labour market and the tic markets. Although the economic crisis mainly

reduced real wage growth. Lower nominal wage

growth together with moderately

increased inflation rates will F i g u r e 1




suppress developments in real

disposable income.

Stronger growth in emerging

markets together with moderate

developments within the Euro-

pean Union will allow net ex-

ports to contribute positively

again to overall growth, thereby

increasing the prevailing trade

account surplus again after its

shrinkage last year. Both ex-

ports and imports will grow,

albeit the latter at a somewhat

slower pace. 40

EEAG Report 2010 Chapter 1

evolved within the export-ori- F i g u r e 1




ented manufacturing and the

domestic-oriented construction

sectors, to a large extent only the

latter could benefit from sup-

portive government actions. As

the turn-around in international

trade seems to have been accom-

plished, this is, however, less

clear for construction invest-

ment in Europe. Nevertheless,

fiscal stimulus measures are

bound to fade out, not least

because of the sharply deterio-

rated public finance situation in

many countries. This suggests

that there will be a relative shift

of economic problems away

from the export-oriented sectors

towards the domestic economy

and in particular the construc-

tion sector.

This is further supported by

consumer behaviour. Whereas

in some European countries

consumption was able to act as

a buffer during the crisis, labour

market and income develop-

ments are likely to suppress

that. As a consequence, and

given that emerging markets are

continuing to develop, export-

oriented sectors are likely to

regain some of their growth,

whereas those that focus more

on the US and EU consumers

will suffer the aftermath of the

economic crisis. cycle forces are gaining strength, the impact of eco-

The increase in prices will all together accelerate nomic stimulus measures will gradually fade.

somewhat, but – given low capacity utilisation rates Furthermore, credit constraints will increase and

and stable inflation expectations – remain restrained. labour market conditions deteriorate. The German

The increase in consumer prices will be 1.2 percent in economy remains weak and a self-supporting upswing

the European Union in 2010 (after 0.8 percent last is not obvious.

year). In the euro area, the inflation rate will equal

0.9 percent in 2010 (after 0.3 percent last year). Given world economic developments, German ex-

ports will only grow moderately. Together with weak

Differences in output growth within Europe domestic developments, imports will show a similar

profile and the external balance will only marginally

Economic developments in remain subdued

Germany contribute to economic growth. Machinery and

in a historical perspective – albeit above the EU aver- equipment investments will only rise a little as capac-

age (see Figure 1.38). Although endogenous business ity utilisation rates are still low and financial con-

41 EEAG Report 2010

Chapter 1 straints increase. At the end of this year, the removal labour market situation has continuously deteriorat-

of degressive depreciation schemes might lead to a ed. Furthermore, capacity utilisation rates remain at

short and temporary uplift in investment activity. historically low levels after having fallen deeply at the

For the time being, infrastructure investments will beginning of last year. The initial increase of GDP

continue to benefit from the fiscal stimulus mea- might level out in the course of the year as a result of

sures. However, construction of commercial build- the phasing out of economic stimulus measures.

ings will show negative growth this year. At the Overall GDP will rise by 1.6 in 2010.

beginning of this year, disposable income and hence economy will continue to suffer from its

private consumption have received an impulse as The Italian

low degree of competitiveness and therefore only

child benefits and tax exemption for dependent chil- marginally benefit from the recovery of world

dren have been increased. However, this will only demand. Although the manufacturing industry has so

temporarily increase dynamics. Furthermore, car far carried out a number of substantial restructuring

sales will drop further as the car scrappage scheme measures which have led to a relative improvement in

has ended. The savings rate remains high in view of particular with respect to product quality, within the

labour market uncertainty and stagnant economic scope of this restructuring many firms depend on

developments. Real GDP will increase by 1.6 percent credit supply and therefore currently face two prob-

this year. lems: A more restrictive credit supply by banks and at

give a pos- the same time the weakness of domestic and foreign

Leading indicators in the United Kingdom

itive but still restrained picture with respect to the demand. This year, production will recover only slow-

recovery of private consumption and investment. ly. GDP in Italy will increase by 0.5 percent. The

Consumer confidence and the business climate have strongest positive impulses will come from private

improved during the last months. However, they consumption. In addition, tax breaks on machinery

remain below their long-term averages. In spite of and equipment investments are scheduled until the

expansionary monetary policy, credit supply of banks end of June. This will temporarily reduce the fall in

remains restrictive largely because banks’ balance investment. The slow recovery of the world economy

sheet problems have still not been fully solved. This will strengthen Italian exports.

puts a burden on the recovery of residential and non-

residential investments and purchases of durable con- The sharp decline in house prices and construction

sumption goods. Another restraint on private con- activity, the resulting substantial rise in unemploy-

sumption is the high unemployment rate, which aver- ment, its weak international competitiveness and the

aged 7.8 percent last year. Because labour productivi- scheduled restraint in fiscal policy will altogether


ty has fallen sharply, the unemployment rate is bound constrain economic development in Spain

our forecasting horizon. The high unemployment

to increase further. It is estimated to reach 9.2 percent rate, reaching 20 percent on average this year, will

this year, on average. On the other hand, real-estate decrease wage income and thereby dampen private

markets appear to have stabilised on account of bet- consumption. Furthermore, the risk of unemploy-

ter loan conditions and a somewhat positive wealth ment will encourage precautionary savings. The

effect. All together the British economy will only large number of unsold houses remains a consider-

slowly recover. Improved export possibilities due to able burden on the construction sector. Hence, a

the weak pound and the recovery of the world econo- continuation of the recession is to be expected. Real

my will allow the United Kingdom to enter into a sta- GDP will decrease by 0.5 percent this year (after a

bilisation phase in which GDP will grow by 1.0 per- 3.7 percent decline in 2009).

cent this year. The inflation rate will remain near its

target value of 2 percent. The consequences of the worldwide economic reces-

the sion will retard economic recovery in the central and

For the economic development in France,

increase of government consumption will be decisive eastern European region more than in other regions in

during the first part of the year. Hence, the French the world. Although, with the help of international

economy will initially be able to revive itself, financial institutions, a breakdown of financial and

although business cycle prospects remain mixed. economic systems has been prevented, the necessary

Industrial production has risen recently and also adaptations to the new situation are still on the agen-

leading indicators have once more improved largely da. A return to credit-based growth financed by for-

on account of positive expectations. However, the eigners seems unlikely in the years to come. Domestic


EEAG Report 2010 Chapter 1

demand will remain weak in view of rising unemploy-

ment rates, reduced tax receipts, and the pressure to

consolidate public finances. Altogether, GDP of the

region will only grow by 1 percent this year. Caused

by persistent, although weak, consumption growth,

the two largest central and eastern European Union

member countries, the Czech Republic and Poland,

will be able to outperform the others and grow faster

than the EU average. Especially the recessions in the

three Baltic States, Estonia, Latvia and Lithuania,

will remain deep.

R e f e r e n c e s

Bernanke, B. and C. Lown (1991), “The Credit Crunch”, Brookings

2, 205–47.

Papers on Economic Activity

Bloom, N. and M. Floetotto (2009), “The recession will be over soon-

er than you think”,, 12 January 2009.

Düwel, C., H. Rottmann and T. Wollmershäuser (2010), “A Micro

Data Approach to the Identification of Credit Crunches”, Working

Paper, Ifo Institute for Economic Research.

Girouard, N. and C. André (2005), “Measuring Cyclically-adjusted

Budget Balances for OECD Countries”, OECD Economics

Department Working Papers 434.

IMF (2009), Global Financial Stability Report: Navigating the

Financial Challenges Ahead, October 2009, IMF, Washington,

Chapter 1. 43 EEAG Report 2010

Chapter 1 Ap p e n d i x 1 :

F o r e c a s t i n g t a b l e s

Tablee A.1

1 GD P gr owt h,, inflatio n an d u nem plo ym entt inn v ariouss co u ntries d)

GDP growth CPI inflation Unemployment rate

Share of

total GDP in %

in% 2008 2009 2010 2008 2009 2010 2008 2009 2010

34.0 0.8 – 4.0 1.0 3.5 0.8 1.2 7.0 9.0 9.9

EU27 25.1 0.6 – 4.0 1.0 3.3 0.3 0.9 7.6 9.4 10.3

Euro Area 0.9 1.8 – 2.0 1.1 2.4 – 0.5 0.5 3.5 3.8 4.4

Switzerland 0.8 2.1 – 1.4 2.0 3.8 2.4 1.7 2.5 3.5 3.7


Western and Central

Europe 35.8 0.9 – 3.9 1.0 3.5 0.8 1.2 6.9 8.8 9.7

26.7 0.4 – 2.4 2.4 3.8 – 0.4 1.6 5.8 9.2 9.5

US 9.1 – 0.7 – 5.3 1.0 1.4 – 1.3 – 0.4 4.0 5.3 5.8

Japan 2.8 0.4 – 2.4 2.2 2.4 0.3 1.6 6.1 8.3 8.7



countries total 74.4 0.5 – 3.5 1.6 3.3 0.1 1.2 6.1 8.4 9.1

Newly industrialised

countries · · · · ·

3.1 5.6 – 8.0 1.5 ·

Russia · · · · ·

China and Hongkong 8.4 8.7 7.8 8.5 ·

· · · · ·

2.2 7.3 6.1 6.8 ·

India · · · · ·

a) 5.0 3.0 – 1.5 3.5 ·

East India · · · · ·

b) 6.9 3.7 – 2.2 3.1 ·

Latin America

Newly industrialised · · · · ·

countries total 25.6 5.8 1.2 5.1 ·

· · · · ·

c) 100.0 1.8 – 2.3 2.5 ·

Total · · · · ·

– – – 11.0 5.0 ·

World trade, volume

a) Weighted average of Indonesia. Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand. Weighted with the

b) Weighted average of Argentina, Brasil, Chile, Columbia, Mexico, Peru,

2006 GDP levels in US dollars. – c)

Venezuela. Weighted with the 2006 GDP levels in US dollars. – Sum of the listed groups of countries. Weighted


with the 2008 GDP levels in US dollars.. – Standardised unemployment rate.

Source: EU; OECD; IMF; National Statistical Offices; 2009 and 2010: forecasts by the EEAG.


EEAG Report 2010 Chapter 1

Tabl e A.22 GDP

P growth,, infla tionn a nd

d un em plo ym entt inn E uro pe an

n co untri e s

a) b)

Unemployment rate

GDP growth Inflation

Share of in %

total GDP

in% 2008 2009 2010 2008 2009 2010 2008 2009 2010

Germany 20.0 1.3 – 5.0 1.6 2.8 0.2 0.6 7.3 7.5 7.9

France 15.6 0.4 – 2.3 1.6 3.2 0.1 0.8 7.9 9.6 10.2

Italy 12.6 – 1.0 – 4.8 0.5 3.5 0.8 1.1 6.8 7.7 8.8

Spain 8.7 0.9 – 3.7 – 0.5 4.1 – 0.3 0.9 11.4 18.5 20.0

Netherlands 4.8 2.0 – 4.0 1.3 2.2 1.0 1.2 2.8 3.5 5.0

Belgium 2.8 1.0 – 3.1 1.1 4.5 0.0 1.1 7.0 8.0 9.1

Austria 2.3 2.0 – 3.3 1.4 3.2 0.4 1.0 3.9 4.6 5.7

Greece 1.9 2.0 – 1.0 – 0.4 4.2 1.3 1.5 7.7 9.6 11.0

Finland 1.5 1.0 – 6.5 0.7 3.9 1.6 1.4 6.4 8.3 9.5

Ireland 1.5 – 3.0 – 7.0 – 0.7 3.1 – 1.7 – 0.3 6.0 12.0 13.6

Portugal 1.3 0.0 – 3.3 0.6 2.6 – 0.9 1.2 7.8 9.7 10.6

Slovakia 1.3 6.2 – 5.0 1.5 3.9 0.9 1.9 9.5 11.6 12.3

Slovenia 0.3 3.5 – 7.0 1.3 5.6 0.9 1.7 4.4 5.9 6.8

Luxembourg 0.3 0.0 – 3.5 1.4 4.1 0.0 1.6 4.9 6.3 7.6

Cyprus 0.1 3.6 – 0.7 1.5 4.4 0.2 2.3 3.6 5.4 6.1

Malta 0.0 2.1 – 2.0 1.6 4.7 1.9 2.0 6.0 7.2 9.0

c )


o are a 74.2 0.6 – 4. 0 1.0 3 .3 0.3 0.9 7.6 9.4 10.3

United Kingdom 14.6 0.5 – 4.6 1.0 3.7 2.1 1.6 5.6 7.8 9.2

Sweden 2.6 – 0.2 – 4.6 1.4 3.4 1.9 2.0 6.3 8.4 9.1

Denmark 1.9 – 0.9 – 4.4 1.0 3.6 1.1 1.5 3.4 5.9 6.4

c )


U 19 93.3 0.6 – 4. 1 1.0 3 .3 0.6 1.0 7.1 9.0 10.0

Poland 2.9 5.0 1.3 2.2 4.2 4.0 2.5 7.1 8.2 8.5

Czech Republic 1.2 2.5 – 4.3 1.5 6.3 0.6 1.6 4.4 6.5 7.2

Romania 1.1 7.3 – 7.3 0.7 7.9 5.6 3.3 5.8 7.0 8.1

Hungary 0.8 0.6 – 6.6 – 0.5 6.1 4.0 3.8 7.8 9.8 10.6

Lithuania 0.3 2.8 – 16.0 – 4.2 11.1 4.2 2.0 5.9 14.5 17.0

Bulgaria 0.3 6.0 – 5.3 – 0.1 12.0 2.5 2.7 5.6 7.0 8.1

Latvia 0.1 – 4.6 – 18.0 – 4.5 15.3 3.3 4.2 7.5 18.1 20.0

Estonia 0.1 – 3.6 – 13.5 – 3.0 10.6 0.2 1.2 5.6 14.5 16.5


U 8 6.7 4.1 – 3. 5 0.9 6.3 3.5 2.6 6.5 8.6 9.4

c )


U 27 100. 0 0.8 – 4. 0 1.0 3.5 0.8 1.2 7.0 9.0 9.9

– –

a) b) c)

Harmonised consumer price index (HCPI). Standardised unemployment rate. Sum of the listed countries.

Source: EUROSTAT; OECD; IMF; 2008, 2009, 2010: forecasts by the EEAG.

Tablee A.3

3 Key

y for ecastt figuress forr th e eur o ar ea

2007 2008 2009 2010

Percentage change over previous year

Real gross domestic product 2.7 0.6 – 4.0 1.0

Private consumption 1.5 0.4 – 1.0 0.4

Government consumption 2.3 2.0 2.4 1.7

Gross fixed capital

formation 4.7 – 0.5 – 10.0 – 1.5


Net exports 0.4 0.0 – 1.0 0.4


Consumer prices 2.1 3.3 0.3 0.9

Percentage of nominal gross domestic product

Government fiscal balance – 0.6 – 2.0 – 6.4 – 7.0

Percentage of labour force


Unemployment rate 7.5 7.6 9.4 10.3

a) Contributions to changes in real GDP (percentage of real GDP in previous

– –

b) c)

year). Harmonised consumer price index (HCPI). Standardised un-

employment rate.

Source: Eurostat; 2009, 2010 and 2010: forecasts by the EEAG.

45 EEAG Report 2010

Chapter 1 Ap p e n d i x 2: since economic changes are revealed earlier than by

I f o W o r l d E c o n o m i c S u r v e y ( W E S ) traditional business statistics. The individual replies

are combined for each country without weighting.

The Ifo World Economic Survey (WES) assesses The “grading” procedure consists in giving a grade of

worldwide economic trends by polling transnational 9 to positive replies (+), a grade of 5 to indifferent

as well as national organisations worldwide about cur- replies (=) and a grade of 1 to negative (–) replies.

rent economic developments in the respective country. Grades within the range of 5 to 9 indicate that posi-

This allows for a rapid, up-to-date assessment of the tive answers prevail or that a majority expects trends

economic situation prevailing around the world. In to increase, whereas grades within the range of 1 to 5

2009, 1,026 economic experts in 88 countries were reveal predominantly negative replies or expectations

polled. WES is conducted in co-operation with the of decreasing trends. The survey results are published

International Chamber of Commerce (ICC) in Paris. as aggregated data. The aggregation procedure is

The survey questionnaire focuses on qualitative infor- based on country classifications. Within each country

mation: on assessment of a country’s general eco- group or region, the country results are weighted

nomic situation and expectations regarding important according to the share of the specific country’s

economic indicators. It has proved to be a useful tool, exports and imports in total world trade.




EEAG Report 2010 Chapter 1

47 EEAG Report 2010

Chapter 1 48

EEAG Report 2010 Chapter 1

49 EEAG Report 2010

Chapter 1 50

EEAG Report 2010 Chapter 1

51 EEAG Report 2010

Chapter 2

A - activity suddenly stops. This is what happened in

TRUST DRIVEN FINANCIAL October 2008 and the subsequent months.

. I

CRISIS MPLICATIONS FOR THE This chapter documents the unprecedented drop in

FUTURE OF FINANCIAL MARKETS trust in financial markets and financial intermedi-

aries, both in the US and in Europe, that has taken

place since the emergence of the crisis. It will be

Introduction argued that the collapse in trust played a crucial role

There are many important dimensions of the, hope- in the crisis as it led those who distrusted to run on

fully overcome, financial crisis that have appeared in their banks. This role is distinct from that played by

the vast debate that it has originated: its unprecedent- the drop in confidence about the solvency of financial

ed size at least in the post World War II period; the institutions and their ability to repay their obligations

fact that, contrary to many other financial crises (but – the other factor that freezed up financial markets

similar to the 1929 collapse) it originated and had its and led investors to run on banks. The collapse in

epicenter in the US; its nature, the ingredients and trust was in fact provoked by the revelation of the

proximate causes that triggered it: too much financial opportunistic behaviours that the unfolding of the cri-

deregulation?; too relaxed monetary policy?; too sis brought to light, of which the Bernard Madoff

much concentration of power in the hands of the fraud is emblematic, and has contributed to shed a

banks following the impetuous wave of mergers dur- dark light on the whole financial industry.

ing the late 1990s that amplified moral hazard and

risk taking? All these factors are likely to have played The destruction of trust inherited from the crisis has

a very important role in triggering the crisis but with important implications for the future of financial

them alone it would be hard to explain the sudden col- markets, including the demand for financial products

lapse in economic activity that took place after and investors’ portfolio choices, their reliance on

October 2008, at least within the framework of a stan- financial intermediaries when making financial deci-

dard macroeconomic model: though the economy was sions and the demand for regulation. It will be argued

slowing down, in summer 2008, there was no relevant that unless remedies are adopted to rebuild trust,

shock to productivity to justify the observed subse- these consequences will most likely be long lasting as

quent drop in economic activity; interest rates were self-construction of trust evolves slowly. Accordingly,

low and demand relatively sustained. We argue that the chapter discusses possible policies to rebuild trust

one important factor that can explain the extremely some involving non-imposed changes in behaviour in

rapid deterioration in economic activity was the col- the financial industry, others involving specific regu-

lapse in trust. Starting in summer 2008 something latory interventions.

very important was destroyed: first the trust that

intermediaries have in each other and then the trust

that investors have in the financial industry. Trust – The disappearance of trust

the belief a person has that his counterpart in a trans-

action will not take advantage of him – is normally Measuring trust

ignored in standard economic models, perhaps on the

presumption that external bodies, such as the police To monitor the evolution of trust during this financial

and courts, can enforce any promise and thus effec- crisis, Northwestern University and the University of

tively protect contracting parties from each other Chicago conducted a telephone survey on a represen-

abuses. But this is rarely the case: because legal pro- tative sample of about 1,000 American households,

known as the Financial Trust Index Survey (FTIS).

tection is often imperfect and costly it leaves many The first survey was launched in December 2008,

open gaps which are typically filled in by trust. Thus, three months after the collapse of Lehman Brothers;

without trust, financing disappears and economic 53 EEAG Report 2010

Chapter 2 three other surveys were fielded Figure 2.1

subsequently at a quarterly fre-

quency. In this study we will be

drawing from the FTIS and com-

plement the evidence with data

from other countries when avail-


able. In the FTIS one adult

respondent in each household

was randomly contacted and

asked whether they were in

charge of household finances,

either alone or together with a

spouse. Only individuals who

claimed such responsibility are

included in the survey. A first set

of questions asked how much the

respondent trusts certain types of figure had been as high as 40 percent in the late 1970s

people or institutions with a focus on financial insti- 3

and was around 30 percent just before the crisis.

tutions such as the stock market, banks and bankers,

brokers, pensions funds. Answers were provided on a As an alternative way to highlight the drop in trust

scale ranging from 1 to 5, where 1 means “I do not towards financial markets and intermediaries, we

trust at all” and 5 means “I trust completely”. Since compute from the GSS the average trust that people

the survey was started after the crisis we lack a level of have in banks and financial markets relative to the

trust in financial intermediaries and markets before trust they have in other people in general (what is

the crisis to compare with and to document how trust known as generalized trust) over the years prior to the

in these different institutions has evolved as a conse- crisis covered by the GSS (1977–2007). This figure is

quence of the crisis. To deal with this issue we com- around 1.5 meaning that Americans used to trust

bine the trust responses from the FTIS with compara- banks and financial markets 50 percent more than

ble data from the General Social Survey (GSS), which they trust a generic member of the US population.

for many years has been asking people whether they This conforms with intuition and common sense:

have a great deal of confidence in banks and financial

2 after all we rely on banks and other financial institu-

institutions. Since the GSS question embraces both tions as custodians of our savings and not on a ran-

banks and financial institutions, to make the FTIS dom member of the population.

answers as comparable as possible to the GSS we pool

together the answers people provide to trust in banks, Since the FTIS also asks people how much they trust

in brokers, in mutual funds and the stock market and a generic American (that is it measures generalised

compute the fraction of people that trust these insti- trust in unknown people), we compute relative trust in

tutions completely. We then append these figures to banks, bankers, brokers, mutual funds and the stock

the GSS series that refer to the pre-crisis years. Figure market respectively for the three waves of the FTIS

2.1 documents the dramatic drop in trust vis-à-vis and report it in Table 2.1. Interestingly, after the crisis

banks and financial markets in the latest part of 2008 people trust banks as much as they trust a random cit-

and the beginning of 2009. Though the index shows izen, and trust mutual funds and the stock market

swings that reflect the business cycles, since 1975 the much less than they trust a random individual. This is

fraction of people that trust banks and financial mar- in sharp contrast with the higher trust they had in

kets has never been as low as during the 2008–2009 banks and financial markets relatively to unknown

crisis. Only 5 percent report having full trust in banks, people before the crisis, suggesting that even if trust

brokers, mutual funds or the stock market while the fell in general, it is trust in finance that has collapsed.

Furthermore, the table shows that investors distin-

1 The first questionnaire for the FTIS was designed by Luigi Guiso,

Paola Sapienza and Luigi Zingales. Detailed information on the sur-

vey is available at

2 3

The wording of the question asked is “I am going to name some Notice that the GSS question refers to how much trust people have

institutions in this country. As far the people running these institu- in those running financial institutions rather than to the institution

tions (banks and financial institution in this case) are concerned, itself. Thus it perhaps matches better with trust in bankers and bro-

would you say you have a great deal of confidence, only some confi- kers in the FTIS. If we replace trust in bankers and brokers in

dence or hardly any confidence in them?” Figure 2.1, the drop in trust would be even more pronounced.


EEAG Report 2010 Chapter 2

Tabl e 2. 1 Tabl e 2. 2

Relati vee tr ustt le velss ov err ti mee Chan g ess inn trustt ov err ti mee i n th e US


A. Banks

Wave I Wave II Wave III Wave I Wave II Wave III

Banks 0.99 0.94 1.00 Decreased a lot 24 25 15

Bankers 0.88 0.84 0.92 Decreased a little 31 28 26

Brokers 0.71 0.69 0.72 No change 40 41 50

Mutual funds 0.86 0.87 0.88 Increased a little 4 4 7

Stock market 0.70 0.71 0.71 Increased a lot 1 2 2

Government 0.77 0.78 0.83 B. Stock Market


Large corporations 0.71 0.67 0.73 Wave I Wave II Wave III

The Fed 0.77 0.78 0.84 Decreased a lot 46 36 28

The table shows the level of trust towards the specified Decreased a little 22 23 21

entity relatively to the level of trust towards people on

general. No change 29 36 41

Increased a little 2 4 8

Source: Elaborations on the FTIS. Increased a lot 1 2 1

C. The government

guish between trust in financial institutions and trust Wave I Wave II Wave III

Dec 08 March 09 June 09

in the people that manage those institutions. In fact Decreased a lot 32 29 25

trust in bankers is much lower, relatively to trust in Decreased a little 23 15 15

people in general, than is trust in banks. No change 35 27 33

Increased a little 7 18 17

Increased a lot 3 12 10

Why is trust in bankers much lower than trust in The table shows people’s responses on how much their

banks? One reason is that bankers are considered to trust towards the specified entity has changes over the

three months before the interviews in the FTIS.

be worse and less reliable than the average person Source: Elaborations on data from the FTIS.

compared to the institution they work for, as they may

damage people more than the institution. Alterna- trust changes were asked). Trust in banks and the

tively, the incentive structure within banks is believed stock market has fallen either a lot or a bit in all three

to lessen the trustworthiness of bankers making the waves, though at a slowing pace in the last survey. On

banks more reliable than the bankers. At any rate, the other hand, very few report that their trust

what this suggests is that the fall in trust during the towards these financial institutions has improved

crisis does not simply reflect the fear aroused in either a lot or a bit. The change in trust towards the

autumn 2008 that banks could become insolvent: if government instead follows a different pattern: it falls

that was all the measure of trust we were picking, we sharply in the first quarter after the collapse of

would see the opposite pattern with trust in banks Lehman Brothers, but starting in March 2009 opin-

falling more than trust in bankers, which does not ions become more polarized: some people continue to

seem to be the case from Table 2.1. lose confidence in the government while others raise

their trust significantly – an heterogeneous reaction

There are two other points to notice. First, not only reflecting differences in opinions about the benefits of

do people trust other individuals more than they trust the policies adopted to contrast the crisis. Though the

bankers and financial institutions (Table 2.1), but crisis originated in the US, the drop in trust is not lim-

investors trust other people more than they trust the ited to the US, but because the crisis was universal

government or the Fed! Second, there is very little also the loss in confidence is likely to have spread out

change in trust in financial markets over the whole to all countries involved. Unfortunately, there is no

period between the end of 2008 and autumn 2009, worldwide survey to document it. The available evi-

suggesting there is persistence in the fall of trust. dence for specific countries, however, points in that


As another way to look at the changes in trust, the

FTIS has elicited self-assessed changes by asking peo- Guiso, Sapienza and Zingales (2009) conducted a

ple how much their level of trust changed in the three phone survey similar to the FTIS on a sample of cus-

months after the interview. What emerges is that a tomers of a large Italian bank (UniCredit) which

number of people, while still confiding in other peo- was launched in June 2009. As in the US, also in this

ple, dramatically lost confidence in financial institu- survey trust in financial markets has decreased sub-

tions following the collapse of Lehman Brothers. This stantially. When asked how their trust changed since

is shown in Table 2.2 for banks, the stock market and

also the government (the three institutions for which the emergence of the crisis, 46 percent report they

55 EEAG Report 2010

Chapter 2 have lowered their trust towards banks in general ual than towards a bank or a banker, that is towards

those institutions and people that should deserve to

either by a lot or substantially, 47 percent have low- be trusted the most in light of the role they play as the

ered their trust in bankers and 52 percent that their custodians of our savings.

trust in the stock. These patterns are qualitatively

very similar to the ones in the US, confirming that

the drop in trust is very likely universal. Similar in What do the trust measures measure?

sign but more contained in magnitude are the

changes in trust towards banks reported in a survey What do our measures of trust reflect? All financial

of Austrian investors available before and after the crises are characterized by a significant change in

crisis (Knell and Stix, 2009). investors’ beliefs and a loss of confidence. This

financial crisis is no exception as confidence has

One interesting feature of the UniCredit survey on dropped perhaps even more than in other crises. But

Italian investors is that it has a panel component, there are two notions of confidence that matter: the

since people in the sample were interviewed also in first concerns the rise of pessimistic expectations

2007 when the financial crisis was not yet in sight. about banks’ ability to repay and to keep their com-

Since some questions were asked in both surveys it is mitments, i.e. the probability that a generic bank

possible to compare how they evolved over the crisis. goes bankrupt. These beliefs obviously became more

In particular, participants in the survey were asked pessimistic during the crisis particularly after

how much trust they have towards their own bank or Lehman Brothers collapsed. But there is a second

financial advisor and answers, as before, are provided notion of confidence, which is the one we focus on

on a 1 (no trust) to 5 (full trust) scale. Not surprising- here, that has to do with the emergence of diffused

ly, the level of trust towards one’s own bank is higher beliefs that financial intermediaries and the various

than trust towards banks in general – a feature con- players present in the financial market – brokers,

sistent with the idea that trust is a key feature in select- bankers, financial advisor etc. – are less reliable than

ing the bank or financial advisor and that, as these people thought them to be and so deserve less trust

people report, not all banks are equally reliable. Yet, because it has become more likely that they act

compared to the year 2007, 34 percent of these 4

opportunistically and deceive investors. The first

investors have revised their trust levels towards their notion pertains to the probability that an investor

banks/advisor downwards. This clearly provides a may lose part or all of his investment because, due to

lower bound of the actual fraction of those who lost the crisis, the of investment has

intrinsic riskiness

trust in their banks/advisor since it was only possible increased. The second notion concerns the risk

to re-interview customers that stayed with the involved in any financial contract because the

bank/advisor, not those who left because they lost investor delegates the bank/broker to manage his

confidence. funds and the latter can manipulate the management

to his own advantage, for example by charging com-

In sum, data from both sides of the Atlantic show that missions that are difficult to verify, hiding relevant

during the financial crisis there has been a dramatic information, shifting unwanted risks to the cus-

drop in trust towards all segments of the financial sys- tomers etc. This second type of risk is a social risk as

tem though the fall was stronger for some of them, it arises from the actions adopted by the counterpart

particularly those segments involved in trading less in the exchange. Thus while the first type of risk con-

familiar and ambiguous instruments such as mutual cerns the solvency of the intermediary the second

funds and stocks. The drop is considerable but more reflects the perceived trustworthiness of the financial

contained for banks. Besides the level of trust in intermediaries and their managers. The financial cri-

financial markets and institutions, trust towards peo- sis has affected both but the trust measures shown in

ple in general has also fallen, implying that mistrust in Figure 2.1 and Tables 2.1 and 2.2, though perhaps

finance has spilled over and generated mistrust in gen- correlated with intrinsic risk, reflect the greater per-

eral. This feature can help explain the sudden drop in ceptions of an increased social risk that has deterio-

economic activity following the Lehman collapse: the

fall in trust freezed up not only financial exchanges

but, due to the cited spill over, stopped also any other 4 Of course the two notions are interwinned and may not be inde-

pendent of each other. If a bank solvency is at risk, managers may

types of exchange that require trust. Remarkably, the be more tempted to make profits by deceiving investors in order to

avoid bankruptcy. On the other hand, dishonest behaviour when dis-

fall in trust was so strong that after the crisis people covered may result in a loss of reputational capital that may force a

show more trust towards a generic unknown individ- bank into a solvency crisis as customers run away.


EEAG Report 2010 Chapter 2

for the effect that it may have had on investors’ trust

rated the relation between investors and financial in-

termediaries. Here we focus on this notion of confi- towards financial markets and intermediaries: the

dence and show evidence that is consistent with the fact that Bernard Madoff was an insider to the

decrease in our measures of trust, reflecting a greater industry! An important professional market player


social risk. and former Chairman of the NASDAQ Stock

Exchange that had been running his Ponzi scheme

for almost 20 years! It should not then be surprising

Why did trust fall? that if such an insider and professional player can

trick even quite expert investors (not only individu-

Trust is the belief that an opponent in a relationship als but also institutions invested in Madoff ’s fund),

behaves accordingly to what he promised and does non-professional investors will legitimately tend to

not take advantage of the person he is trading with. In think that other players in the financial industry

other words it is the probability that person A trading play similar games, perhaps not as extreme as a

with B attaches to the possibility that B will behave Ponzi scheme and perhaps on a smaller scale.

opportunistically and take advantage of him. Trust is

thus A’s probability that B will not “cheat”. Obvious- But the crisis has uncovered many other cases were

ly, when the business partner deviates from the the intermediary failed to act in the investor’s best

promised behaviour, trust attitudes are revised down- interest: for instance, the holding by many investors in

wards. The financial crisis, among other things, many countries of poorly diversified portfolios often

brought to light diffused opportunistic behaviour and recommended by their financial advisor, has exposed

some serious frauds. Following the collapse of them to excessive risks that have resulted in effective

Lehman Brothers many felt “cheated”. People had losses during the crisis. The latter has made those risks

been advised to invest in Lehman securities because manifest, leading investors to hold those who recom-

they were remarkably safe; in fact up until a few mended the investments responsible for the losses. In

months before the collapse, Lehman securities were all these cases it is very likely that investors have

highly rated by S&P. revised downwards their trust towards intermediaries

and financial markets.

One of the effects of the financial crisis has been

that of revealing the existence of pervasive oppor-

tunistic behaviour in the financial industry and to Trust and cheating: proving the link

have brought to light several cases of outright finan-

cial frauds that without the crisis investors would To examine this link we rely on the second wave of

probably have discovered much later if at all. The the European Social Survey that was conducted in

Madoff fraud is the one that has received the great- 2004, well before the crisis, and that reports infor-

est attention from the media

and that will likely remain Figure 2.2a

lodged in the minds of investors

for many years to come. Many Cheating in financial markets

have focused on the unprece- Pooled sample

dented size of this fraud – half 80

of a percentage point of GDP – 72.66

often ignoring a much more

important feature of this fraud 60

5 Notice that while adequate government

interventions including monetary and fis- Percent

cal policies such as the ones adopted dur- 40

ing the crisis can successfully reduce intrin-

sic risk and stabilize assets prices, it is hard-

er to rebuild the personalized trust that has

been lost. This is because we learn about a

person’s trustworthiness by exchanging 20

with him. But incentives to exchange are 15.59

low when there is no trust, which slows

learning and thus the revision of trust atti- 7.2

tudes even when the effective trustworthi- 3.132 1.411

ness of the partner in a transaction has 0

increased. Thus, it is reasonable to expect 0 1 2 3 4 5

that the fall in trust towards financial inter- Number of times cheated

mediaries will be long lasting. 57 EEAG Report 2010

Chapter 2 ingly, in all cases there is a spike at “never”, so that

mation for a sample of individuals in each of the the vast majority of respondents report not having

then 26 countries of the European Union on been cheated. However, there is a non-negligible

whether they were deceived over the recent past by a fraction of people in all countries, varying between

bank or insurance company, in the sense that they 9 and 32 percent, that report having been deceived

failed to offer them the best deal. Participants in the one or more times by an intermediary. Though there

survey were asked: “How often, if ever, has this thing could be problems with this measure (the exact

happened to you in the last five years? A bank or meaning of a bank/insurance company having failed

insurance company failed to offer you the best deal to offer the best deal may be subject to interpreta-

you were entitled to.” The respondent could answer tion; true frauds may go unobserved for a long time,

in one of 5 ways – never, once, twice, 3 or 4 times or, as in the Madoff case, and so the measure could be

finally, 5 times or more – which we code with the biased downward; but this could be balanced by the

numbers 0 to 4. Figure 2.2a+b show the histogram of tendency to self attribute successes and to hold oth-

the answers for the pooled datasets (panel A) and for ers responsible for failures, etc.), it is instructive to

each country in the sample (panel B). Not surpris-

Figure 2.2b Cheating in financial markets

By country AT BE CH CZ

100 74.51

72.44 71.67


50 20.65 18.39

15.96 15.21

10.5 8.009 6.95


3.936 2.945 2.594 2.027

1.711 .9653



0 0 2 4 6 0 2 4 6 0 2 4 6 0 2 4 6


100 78.92 69

64.79 64.73

50 17.44 16.35 15.77



10.02 8.051

5.094 4.847

4.73 3.859 3.327

2.649 2.49 1.292 .5654

0 0 2 4 6 0 2 4 6 0 2 4 6 0 2 4 6


100 89.71

78.01 70.13 63.69

50 18.9 18.1

14.99 9.914 7.183

6.835 6.225

4.399 3.389

2.046 2.075 1.854 .8341


.5627 .4171

0 0 2 4 6 0 2 4 6 0 2 4 6 0 2 4 6



Percent 68.37 68.01 66.87


50 20

18.03 17.32

16.71 11.73 10.09

9.207 7.839 7.115


3.836 3.614


2.205 2.108


0 0 2 4 6 0 2 4 6 0 2 4 6 0 2 4 6


100 79.18


68.78 58.28

50 21.46 19.15

19.03 13.63 11.49

6.69 6.242 6.091

5.704 2.701

2.091 2.037 2.082 1.157

.9756 .6985

0 0 2 4 6 0 2 4 6 0 2 4 6 0 2 4 6


100 86.24 75.94



50 17.26 16.33 15


8.583 6.365 5.947


2.996 2.684 1.921


1.524 1.534 1.189


0 0 2 4 6 0 2 4 6 0 2 4 6 0 2 4 6


100 91.89 80.25

50 10.75 5.963

4.117 2.053

1.809 1.684 .9775


0 0 2 4 6 0 2 4 6

Number of times cheated


EEAG Report 2010 Chapter 2

see how it correlates with the

Figure 2.3 trust these people have towards

banks and insurance companies.

The survey in fact also reports

information on how much peo-

ple trust banks and insurance

companies, which can be corre-

lated with their past experience

of financial fraud. This correla-

tion is shown in Figure 2.3 which

clearly documents that those

who were cheated more often in

the past 5 years tend today to

trust intermediaries less than

those who were cheated less

often or not cheated at all.

Hence one expects that similar

Figure 2.4a effects have been at work during

The geographical spread of Madoff´s victims the financial crisis as its unfolding

US victims concentration revealed the frauds to which in-

vestors were exposed. To test for

this effect we rely on the Financial

Trust Index Survey and merge the

data with the number of Madoff

victims in the area (either the zip

code district or the state) were the

investor lives and check how it

correlates with the level of trust of

these investors. The idea is that

in areas where the number of

Madoff victims is larger (for a

given population), Madoff ’s

fraud, and more generally finan-

cial frauds, are more salient, either

because chances of knowing di-

Figure 2.4b rectly or indirectly (through word

The geographical spread of Madoff´s victims of mouth) one of the victims are

Europe victims concentration higher or because, in places with

lots of victims, the local press

devotes a lot more attention and

coverage, which adds to that

devoted by the national press.

Hence, in these states the drop in

trust following Madoff scandal

should be more marked. Figu-

re 2.4a shows how spread out are

the Madoff victims and where

they were located in the US.

Figure 2.4b documents that the

victims of this fraud were present

also across Europe so that if it had

any effect on trust it also under-

59 EEAG Report 2010

Chapter 2 and actually may have behaved honestly. Indeed, when

mined that of European investors. Because of data the fraud comes to be known by many it tends to

availability we focus on the effect on the trust of US spread the suspicion to the whole financial industry

investors. Figure 2.5 shows in four different panels the leading, to a shared fall in trust, as happened during

correlation between the average level of trust investors the crisis. In other words, the emergence of Madoff’s

living in a state have towards banks, bankers, brokers fraud undermined the confidence in the whole financial

and the stock market, respectively, and the density of industry. Interpreting this popular sentiment Paul

Madoff victims in the state where they live. The figure Krugman in a New York Times column (December

shows clearly that trust towards banks, bankers and 2008) asked: “How different is what Wall Street did

brokers is lower where the number of Madoff victims from the Madoff affair? Well Madoff simply skipped a

is larger, while the salience of this fraud seems to have few steps, simply stealing his clients’ money rather than

little effect on the trust towards the stocks market, collecting big fees while exposing investors to risks they

which is consistent with the fact that Madoff was a did not understand” (NYT, December 2008). Obvious-

fund manager. There are three points to notice. First, ly, those who have been damaged the most are the inter-

these correlations show that a financial fraud not only mediaries or brokers that have always done their job

affects the trust of the direct victims of the fraud but it honestly. Quint Tatro, president, founder and manager

also affects the trust of those who, even if they have not of Tatro Capital, an investment management company,

directly suffered from the scandal, have come to know in a sorrowful letter wrote in January 2009: “A funny

about it, either because the information was publicised thing happened recently: Many new individuals simply

through the press or because they met a victim. This is have a hard time believing a traditional investment

more likely when the fraud is sizable and information manager from Kentucky didn’t ‘get killed’ along with

about it reached many investors, as it was the case dur- everyone else. I have now heard that at least 2 people,

ing the financial crisis with the Madoff case first, fol- when my firm was recommended to them, responded

lowed by the Sir Allen Stanford fraud and many other by asking whether we were ‘legit.’ One advisor, who

minor but diffused examples of deception and financial held half of a mutual client’s investment and will no

abuses that, because the topic was on demand, cap- longer be holding that half, went so far as to request the

tured the attention of the press. Second, not only the Schwab statements from the client verifying my per-

trust towards those who committed the fraud falls – a formance. I suspect the client didn’t amuse the advisor

specific banks or banker – but the drop in trust spills with this degrading request, but who knows. While

over to many other agents that are not directly most of my frustration can be pushed back onto Wall

involved, such as banks, bankers or brokers that may Street … I entirely believe that Bernard Madoff is

have no direct link with those who committed the fraud directly correlated with this

Figure 2.5 new rise in scepticism. So

now, in addition to battling

Madoff´s victims and loss of confidence Mr. Market on a daily basis, I

Effect of Madoff victims on trust on banks Effect of Madoff victims on trust on bankers


4 have to deal with charges of


3.5 untrustworthiness.”


banks 3

on 3 on

Trust Trust Third, the correlations shown


2.5 in Figure 2.5 only show the


2 effect on the level


0 2 4 6 8 0 2 4 6 8

N. of Madoff victims (logs)

N. of Madoff victims (logs) of trust of the Madoff’s fraud

Level of trust in bankers Fitted values

Level of trust in banks Fitted values due to the fact that investors

Effect of Madoff victims on trust on brokers Effect of Madoff victims on trust on stock market

2.8 3 in different states were differ-

2.6 entially informed about it, for

market 2.5

brokers 2.4 example, because in states


on 2.2 on with more victims local news-

Trust Trust 2

2 papers devoted more space

1.8 and for more time to it. This


0 2 4 6 8 0 2 4 6 8

N. of Madoff victims (logs)

N. of Madoff victims (logs) proves that the Madoff fraud

Level of trust in brokers Fitted values Level of trust in stock market Fitted values has lowered trust in financial

The figure shows the relation between the n. of Nadoff´s victim by State and the average value of trust

in banks, bankers, brokers and the stock market in the US after the October 2008 crisis. intermediaries, but it is likely

Effects: 1 sd in lncase lowers trust in banks by 1/3 of trust in banks standard deviation. to understate the effect since it

Effects: 1 sd in lncase lowers trust in bankers by 1/3 of trust in bankers standard deviation.


EEAG Report 2010 Chapter 2

impact on the working of financial markets in the

is unable to identify the drop in the average level trust coming years. But before illustrating these margins, it

of American investors after the discovery of Madoff’s is worth noticing that the decline in trust played a very

fraud: the latter could be first order. important role already during the crisis as those who

lost their trust towards their bank were also the first

Finally, to further strengthen the link between the fall in to withdraw cash from their deposits during the days

trust and the perceptions of opportunistic behaviour in following the collapse of Lehman Brothers.

financial markets brought to light by the crisis, we

examine the following question asked in the FTIS: “Do In ongoing research, Guiso, Sapienza and Zingales

you feel you have been cheated or misled by a bank in (2009) argue that differences in levels of trust across

the last year?” Respondents could answers “yes” or individuals can explain who starts a run on the bank

“no”. In unreported regressions we find that those who in a period of financial distress. Using data from the

have been cheated or misled by a bank over the year Trust Fi-nancial Index Survey they show that those

prior to the crisis report a lower level of trust towards investors that lost trust in banks and the financial sys-

banks and bankers. Furthermore, not only these people tem where the first to withdraw cash from their

lost confidence in the intermediary that cheated them accounts at the peak of the crisis – that is they started

(banks in this case) but also in other intermediaries and a bank run. Figure 2.6 documents this finding show-

markets such as brokers, mutual funds and the stock ing the correlation between the fraction of people that

market though by a somewhat smaller amount – a more run on the bank and the level of trust of the investors:

direct way of supporting Quint Tatro’s closing state- people that lost trust in their bank were more than

ment in the previous citation and showing its generali- four times more likely to run on the bank than those

ty. Thus misbehaviour by one intermediary triggers a who retained full trust, contributing to the spread of

loss of trust in the whole industry. In addition this

6 the panic. Guiso, Sapienza and Zingales (2009) report

spillover effect extends to trust in large corporations similar evidence for a sample of investors of a large

and even to trust towards other people in general, Italian bank. The interesting feature is that in this case

though the effect is much smaller. Insofar as trust they can look at the correlation between the decision

towards these entities also matters for transactions and to run and the level of trust well before the crisis.

trade, the loss of trust provoked by the crisis has affect- Those who used to trust less were also more likely to

ed the economy not only because investors have become take out their deposits, consistent with the idea that

more cautious in making their money available to the lack of trust makes a bank fragile and more exposed

financial industry but also because they have become to runs.

more reluctant to trade in general. This has acted as an

amplifier of the effect of the financial crisis on the econ- For the future, the drop in trust is likely to have perva-

omy. Finally it is interesting to note that these effects sive effects on investors’ reliance on financial markets

were obtained after controlling for a variety of charac- across various dimensions – one of the most impor-

teristics, in particular for an index of how angry tant legacies of the financial crisis. In particular the

investors were because of the crisis, reassuring that the

effect of the experience of decep-

tion on people’s trust does not Figure 2.6

reflect some other variable that

also may impinge on their trust.

How will the fall in trust affect

financial transactions?

The fall in trust is likely to affect

investors’ decisions on various

margins that may have a strong

6 Notice that also trust in the Fed drops; to

some extent this may look surprising, since

in principle the Fed’s response to the crisis in

terms of liquidity provision was “right”. But

people seem to think otherwise. One inter-

pretation is that they held the Fed responsi-

ble for not having done enough prior to the

crisis to prevent banks’ misbehaviour. 61 EEAG Report 2010

Chapter 2 fall in trust is likely to affect peo- Tabl e 2. 3

ple’s willingness to enter into any Chan g e inn willi ng nesss too i nv estt inn t hee stoc k mar kett

type of financial contract. This afterr t hee fi na nci all crisiss

should not be surprising since any United

Great France Italy Spain Germany States


financial transaction involves an % % % % % %

exchange of money today against Unweighted base 821 824 657 639 701 777

a promise of returning (more) More likely to

invest in stocks

money tomorrow. But the willing- and [EU: share,

ness to believe the promise and US: stock funds] 7 5 7 9 6 9

thus enter the transaction crucial- My attitude has

stayed the same 54 50 40 46 52 46

ly hinges on how much trust one Less likely to

has in the person that issues the invest in stock and

[EU: share, US:

promise. Below we examine some stock funds] 39 44 54 46 41 46

of the effects in greater detail. Answers to the question: “Compared with two years ago how has your attitude

to investing on the stock market changed, if at all?”

Source: September 2009 Financial Times/Harris Poll, Base: All EU adults in five

countries and US adults with savings/investments.

Trust and investment in risky

assets because the probabilities of the returns are intrinsical-

There is evidence that the level of trust affects investors’ ly uncertain (e.g. because they have a short history on

willingness to invest in stocks and, more generally, in which to estimate these probabilities) are more

risky assets. Stocks and risky assets lend themselves exposed to the risk of frauds and consequently are

more easily to opportunistic behaviour than simpler more easily placed among high-trust investors. When

securities. For instance Guiso et al. (2008) find that trust falls and becomes scarce one should see a decline

high-trust people are less likely to hold stocks in their in the demand for these instruments and an increase in

portfolio and conditional on holding, they invest lower the demand for simpler and more familiar securities.

shares in stocks. Since this finding is obtained using One of the consequences is that investors will revert to

variation in trust in a sample of Dutch investors, it can- instruments issued by national agents, perceived as

not be due to trust reflecting differences in the quality more “familiar” which become attractive as gener-

or effectiveness of legal enforcement (which is held con- alised trust vanishes. More generally, one of the conse-

stant) but rather the subjectively perceived probability quences of the crisis will be to shorten the distance

that people have of being cheated by the counterpart in between the investor and the issuer of the financial

a trade. This finding, which the same authors show instrument, thus reducing portfolio diversification and

holds in a sample of Italian investors, is consistent with amplifying a home bias. There is anecdotal evidence

the results of a recent Financial Times/Harris Poll that consistent with this idea. In some countries, in spite of

interviewed a sample of investors in the US and vari- the crisis, some banks – typically smaller, unsophisti-

ous European countries. It shows that in most coun- cated banks that in the past were not involved in the

tries people today have a lower propensity to invest in placement with their customers of structured securi-

stocks (Table 2.3). For instance, in Germany 41 percent ties and derivatives – have experienced a significant

report that today they are less ready to invest in stocks growth in deposits notwithstanding the crisis; on the

than before the crisis, and the percentages are similar in other hand, large, sophisticated banks that used to

other countries. Sapienza and Zingales (2008), using place complex securities have lost deposit market

the FTIS, find that those who plan to decrease their shares. One explanation is that investors revert back to

stock investments after the crisis are those who have the “familiar” for fear of being cheated by an interme-

less trust in financial markets and in particular the diary that deals with unfamiliar securities.

stock market. Thus, as a consequence of the fall in

trust, portfolios will likely be twisted markedly towards

safer securities and away from stocks. Trust and diversification across stocks and banks

One implication of the diminished trust is that

investors will form less diversified portfolios

Trust and investment in ambiguous securities because they will focus more on domestic assets.

Financial instruments that are more ambiguous either Guiso et al. (2008) show that this property is more

because of the complex nature of the contract or general and that investors that invest in stocks tend


EEAG Report 2010 Chapter 2

their own without any involve-

Figure 2.7 ment of the intermediary. All the

others relied on the intermediary

to a smaller or greater extent,

with 20 percent that delegated

either all decisions or a substan-

tial part to the intermediary. The

last two columns of Table 2.4

show the average level of trust

and the fraction of investors that

trusted the intermediary a lot. It

is clear that a fundamental ingre-

dient in the intensity of financial

delegation is the level of inves-

tors’ trust. Among those who rely

only on themselves when making

financial decisions 39.7 percent

to hold a more diversified stock portfolio when they trust the intermediary either substantially or a lot;

trust more. On the other hand, diminished trust among those who let the bank choose for them, the

towards intermediaries leads an investor to enter- share of those who trust a lot is 93 percent. Thus, the

tain multiple relations to diversify the risk of fall in trust should result in a marked decrease in del-

opportunistic behaviours by reducing exposure to egated investment. Since delegation is all the more

each one of them. We document this effect in necessary the more one invests in sophisticated securi-

Figure 2.7, which shows that in a sample of Italian ties, also through this channel there should be a move

investors, those who trust more (on a scale between towards simpler portfolios. These portfolios, however,

1 and 5 where 1 stands for very low trust and 5 for need not be necessarily better ones in the sense of pro-

very high trust) there is a strong negative correla- viding a higher return per unit of risk. Guiso and

tion between the level of trust and the number of Jappelli (2006) in fact find that investors who trust

bank relations an investor has. Both effects are more and delegate more are better diversified and are

costly: the first because one loses the benefits of able to attain more efficient portfolios.

diversification, the second because of the cost of

setting and maintaining multiple relations. Trust and the demand for insurance

Trust, demand for advice and delegation Though most of the literature has focused on the

effects of trust on investors portfolios, the fall in trust

Besides selling financial products, financial intermedi- involves all operators in the financial industry as shown

aries offer investors advice and information on how to in Table 2.1, including insurance companies. In fact,

allocate their financial wealth. Investors’ willingness since an insurance contract is itself a financial contract

to heed this advice depends on the trust they have in and as such is prone to the opportunistic behaviour of

the intermediary as much as their

decision to lend their savings to

the intermediary. One of the con- Tabl e 2. 4

sequences of the fall in trust is a Trustt an d d el eg atio n off fi na nci all d e cisionss

lower investors’ propensity to % share of

delegate financial decisions to the Average those trusting

level of a lot or


intermediary and to use his trust

Mode of making financial decisions responses substantially

advice. Table 2.4 shows the distri- I decide entirely on my own 12.0 2.98 39.7

I ask the bank to review my choice 30.4 3.92 82.4

bution of the extent of delega- I listen to my bank/advisor proposals but the

tion of financial decisions in a final word is always mine 37.7 3.88 78.3

UniCredit sample of Italian By and large I follow my bank/advisor 16.3 4.19 86.4

I let my bank/advisor decide everything 3.7 4.49 93.3

investors before the crisis. Only Source: UniCredit Italian Investors Survey, 2007 wave.

12 percent chose to decide on 63 EEAG Report 2010

Chapter 2 Box

x 2 .1

1 Prop osalss b y th e Fi na nci all S ta bility

y B oar d (FSB)) t o i mpro vee finan ci all re gul atio n

The predecessor of the Financial Stability Board (FSB) was the Financial Stability Forum (FSF), which was established by the G7

Finance Ministers and Central Bank Governors in 1997. The main idea was to create an institutional body that promotes coopera-

tion among national and international supervisory boards as well as international financial institutions to achieve more stability in

the financial system. Additionally it included representatives of the International Monetary Fund (IMF), the World Bank, the

Bank for International Settlements (BIS) and the OECD.

In November 2008 with the financial crisis in full swing, the G20 proposed extending the membership of the FSF by all those G20

countries that were not participating so far, and – at the same time – to broaden its mandate. This proposal was implemented at the

G20 Summit in April 2009 by founding the FSB, with Mario Draghi, Governor of the Banca d'Italia, being the first chairperson.

The mission of the FSB is to enhance stability by implementing strong regulatory and supervisory measures.

Already in April 2008 a report was produced which highlighted the main sources of the crisis and put forward concrete actions for

strengthening the financial system. A second report was published in April 2009 – with its major focus lying on reducing procyc-

licality and improving cross-border crisis management. Both reports constituted the basis for the Washington and London declara-

tions of the G20. Since then, the FSB is in charge of monitoring and co-ordinating the implementation of the action plan.

The main cornerstone of the FSB proposals is a less leveraged financial system in which all institutions have significantly higher

capital and liquidity reserves. However, in total there are nine building blocks that are addressed by the FSB:

1. Strengthening the global capital framework

A revised capital framework by the Basel Committee on Banking Supervision will become operative once the economic crisis is

overcome. Accordingly, minimum capital requirements will increase in their level and quality, and will be required to behave

countercyclically so that capital is accumulated during good times and may be used to overcome bad times. This step also in-

cludes the specification of a harmonised definition of capital in order to facilitate the comparability of institutions in different


2. Making global liquidity more robust

The financial crisis has shown that insufficient liquidity may have severe consequences even for banks that had a sound capital

basis. This problem is addressed by the Basel Committee by introducing a liquidity coverage ratio, thus creating a harmonised

framework that in particular is supposed to reduce cross-border liquidity shortages.

3. Reducing the moral hazard posed by systemically important institutions

A major source of instability was created by moral hazard due to “too big (or too complex) to fail”. Strengthening capital and

liquidity are steps in the right direction; however, further measures will be needed to overcome this problem. Until the end of

2010 measures to reduce systemic risk will be developed which – according to the FSB – may include actions to reduce the com-

plexity of group structures, specific additional capital requirements and promotion of stand-alone subsidiaries.

4. Strengthening accounting standards

In order to meet the objectives of convergence, transparency, and the mitigation of procyclicality, standard setters are required to

agree upon a single set of high quality global accounting standards. However, the International Accounting Standards Board

(IASB) and the US Financial Accounting Standards Board (FASB) are considering different accounting approaches that may lead

to significant differences in banks’ total assets. The FSB strongly encourages the IASB and FASB to cooperate with supervisors,

regulators and other constituents in order to converge and improve their accounting standards with respect to the required amount

of credit information, and the simplification of accounting principles for financial instruments.

5. Improving compensation practices

In order to improve the effectiveness of compensation policies, the FSB Principles for Sound Compensation Practices outline

private and official sector action. The principles need to be applied to significant financial institutions and systemically relevant

firms, and have to be implemented in all major financial centres in a fast and coordinated way. Constant and independent supervi-

sion ensures that all necessary improvements are made.

6. Expanding oversight of the financial system

It is necessary that not only the banking sector but the broader financial sector is subjected to appropriate oversight and regulation.

Such a broad framework of regulation should particularly take hedge funds and rating agencies into account.

7. Strengthening the robustness of the OTC derivatives market

The risk in the market for over-the-counter (OTC) derivatives has to be reduced. Therefore, international standards need to be

established that take full account of counterparty risks, the benefits of centrally cleared contracts and collateralisation. The regula-

tion should ensure that equivalent standards are met outside the banking sector.

8. Re-launching securitisation on a sound basis

The revival of securitisation markets is crucial for the provision of credit to the real economy, whereas the official sector is re-

quired to provide a framework that ensures discipline in the securitisation market. In 2010, the main goals for supervisors and

regulators are the establishment of rules for banks’ management and disclosures, and the alignment of incentives of issuers with

investors. If necessary, measures may be adjusted in order to reduce complexity and enhance transparency.

9. Adherence to international standards

In order to strengthen adherence to international regulatory and prudential standards, the FSB framework intends to facilitate the

provision of comprehensive and updated compliance information and to identify non-cooperative jurisdictions. An important

means for achieving these goals is the system of peer reviews among FSB members to assess the implementation of international

financial standards and to discuss additional steps.

Source: 64

EEAG Report 2010 Chapter 2

the insurance company, the fall in Figure 2.8a

trust should also affect the de-

mand for insurance. Guiso et al.

(2008) find that, in the sample of

Dutch investors they examined,

individuals that trust less are less

likely to purchase insurance. In an

interesting paper that relies on a

field experiment in Indian villages,

Cole et al. (2009) show that over-

coming mistrust can result in a

significant increase in peasants’

adoption of insurance contracts

and Guiso and Schivardi (2009)

find that in a sample of small

businesses a critical factor limiting

entrepreneurs willingness to in-

sure their firm is mistrust towards

insurance companies. To sum up,

given the importance of trust in

all financial contracts, the fall in

trust towards all segments of the

financial industry will give rise to

a generalised flight from financial

trades and particularly deal from Figure 2.8b

those trades that are severely

exposed to opportunistic be-


Rebuilding trust in finance

As illustrated, the fall in trust is

likely to have pervasive effects on

people’s willingness to enter into

financial contracts and can thus

hamper the process of financial

development. Insofar as it results

in a shift towards safer assets, it

will push up the equity premium

and make equity financing more

expensive. This may have conse-

quences for fast growing and

innovative firms that depend

more heavily on this type of

financing. Similarly, if the in-

creased mistrust results in a pref-

erence for instruments with

shorter maturity, it will raise the

cost of long-term financing, hampering projects with The regulatory approach

high-yields but longer maturities. Because of this it is One approach, so far the only one that has been fol-

important to understand how one can rebuild trust in lowed to raise trust, is to enhance the intensity of

financial markets and intermediaries. Here we will ex- financial regulation. This approach, shared by many

amine some avenues. 65 EEAG Report 2010

Chapter 2 governments particularly in Europe, has been the sub- would be capable of increasing the trustworthiness of

the intermediaries and because of this the trust of the

ject of several of the recent G20 meetings and of the investors is still to be proved. The evidence so far from

proposals for intervention that are being discussed at cross country correlations is that countries with

the Financial Stability Board (see Box 2.1). stronger regulation have lower average levels of trust,

not higher! (See Aghion et al. (2010); Pinotti (2008);

Needless to say, many of the regulatory proposals Carlin et al. (2009).)

that are under scrutiny go beyond the purpose of

rebuilding trust. Rather, they are justified by regula- From the viewpoint of individual investors and of

tory failures that have become manifest during the the regulation of their relation with financial inter-

financial crisis. In fact, the set of proposals under dis- mediaries, the closest proposal that can help rebuild

cussion is ample and heterogeneous and ranges from trust is the creation of a consumer protection

more stringent capital requirements to the establish- agency, as proposed by the Obama administration.

ment of new authorities for macro-prudential super- The agency would oversee consumer financial prod-

vision, the breaking up of banks into smaller units to ucts which have been regulated in the past but

deal with too-big-to-fail issues, to policies aimed at whose oversight was exposed as lax. Another initia-

lessening the impact of bank failures and the associ- tive that has been taken very recently is the creation

ated contagion risks through regulatory constraints in the US of a Financial Fraud Enforcement task

on connectedness. Many of these policies, assuming 7 Interestingly, as

force to combat financial crimes.

they will be finally adopted, will most likely affect the made clear by Attorney General Eric Holder, the

of the intermediaries and may

perceived solvency task force is intentionally created to address the fall

result in a lower likelihood of future crises. Some in trust induced by the scandals that have been

policies – such as the limitations that the Financial brought about by the financial crisis. He notes: “We

Stability Board proposed for implementation in face unprecedented challenges in responding to the

September 2009 on the structure of compensation of financial crisis that has gripped our economy for

top managers at financial institutions – may help to the past year. Mortgage, securities, and corporate

assuage investors anger for the losses suffered during fraud schemes have eroded the public’s confidence

the crisis and their indignation at the high level of in the nation’s financial markets and have led to a

compensation for top executives in the financial growing sentiment that Wall Street does not play by

industry, thought to be responsible for their losses. the same rules as Main Street. Unscrupulous exec-

But these measures are likely to have little impact on utives, Ponzi scheme operators, and common crim-

the trust investors have in financial intermediaries inals alike have targeted the pocketbooks and

and markets. Rather, it is the drop in trust that retirement accounts of middle class Americans, and

increases the demand for regulation and builds con- in many cases, devastated entire families’ futures.

sensus around it. In fact, those who mistrust banks We will not allow these actions to go unpunished,

and financial intermediaries tend to favour tighter which is why President Obama has established this

regulations. To show this link we rely on a set of Financial Fraud Enforcement Task Force to inves-

questions that have been asked in the FTIS on tigate and prosecute fraud and financial crime …

whether the respondent is supportive or not of This Task Force’s mission is not just to hold

tighter regulation of US financial intermediaries and accountable those who helped bring about the last

large corporations and whether he agrees on setting financial meltdown, but to prevent another melt-

caps on the compensation of top managers in finan- down from happening.”

cial corporations. Figure 2.8 shows the correlation

between the intensity of trust towards financial inter- Because these initiatives are both specifically target-

mediaries (Panel A) and bankers (Panel B) and the ed to protecting investors from abuses they may

support for regulation measured by the fraction of actually contribute to rebuilding trust. But there are

people that agrees with the policy. The fraction of also reasons to believe that by themselves, these

those supporting a more stringent regulation is high- interventions may have limited impact. Concerning

er among those whose trust has fallen during the cri- the consumer protection agency and more generally

sis than among those who continue to trust banks regulatory interventions, because they are imposed

and financial markets. from outside the industry perceives the costs of the

But causality here most likely runs from the fall in

trust to the demand for regulation. The latter, in turn, 7 See


EEAG Report 2010 Chapter 2

regulations but not the benefits; hence financial playing partners manipulated to resemble themselves

they trusted them more than when the face of an

intermediaries will tend to circumvent their applica- unknown person was shown. Guiso and Schivardi

tion, with greater success the weaker the actual report evidence that is consistent with De Bruine’s

enforcement is. Since investors anticipate this, they (2002) findings. In a survey of a sample of small busi-

may not revise their trust priorities significantly. nessmen interviewees (280 overall) were asked to

Furthermore, sometimes financial regulation, even report, at the end of the face-to-face interview, their

when designed to protect investors, may be bother- judgment about the trustworthiness of businessman

some for them as well. Because of this and in order that they interviewed on a scale between 0 and 10

to limit the burden, they will be willing to tolerate (0 = totally untrustworthy, 10 = fully trustworthy).

intermediaries’ misapplications of these rules. A Interviewees also reported their opinion (again on a

good example is the recent set of norms imposed by scale between 0 and 10) on how much affinity they

the EU’s Markets in Financial Instruments Directive felt to the businessman (0 = no affinity, 10 = com-

(MiFID) to classify investors according to their abil- plete affinity). The data show two interesting facts:

ity to make financial decisions and their capacity to first, the more a person feels affinity the more he

bear financial risk. To achieve this classification trusts; second, while at low levels of affinity the level

banks can obtain information from their customers, of trust towards the businessman is highly variable, at

for example, by asking them to fill in specific ques- high levels of affinity one trusts fairly reliably. It is

tionnaires. But because the latter are costly to sub- reasonable to assume that one tends to trust people

mit, banks have all the incentives to minimise the that are not much different from oneself. This ten-

effort and propose minimal questionnaires, possibly dency to trust those who are similar is also true when

based on investors’ self-classification (so as to avoid similarity is measured along various dimensions,

any responsibility for misclassifications); since filling including cultural and genetic distance among people

in these forms is bothersome for investors too, they (Guiso et al. 2009). Thus, one possible strategy to

care little about the quality of the information that raise trust is to improve the match between investors

banks collect and will instead join them in minimis- and the manager of the relation at the intermediary,

ing the effort put in collecting the MiFID data. But for instance assigning a manager of the same gender

this contributes to the failure of MiFID objective: 8

and geographical origin to the investor. While this

limiting banks opportunistic behaviour by forcing may help in raising the average trust that investors

them to segment their clientele and restrain products have towards their bank/broker, it is unclear that it

that can be sold to unsophisticated and risk adverse helps raising the trust of those who lost it. To raise

investors. Anticipating this, people’s trust in banks is the latter one needs to set up mechanisms that signal

likely to change little. in a credible way that the intermediary has become

more trustworthy because, thanks to the mechanism,

there are weaker incentives to adopt predatory

An industry-based strategy actions towards the investors. Below we will discuss

some possible mechanisms.

Losing investors’ trust is very costly for the financial

industry. Since this is the case one would expect that

intermediaries have strong incentives to take actions A rating system that even the most (financially)

to re-build their reputation and re-gain the trust of illiterate investor can understand

their customers. Today one of the big questions that

any financial operator is confronted with is how to One possibility is to adopt a rating system aimed at

rebuild the trust of their investors. reducing the scope for exploiting conflicts of interests

that often arise in universal banks that manage the

Unfortunately there are no easy recipes on how A savings of the investors. The strategy followed so far

may convince B to re-consider his opinion about the by the regulators to control conflicts of interests is to

trustworthiness of A. The recent literature on trust

has shown evidence that B would trust A more if A is

“similar” to B in some dimension. In a well-known 8 Of course if matching according to similarity is an effective way to

raise trust, markets should be doing it already. If they already do,

trust game experiment, De Bruine (2002) reports the then this is not a relevant policy. If they do not it may be because this

type of matching entails costs that exceed the benefits, in which case

effects of a manipulation of facial resemblance on and the proposal would have little practical value. But it may also be

that they do not match according to similarity because they ignore

players’ willingness to trust the opponent. She finds its potential benefits. We cannot rule out this possibility; after all,

that when subjects were shown faces of ostensible research showing the trust effects of similarity is quite new.

67 EEAG Report 2010

Chapter 2 impose tighter disclosure requirements on the inter- the bank. Needless to say there could be many imple-

mediaries. Yet this strategy has proved to be faulty or mentation problems, including the fact that finding

insufficient. The main problem with disclosure is that independent and uncorrupted rating agencies may, as

it takes for granted that investors are able to under- the crisis has shown, not be a trivial issue. But the

stand what is disclosed and its implications in terms biggest problem, in our view, is initialising the

of incentives of the intermediary. However, the avail- process. If the exploitation of conflicts of interests

able evidence on poor levels of financial literacy and and misbehaviour more generally is a diffused prac-

knowledge of the majority of the investors in almost tice in the industry, then even a honest intermediary

all countries (see e.g. Lusardi and Mitchell (2009), (but still sensitive to short-run profitability) may find

Guiso and Jappelli (2008) Jappelli (2009)), even those it difficult to subject its bank to the “bank fairness

with high levels of achieved education, casts serious index” and give up a source of profit, as this may

doubts on the validity of the assumption. Relying on concede an advantage to its competitors. To put it

the loss of reputation as a deterrent for intermedi- differently, an outcome where low trustworthiness is

aries misbehaviour, and thus as a mechanism to raise pervasive may be stable. It may be unwise to play

trust in financial intermediaries, requires not only honestly when everyone else is cheating; if an inter-

that information about potential conflicts is made mediary does not cheat while all the others do, it

available but also that the investor has the ability to misses the upside. If it cheats when all the others do,

elaborate this information. For this to be the case one there is no downside as “cheating” becomes the pre-

has to make the disclosed information understand- dominant rule of behaviour and one cannot punish

able to the least experienced and financially knowl- the whole industry when all follow the same practice.

edgeable investor – i.e. to the typical customer of a Today it is perhaps easier to circumvent this problem

bank. One way of doing this is to rely on a third party given the greater value that rebuilding reputation has

to rate banks on the basis of their trustworthiness for any intermediary. Furthermore, since the incen-

and fairness when dealing with their customers and tive to behave in the same way as the others do natu-

when managing their portfolios and providing finan- rally implies that the financial industry can either set-

cial advice. This “bank-fairness index” may be tle on a bad equilibrium in which all cheat or instead

reported on a scale between 0 and 10, with higher val- in a good equilibrium where all play honestly, one

ues meaning a more reliable intermediary – a metric can think of a role for regulation/supervision that

that any investor can understand. The “bank-fairness encourages intermediaries to coordinate on a differ-

index” is similar to the rating system adopted for ent, no-cheating equilibrium.

issuers of specific securities and its role would be

analogous to that of standard rating: making avail-

able to the investors synthetic information that aggre- A trust-based compensation scheme

gates the judgment of an expert observer (and based A second, more direct mechanism to raise trust is to

on a multitude of data) on the quality of the issuers, provide incentives to build it. If the compensation of

subject to periodic revisions. In contrast to standard the investor’s manager depends on the level of trust

rating, the “bank-fairness index” is aimed at measur- investors have in their asset manager, the latter have

ing a bank’s ability and reliability in its role as dele- strong incentives to behave in a trustworthy manner

gated portfolio manager and in general as provider of and this, perhaps slowly, will raise the investors’ trust

financial advice that un-experienced investors use in and his willingness to invest. As trust increases, the

their financial decisions. Banks with an internal investor will also tend to concentrate more assets

organisation that discourages the exploitation of with a single manager, thus avoiding costly duplica-

conflicts of interest or that distributes easily under- tions of relationships. A mechanism of this sort

standable information to its customers, that allocate could be implemented for instance by relying on the

qualified personnel to financial consulting services, information that intermediaries have to collect from

etc. would obtain a high rating, attracting more cus- the investors to comply with the EU’s Markets in

tomers and this would provide enough incentives for Financial Instruments Directive (MiFID). The infor-

them to adopt actions that discourage the exploita- mation in this directive is presently essentially per-

tion of conflicts of interests. These banks would be ceived as a burden and unutilised. One could insert

compensated for the extra costs they incur with specific questions that the investors can report

increased trust from their customers. Reliance on a anonymously on how much they trust the intermedi-

rating system – which is a voluntary choice of a bank ary, the portfolio manager and in general the person

– is credible precisely because it entails some costs to 68

EEAG Report 2010 Chapter 2

they deal with when making financial decisions. Promoting investors’ financial education

Manager pay could then respond to the level of trust A third type of strategy is to take actions that pro-

(or its change) of the pool of customers he is respon- mote the financial education of the investors – for

sible for. One benefit of the trust-based compensa- instance transparently lobbying with the government

tion scheme is that it naturally leads the bank man- for having financial education taught at schools,

ager to adopt a long horizon. Since building trust making financial education material certified by

takes time and is accumulated only slowly, if only third parties available to investors etc., since people

because those with low levels of trust do not experi- with lower levels of financial education and financial

ment (or experiment less) and thus do not learn (or experience are more likely to be victims of financial

learn slowly), they cannot learn immediately the deception by intermediaries. The main reason is that

increased trustworthiness of the bank manager. unsophisticated investors are more vulnerable to

Furthermore, since trust is slow to accumulate but deception because they are more dependent on the

fast to vanish, once a reputation of trustworthiness intermediary advice for their financial choices.

is obtained it becomes costly to dispel it, strengthen- Second, they are also more subject to interpretation

ing the incentives to behave in a trustworthy manner. problems when investments result in negative returns

Obviously, this too, like all incentive schemes, can be and are thus more likely to think that they have been

distorting. In particular, if one encourages building cheated. Consistent with this view, Butler et al.

trust one provides incentives not only to create but (2009) find that the probability a person being de-

also to extort trust especially if this is a less costly ceived by a bank or insurance company is much

activity than creating trust by behaving in a trust- higher for people with low levels of education.

worthy manner. One way to limit this possibility is to Furthermore, this probability is higher also for peo-

integrate an investor’s opinions with those of some ple that – holding constant their level of education –

internal auditing committee at certain frequencies. live with parents with low education. This feature

Another is to rely on the legitimate interest of the has an important implication: since the family is an

other managers for having their colleagues behave important channel through which reliable financial

honestly, particularly those that are located in close education is obtained, raising the level of financial

proximity. The reason for this is that if manager A education has important spillovers through the fam-

cheats his investors, also the trust of the investors of ily and informal (but reliable) network channels. An

manager B will be affected, as the Quint Tatro tale in intermediary that promotes financial education sig-

the introduction illustrates. Thus, one could rely on nals its intention to be willing to deal with experi-

an internal reporting system that allows and actual- enced and sophisticated investors, with enough abil-

ly encourages managers to reports cases of abuses ity not to fall victims to financial abuses and distort-

and manipulation of investors’ trust. ed advice. Because of this the investors’ trust should

To strengthen the scheme even further, also the com- increase. Needless to say investment in financial edu-

pensation of the top management of the bank, in par- cation pays off in the very long run; however the

ticular its CEO (and maybe also the board of direc- return to the intermediary in terms of increased

tors) could be linked to the trust index of the bank trustworthiness may be more immediate if the inter-

customers. mediary’s commitment to transfer power to the

investor through this channel is credible. Credibility

To sum up, the adoption of a “trust-based compen- would be enhanced if the sponsoring of financial

sation scheme” is a practical way to induce a financial education programmes is part of a broader policy

organisation and its workers to limit the incentives to aimed at limiting intermediaries’ incentives to

deceive poorly informed investors and to treat them deceive investors, such as the trust-based compensa-

fairly by always acting in their best interest. Since this tion scheme and the bank fairness index.

commitment is translated into a compensation

scheme, it should be credible and thus able to modify

investors’ beliefs. In other words, trust is the in- Conclusions

vestors’ belief that those who manage their savings The dramatic drop in trust following the revelation

and provide them with financial advice are trustwor- of information of pervasive cheating in financial

thy. For intermediaries hoping to increase investors’ markets is likely to have a very strong negative

trust, the only way is to invest in increasing their impact on investors’ willingness to bear risk and

trustworthiness. 69 EEAG Report 2010

Chapter 2 thus on the cost of risk capital. Insofar as trust lev- Guiso, Luigi, Paola Sapienza and Luigi Zingales (2009), “Trust and

the Fragility of Financial Markets”, mimeo.

els were exceedingly optimistic, their downward Guiso, Luigi and Tullio Jappelli (2008), “Financial Literacy and

revision should be partially welcome as it may help Portfolio Diversification”, EIEF working paper 8/12.

punish dishonest financiers and help restore market Jappelli, Tullio (2009), “Economic Literacy: An International

discipline. Comparison”, CSEF working paper 209.

Lusardi, Annamaria and Olivia Mitchell (2009), “Financial Literacy.

Evidence and Implications for Financial Education”, TIAA-CREF

However, since trust has fallen across the board, its Institute Trends and Issues, May.

decline also affects the honest intermediaries, limit- Pinotti, Paolo (2008), “Trust, Honesty and Regulations”, MPRA

ing the flow of capital to industry in general. We paper 7740.

have proposed a number of measures to rebuild Sapienza, Paola and Luigi Zingales (2008), “The Financial Trust

Index. The results: Wave I”,

trust. The measures proposed all try, from different

angles, to limit the scope for intermediaries’ oppor- Carlin, B., F. Dorobantu and S. Viswanathan (2009), “Public Trust,

tunist behaviour – that is to raise their trustworthi- the Law, and Financial Investment”, Journal of Financial Economics,


ness – and because of this, increase trust. In each Knell, Markus and Helmut Stix (2009), “Trust in Banks? Evidence

case, the policy is not imposed; adhering to it is from normal times and from times of crises”, Oesterreichische

Nationalbank, mimeo .

instead to the discretion of the intermediary.

However, as we have argued, there is no automatic

mechanism that guarantees that intermediaries will

all agree to voluntarily adopt these policies. Rather,

if dishonest behaviour is dominant among interme-

diaries, even the honest ones may on their own be

unwilling to adopt these measures and help the

economy move to a better outcome where competi-

tion drives out dishonest behaviour. We have also

argued that regulation by itself, without the involve-

ment of the intermediaries, may fail to restore trust;

however regulatory agencies may play a very impor-

tant role in coordinating the selection of the honest

equilibrium. For instance, using “moral suasion” to

persuade even a small but important number of

intermediaries to “play the honest game” may be

enough to trigger a response of the same type by the

dishonest ones and influence the whole industry



Aghion, Philippe, Yann Algan, Pierre Cahuc and Andrei Shleifer

(2010), “Regulation and Distrust”, Quarterly Journal of Economics,


Arrow, Kenneth (1972), ”Gifts and Exchanges”, Philosophy and

1, 343–62.

Public Affairs,

Gambetta, Diego (2000) “Can We Trust Trust?” in Gambetta, Diego

(ed.) University of

Trust: Making and Breaking Cooperative Relations,

Oxford, 213–37.

Cole, Shawn, Xavier Giné, Jeremy Tobacman, Petia Topalova, Robert

Townsend and James Vickery (2009) “Barriers to Household Risk

Management: Evidence from India”, mimeo Harvard University.

DeBruine, Lisa M. (2002), “Facial Resemblance Enhances Trust”,

Proceedings of the Royal Society of London B, 269 (1948): 1307–12.

Guiso, Sapienza, and Zingales (2004), “The Role of Social Capital in

Financial Development”, 94(3), 526–56.

American Economic Review,

Guiso, Sapienza, and Zingales (2008), “Trusting the Stock Market”,

63(6), 2557–600).

Journal of Finance,

Guiso, Sapienza, and Zingales (2009), “Cultural Bias in Economic

Exchange?” forthcoming.

Quarterly Journal of Economics, 70

EEAG Report 2010 Chapter 3

F with the overall changes to fiscal positions? What

ROM FISCAL RESCUE TO are the existing and projected levels of public debt

GLOBAL DEBT relative to GDP?

• Was the consensus correct? Did we need a fiscal

stimulus? Can we identify the effects?

1. Introduction • There is now significant concern about debt-to-

GDP ratios. Are they too high? How and when

A broad consensus seemed to have been reached since should they be reduced?

the onset of the financial and economic crisis that

governments needed to undertake collective action to

provide a fiscal stimulus to prevent a deep and long- 2. What has happened to fiscal deficits during the

lasting recession. crisis?

For example, a much-cited note by the IMF at the In 2009 every EU member-state government had a

end of 2008 argued that the “optimal fiscal package budget deficit. In almost all cases, these deficits are

should be timely, large, lasting, diversified, contin- expected to rise in 2010. These deficits varied consid-


gent, collective and sustainable”. erably between countries, and the reasons for the size

of the deficit also varied. Most countries introduced

The European Council of the EU agreed a “European some discretionary fiscal stimulus in response to the

Economic Recovery Programme” (EERP) in De- financial and economic crisis, by cutting taxes or

cember 2008, which called for a discretionary fiscal increasing spending. These discretionary measures

stimulus of at least 1.5 percent of GDP. This was re- were small relative to the size of the deficits.

garded as “a crucial contribution to tackling the glob-

al economic crisis in which all countries with suffi- In this section we present some evidence on the pat-

cient fiscal space need to play a role in filling short- tern of the deficits both over time (since 2004, and up


term demand gaps”. to 2010 using European Commission forecasts), and

across countries. We also describe the extent to which

At its meeting in April 2009, the G20 stated: “We are these deficits were generated by discretionary mea-

undertaking an unprecedented and concerted fiscal

expansion, which will save or create millions of jobs sures, and the extent to which they were due to reduc-

which would otherwise have been destroyed, and that tions in tax revenues or rises in expenditure.

will, by the end of next year, amount to $5 trillion,

raise output by 4 percent, and accelerate the transition A starting point is the measurement of government

to a green economy. We are committed to deliver the debt. Measuring government indebtedness is diffi-

scale of sustained fiscal effort necessary to restore cult, since in principle it should include the extent

growth.” As recently as September 2009, the G20 stat- of future liabilities due to pension provisions and

ed: “We will continue to implement decisively our nec- other factors. There are also difficult issues with

essary financial support measures and expansionary respect to interventions in the banking sector. For

monetary and fiscal policies, consistent with price sta- example, if a government guarantees a loan, then

bility and long-term fiscal sustainability, until recov- typically that is not recorded as an increase in gov-

ery is secured.” ernment debt, even though the government has a

contingent liability. Box 3.1 describes how such

The issues addressed in this chapter are: financial sector interventions are typically recorded

• What has happened so far? What discretionary in national accounts. The figures shown in this

stimulus has taken place? How does this compare chapter are taken from Eurostat and the European

Commission, which are based on a consistent

1 IMF (2008). approach across the EU.

2 European Commission (2009a). 71 EEAG Report 2010

Chapter 3 Bo x 3. 1 Measurin g th e im pactt on

n governm entt debtt off financi all sectorr inter ventionss

EU governments have made significant interventions into the financial sector since the beginning of the financial crisis.

The classification of the costs of these interventions, and their effect on various measures of government debt, are


European System of Accounts 1995

generally estimated in accordance to the .

Several accounting issues arise with respect to financial sector interventions. One is whether the intervention represents an

institution becoming part of the public sector, and hence its debt becoming a public sector liability.

A second issue is which aspects of the financial accounts of an institution are relevant for measuring public sector debt.

public sector net debt

The most commonly-used measure of public sector debt is known as . This includes the financial


liabilities of financial companies which have moved into public ownership. However, only financial assets are

netted out against these liabilities. Because other financial assets are not included, the measure does not give a realistic

general government

indication of the increase in the overall net indebtedness of the public sector. An alternative measure,

gross debt , does net off all financial assets, and can therefore give very different indications of debt.

public sector net debt

For example, it is estimated that, for the UK, the total increase in as a result of financial sector

interventions is approximately £1.1 trillion to £1.6 trillion, which could raise the debt-to-GDP ratio in the UK by more

than 100 percent. (Only a small part of this increase is included in the figures shown here; by far the largest part of this

general government

reflects the public ownership of Royal Bank of Scotland, Lloyds TSB and HBOS). But the increase in

gross debt is estimated at only around £77 billion. While this is still, of course, a large amount, it gives a very different

picture of the extent of the financial sector interventions.

Finally, government debt guarantees – including those in place before the crisis, and those introduced during the crisis –

are typically not included in the figures for debt, even though they represent a contingent liability on the government.

Table 3.6 on page 76 gives an indication of the extent of the public sector interventions in the banking sector during the


1 See Eurostat (1995). The European Committee on Monetary, Financial and Balance of Payments Statistics (CMFB) reviewed financial

interventions and reported its opinion on their appropriate accounting treatment in March 2009. These were reviewed in detail by Kellaway (2009).

Table 3.1 shows the public sector

balances of each member state Tabl e 3. 1

since 2004; 2009 and 2010 are Budg ett bal an cess off EU

U m e mb err stat es,, 2 00 4–2 01 0

projections made by the Euro- perc e ntt GDP

pean Commission. It is clear that 200 4 200 5 200 6 200 7 200 8 200 9 201 0

deficits rose sharply in 2009. In Austria – 4.5 – 1.7 – 1.7 – 0.7 – 0.5 – 4.2 – 5.3

Belgium – 0.4 – 2.8 0.2 – 0.3 – 1.2 – 4.5 – 6.1

2007, the EU as a whole had a Bulgaria 1.6 1.9 3.0 0.1 1.5 – 0.5 – 0.3

deficit of only 0.8 percent of Cyprus – 4.1 – 2.4 – 1.2 3.4 0.9 – 1.9 – 2.6

GDP. That rose to 2.3 percent in Czech Rep. – 2.9 – 3.6 – 2.6 – 0.6 – 1.4 – 4.3 – 4.9

Denmark 1.9 5.0 5.0 4.5 3.6 – 1.5 – 3.9

2008, and then jumped to 6 per- Estonia 1.7 1.5 2.9 2.7 – 3.0 – 3.0 – 3.9

cent in 2009, and to 7.3 percent Finland 2.2 2.6 3.9 5.2 4.1 – 0.8 – 2.9

in 2010. France – 3.6 – 3.0 – 2.3 – 2.7 – 3.4 – 6.6 – 7.0

Germany – 3.8 – 3.3 – 1.5 – 0.2 – 0.1 – 3.9 – 5.9

Greece – 7.4 – 5.2 – 3.1 – 3.9 – 5.0 – 5.1 – 5.7

Romania is the only country Hungary – 6.4 – 7.8 – 9.3 – 4.9 – 3.4 – 3.4 – 3.9

that reduced its deficit between Ireland 1.4 1.7 3.0 0.2 – 7.1 – 12.0 – 15.6

Italy – 3.6 – 4.4 – 3.3 – 1.5 – 2.7 – 4.5 – 4.8

2008 and 2009, but then it had a Latvia – 1.0 – 0.4 – 0.5 – 0.4 – 4.0 – 11.1 – 13.6

relatively high deficit of 5.4 per- Lithuania – 1.5 – 0.5 – 0.4 – 1.0 – 3.2 – 5.4 – 8.0

cent of GDP even in 2008. Luxembourg – 1.1 0.1 1.4 3.6 2.6 – 1.5 – 2.8

Some countries have seen a Malta – 4.7 – 2.9 – 2.6 – 2.2 – 4.7 – 3.6 – 3.2

Netherlands – 1.8 – 0.3 0.6 0.3 1.0 – 3.4 – 6.1

notable worsening of the fiscal Poland – 5.7 – 4.3 – 3.9 – 1.9 – 3.9 – 6.6 – 7.3

position. Ireland jumped from a Portugal – 3.4 – 6.1 – 3.9 – 2.6 – 2.7 – 6.5 – 6.7

small surplus in 2007 to a de- Romania – 1.2 – 1.2 – 2.2 – 2.5 – 5.4 – 5.1 – 5.6

Slovakia – 2.4 – 2.8 – 3.5 – 1.9 – 2.2 – 4.7 – 5.4

ficit of 12 percent of GDP in Slovenia – 2.2 – 1.4 – 1.3 0.5 – 0.9 – 5.5 – 6.5

2009. Likewise, Latvia went Spain – 0.4 1.0 2.0 2.2 – 3.8 – 8.6 – 9.8

from a small deficit in 2007 to a Sweden 0.6 2.0 2.4 3.8 2.5 – 2.6 – 3.9

UK – 3.3 – 3.3 – 2.6 – 2.6 – 5.4 – 11.5 – 13.8

deficit of 11 percent of GDP in EU27 – 2.9 – 2.5 – 1.4 – 0.8 – 2.3 – 6.0 – 7.3

2009. The UK also moved in a Source: 2004–2008, Eurostat; Forecasts 2009–2010 European Commission (2009a).

similar way. 72

EEAG Report 2010 Chapter 3

A small number of countries Tabl e 3. 2

have had substantial deficits for a Fiscall sti mul uss m e asuress i n 2 00 9/10


number of years: notably Greece, perc e ntt GDP


Hungary, Italy, Malta, Poland, 200 9 201 0

Portugal and to a lesser extent, Total Expenditure Revenue Total

the UK. There are significant dif- Austria 1.8 0.4 1.4 1.8

Belgium 0.4 0.2 0.2 0.4

ferences across counties in 2009, Bulgaria 0.0 0.0 0.0 0.0

ranging from Bulgaria with a Cyprus 0.1 0.1 0.0 0.0

deficit of only 0.5 percent of Czech Republic 1.0 0.5 0.5 0.5

Denmark 0.4 0.3 0.1 0.8

GDP, to Ireland with a deficit of Estonia 0.2 0.2 0.0 0.3

12 percent of GDP. Finland 1.7 0.6 1.1 1.7

France 1.0 0.7 0.3 0.1

Germany 1.4 0.6 0.8 1.9

These deficits were only partly Greece 0.0 0.0 0.0 0.0

due to discretionary responses Hungary 0.0 0.0 0.0 0.0

to the economic and financial Ireland 0.5 0.3 0.2 0.5

Italy 0.0 0.2 – 0.2 0.0

crisis. This is shown in Table 3.2 Latvia 0.0 0.0 0.0 0.0

which indicates the size of the Lithuania 0.0 0.0 0.0 0.0

discretionary fiscal stimulus in Luxembourg 1.2 0.1 1.2 1.4

Malta 1.6 1.3 0.3 1.6

each country in 2009 and in Netherlands 0.9 0.4 0.5 1.0

2010 (taking into account those Poland 1.0 0.3 0.7 1.5

measures already announced). Portugal 0.9 0.9 0.0 0.1

These are measured relative to Romania 0.0 0.0 0.0 0.0

Slovakia 0.1 0.1 0.0 0.0

the position in 2008, recording Slovenia 0.6 0.5 0.1 0.5

all discretionary changes in Spain 2.3 1.0 1.3 0.6

these two years. Sweden 1.4 0.6 0.8 1.6

UK 1.4 0.4 1.0 0.0

EU27 1.1 0.5 0.6 0.7

Almost all EU governments in- Figures for 2010 represent changes with respect to 2008, i.e. include permanent

troduced a fiscal stimulus in measures taking effect in 2009 plus the net effect of measures taking effect in


2009, though some maintained Source: European Commission (2009a).

a neutral position. The largest

discretionary changes were in

Spain, with a stimulus of nia and Slovakia both have revenues of 32.2 percent

2.3 percent of GDP, made up of an increase in of GDP, and expenditures of 38.5 percent and

spending of 1 percent and a reduction in taxes of 38.3 percent respectively.

1.3 percent. On average, though, the EU as a whole

introduced a discretionary stimulus of only 1.1 per- Across the whole of the EU, revenues have been very

cent of GDP. Note though that evidence presented consistent as a proportion of GDP, at just over 44 per-

in Chapter 1 suggests that changes in structural cent in each of the 7 years shown. Revenues in 2009

deficits – that part of the deficit that is not auto- and 2010 are lower than in the preceding years, but

matic – were larger than implied by the discre- only fractionally. There is more variation over time for

tionary responses listed in this chapter. individual countries, although in most countries rev-

enues typically only changed in 2009 by less than one

Tables 3.3 and 3.4 split up the deficits in each country percent of GDP.

by considering the size of tax revenues (Table 3.3) and

public spending (Table 3.4) as a proportion of GDP. The substantial rises in deficits therefore appear to be

Of course, there is considerable variation between mainly driven by increases in spending as a propor-

countries. Not surprisingly, the Scandinavian coun- tion of GDP, rather than reductions in taxation as a

tries have the highest revenues: in 2009, Sweden has proportion of GDP. Some countries – typically those

revenues of 53 percent of GDP, Denmark 52.8 per- with large increases in their deficits – have seen sub-

cent, and Finland 52 percent. Their expenditures are stantial rises in spending as a proportion of GDP. But

similarly high: 56.6 percent for Sweden, 55 percent for note that GDP fell in many countries in 2009. The rise

Denmark and 52.8 percent for Finland. Some of the in the spending ratio may therefore not represent only

newer members states are at the other extreme: Roma- a real increase in spending but also a reduction in

73 EEAG Report 2010

Chapter 3 GDP. By contrast, falling nation-

Tabl e 3. 3 al income tends to reduce tax rev-

Rev en uess off EU

U m em b err states,, 20 04 –2 010


perc e ntt GDP

P enues automatically: so it is likely

200 4 200 5 200 6 200 7 200 8 200 9 201 0 that revenues as a proportion of

Austria 49.5 48.2 47.7 48.0 48.2 47.0 47.3 GDP would remain relatively

Belgium 49.1 49.4 48.7 48.1 48.4 48.5 48.2 constant in a downturn.

Bulgaria 41.3 41.2 39.5 41.5 39.0 40.8 40.9

Cyprus 38.7 41.2 42.2 46.4 44.9 44.1 44.1

Czech Rep. 42.2 41.4 41.2 42.0 40.9 40.7 41.1 This analysis of revenues and

Denmark 56.4 57.8 56.6 55.4 55.4 52.8 53.4 expenditures helps to identify

Estonia 35.7 35.5 37.1 38.2 37.9 38.2 38.4 the automatic stabilisers of the

Finland 52.3 52.9 52.6 52.5 52.5 52.0 51.3

France 49.6 50.4 50.4 49.6 49.3 49.4 49.9 economic downturn. However,

Germany 43.3 43.5 43.8 44.0 43.8 43.5 42.3 other factors may also be rele-

Greece 38.0 38.1 39.1 40.1 39.9 40.8 40.0 vant. In some cases, such as the

Hungary 42.6 42.3 42.7 44.8 46.5 46.1 46.4

Ireland 35.1 35.4 37.0 35.9 33.8 33.7 33.9 UK, 2007 spending plans in-

Italy 44.2 43.8 45.4 46.4 46.0 46.5 46.5 tended spending to rise sharply,

Latvia 34.7 35.2 37.7 35.5 35.5 34.1 34.7 financed by higher revenues.

Lithuania 31.8 32.8 33.1 33.9 34.0 34.8 36.0

Luxembourg 41.4 41.6 39.9 40.8 43.3 44.0 42.9 Moving into the recession,

Malta 40.8 41.8 41.2 40.4 40.6 41.1 41.2 spending plans were not re-

Netherlands 44.3 44.5 46.2 45.6 46.4 46.1 45.6 duced, but revenues were much

Poland 36.9 39.1 39.9 40.2 39.2 40.2 40.3

Portugal 43.1 41.6 42.3 43.1 43.2 42.6 42.4 lower than expected, leading to

Romania 32.3 32.3 33.1 34.0 33.1 32.2 32.5 the very high deficit.

Slovakia 35.3 35.4 33.5 32.5 32.7 32.2 32.1

Slovenia 43.6 43.8 43.3 42.9 42.7 41.7 41.6 Where do these deficits leave the

Spain 38.5 39.4 40.5 41.0 36.6 36.4 36.9 level of outstanding debt as a

Sweden 56.1 57.2 56.5 56.3 55.7 53.0 52.7

UK 39.6 40.8 41.6 41.4 42.3 41.4 41.6 proportion of GDP for EU coun-

EU27 44.0 44.4 44.9 44.9 44.5 44.3 44.1 tries? For the EU as a whole, the

Source: 2004–2008, Eurostat; Forecasts 2009–2010 European Commission (2009a). measured debt-to-GDP ratio has

increased from 58.7 percent in

2007 to 72.6 percent in 2009, and

Tabl e 3. 4

Gover nm entt Ex pe ndit uress off EU

U m em berr st ates,, 20 04 –2 010

0 it is projected to rise again to

perc e ntt GDP

P 79.4 percent in 2010. This figure

200 4 200 5 200 6 200 7 200 8 200 9 201 0 is likely to continue to rise even

Austria 54.0 49.9 49.4 48.7 48.7 51.6 52.1 after 2010.

Belgium 49.5 52.2 48.5 48.3 49.9 48.5 48.2

Bulgaria 39.7 39.3 36.5 41.5 37.4 39.5 39.3 Of course, there is again consid-

Cyprus 42.8 43.6 43.4 42.9 44.0 44.0 45.0

Czech Rep. 45.1 45.0 43.8 42.6 42.4 45.9 47.6 erable variation across coun-

Denmark 54.6 52.8 51.6 51.0 51.7 55.0 57.0 tries: from Estonia with debt of

Estonia 34.1 34.0 34.2 35.5 40.9 45.0 47.3 under 7 percent of GDP to Italy

Finland 50.1 50.3 48.7 47.3 48.4 52.8 54.3

France 53.2 53.4 52.7 52.3 52.7 55.6 56.4 with a ratio of 113 percent.

Germany 47.1 46.8 45.3 44.2 43.9 48.2 49.0 There is some evidence that

Greece 45.4 43.3 42.2 44.0 44.9 45.3 45.2 countries with a lower debt ratio

Hungary 48.9 50.1 51.9 49.7 49.8 50.8 52.0 before the crisis have responded

Ireland 33.7 33.7 34.0 35.7 41.0 45.8 49.1

Italy 47.7 48.2 48.7 47.9 48.7 51.2 51.1 with a greater overall fiscal stim-

Latvia 35.8 35.6 38.2 35.9 39.5 46.8 49.8 ulus. For example, Ireland’s

Lithuania 33.3 33.3 33.6 34.9 37.2 39.5 42.7 ratio shot up from 25 percent in

Luxembourg 42.5 41.6 38.6 37.2 40.7 44.2 45.7

Malta 45.5 44.7 43.7 42.6 45.3 44.4 44.8 2007 to 61 percent in 2009, and

Netherlands 46.1 44.8 45.6 45.3 45.5 48.3 50.2 the UK from 44 percent to

Poland 42.6 43.4 43.8 42.1 43.1 46.1 46.8 68 percent. But there is little evi-

Portugal 46.5 47.6 46.3 45.8 45.9 48.9 48.7

Romania 33.5 33.5 35.3 36.6 38.5 38.5 38.9 dence that this was a discre-

Slovakia 37.6 38.2 36.9 34.4 34.9 38.3 39.4 tionary response, whereby coun-

Slovenia 45.8 45.3 44.6 42.4 43.6 47.7 48.6 tries that were more able to pro-

Spain 38.9 38.4 38.5 38.8 40.5 45.2 47.1

Sweden 55.6 55.2 54.1 52.5 53.1 56.6 57.3 vide a fiscal stimulus did so.

UK 42.9 44.1 44.2 44.0 47.7 50.5 52.4 Instead, the underlying reasons

EU27 46.9 46.9 46.3 45.7 46.8 50.1 51.1 appear more to do with the

Source: 2004–2008, Eurostat; Forecasts 2009–2010 European Commission (2009a)


EEAG Report 2010 Chapter 3

3.1 Macroeconomic models

Tabl e 3. 5


P r atioss off EU

U m e mb err stat es,, 2 004 –2 01 0 3.1.1 Theory

perc e ntt

200 4 200 5 200 6 200 7 200 8 200 9 201 0 Theoretical macroeconomic mod-

Austria 64.8 63.7 62.0 59.4 62.5 70.4 75.2 els have explored a variety of

Belgium 94.4 92.2 87.9 84.0 89.6 95.7 100.9

Bulgaria 37.9 29.2 22.7 18.2 14.1 16.0 17.3 channels through which a fiscal

Cyprus 70.2 69.1 64.6 59.4 49.1 47.5 47.9 stimulus can affect the economy.

Czech Rep. 30.4 29.8 29.6 28.9 29.8 33.7 37.9 There are of course fundamental

Denmark 43.8 37.1 31.3 26.8 33.3 32.5 33.7

Estonia 5.0 4.5 4.3 3.5 4.8 6.8 7.8 differences across paradigms as

Finland 44.2 41.4 39.2 35.1 33.4 39.7 45.7 regards the effectiveness of fiscal

France 64.9 66.4 63.7 63.8 68.0 79.7 86.0 policy. Neoclassical models em-

Germany 65.6 67.8 67.6 65.1 65.9 73.4 78.7 phasize that fiscal measures are

Greece 98.6 98.8 95.9 94.8 97.6 103.4 108.0

Hungary 59.4 61.7 65.6 65.8 73.0 80.8 82.3 either irrelevant (Ricardian equiv-

Ireland 29.7 27.5 24.9 25.0 43.2 61.2 79.7 alence prevents tax cuts from

Italy 103.8 105.8 106.5 103.5 105.8 113.0 116.1 boosting private demand) or

Latvia 14.9 12.4 10.7 9.0 19.5 34.1 50.1

Lithuania 19.4 18.4 18.0 17.0 15.6 22.6 31.9 counterproductive (public spend-

Luxembourg 6.3 6.1 6.7 6.9 14.7 16.0 16.4 ing crowds out private spending).

Malta 72.2 69.8 63.7 62.1 64.1 67.0 68.9 Keynesian models emphasise that

Netherlands 52.4 51.8 47.4 45.6 58.2 57.0 63.1

Poland 45.7 47.1 47.7 44.9 47.1 53.6 59.7 fiscal policy can actually crowd-in

Portugal 58.3 63.6 64.7 63.5 66.4 75.4 81.5 private expenditure, especially

Romania 18.7 15.8 12.4 12.7 13.6 18.2 22.7 when economic resources are

Slovakia 41.4 34.2 30.4 29.4 27.6 32.2 36.3

Slovenia 27.8 27.0 26.7 23.4 22.8 29.3 34.9 underutilised in a recession. An

Spain 46.2 43.0 39.6 36.2 39.5 50.8 62.3 important lesson from these con-

Sweden 51.2 51.0 45.9 40.5 38.0 44.0 47.2 trasting theoretical analyses, how-

UK 40.6 42.3 43.4 44.2 52.0 68.4 81.7 ever, is that the macroeconomic

EU27 62.2 62.7 61.3 58.7 61.5 72.6 79.4

Source: 2004–2008, Eurostat; Forecasts 2009–2010 European Commission (2009a). response to fiscal expansion can

vary widely, depending on the

degree of slack in the economy,

the monetary policy response, as

planned spending prior to the crisis and the degree well as the relevance of market distortions, ranging

to which the economies were affected by the finan- from credit constraints and other financial imperfec-

cial crisis. tions to nominal rigidities.

We discuss the implications of these deficits and their It is useful to start our analysis with a brief reconsid-

effects on the debt ratio in Section 4 below. eration of the standard neoclassical model with flexi-

ble prices and well-functioning labour and goods

markets, see e.g. Baxter and King (1993). A specific

3. Is fiscal stimulus effective? Evidence from the reason to do so is that this model clarifies the impor-

literature tant difference between wealth and substitution

effects from fiscal measures, which are often blurred

Most economists and policymakers have agreed that together in the popular account of the way fiscal pol-

the adverse economic effects of the current crisis icy works. In the classical exercise proposed by the lit-

could not have been contained without a strong fis- erature, a temporary increase in government spending

cal stimulus. Nonetheless, there are also sceptics who is eventually matched by an increase in lump-sum tax-

denounced the large fiscal expansions from 2008 as a ation which has the same present value (the timing of

waste of resources that could actually jeopardise the taxes does not matter, as Ricardian equivalence holds

recovery because of their lasting negative impact on in this case). The increase in spending raises output

government finances. Not surprisingly, the long- somewhat, but unambiguously lowers consumption.

standing debate on the fiscal transmission mecha- The fall in consumption occurs for two reasons. First,

nism, and especially on the size of the fiscal multi- as agents anticipate rationally the time path of future

plier, is raging once again. In this section, we briefly spending, they also feel that their net-of-tax wealth

reconsider the theoretical and empirical arguments has fallen by the full increase in the tax burden. Under

in this debate. 75 EEAG Report 2010

Chapter 3 Tabl e 3. 6 Publi c in terv ent ionss i n th e ba nkin g se ctorr

perc e ntt GDP

Guarantees on bank Relief on impaired asset and Guarantees

Capital injections liabilities liquidity and bank support on deposits

Total Effective Total Total ( 000, or

approved capital approved Guarantees approved Effective percent of

measures injections measures granted measures interventions GDP)

Austria 5.5 1.7 25.7 6.8 7.1 2 100 percent

Belgium 5.3 6.1 70.8 16.3 8.1 8.1 100

Bulgaria 0 0 0 0 0 0 50

Cyprus 0 0 0 0 0 0 100

Czech Republic 0 0 0 0 0 0 50

Denmark 6.1 2.4 253 2.5 0.3 0.3 100 percent

Estonia 0 0 0 0 0 0 50

Finland 0 0 27.7 0 0 0 50

France 1.2 1.2 16.6 5.5 0.2 0.2 70

Germany 4.4 2 18.6 7.2 1.4 1.4 100 percent

Greece 2 1.5 6.1 1.2 3.3 1.8 100

Hungary 1.1 0.1 5.9 0 0 2.6 100 percent

Ireland 6.6 6.5 164.7 164.7 0 0 100

Italy 1.3 0.1 NA 0 0 0 c. 103

Latvia 1.4 0.9 25.7 2.8 10.9 4.7 50

Lithuania 0 0 0 0 0 0 100

Luxembourg 6.9 7.9 12.4 NA 0.9 0.9 10

Malta 0 0 0 0 0 0 100

Netherlands 6.4 6.8 34.3 7.7 11.4 5.5 100

Poland 0 0 0 0 0 0 50

Portugal 2.4 0 10 3.3 0 0 100

Romania 0 0 0 0 0 0 50

Slovakia 0 0 0 0 0 0 100 percent

Slovenia 0 0.4 32.8 6.3 0 0 100 percent

Spain 0 0 18.6 2.1 2.8 1.8 100

Sweden 1.6 0.2 48.5 11 12.6 0 50

UK 3.5 2.6 21.7 11.3 16.4 14.7 50

EU27 2.7 1.7 20.5 7.8 2.1 1.4

Source: European Commission (2009b) spending. If the increase in public expenditure is per-

standard assumptions, agents react to the negative manent and immediately implemented, it is the wealth

wealth shocks by reducing consumption and leisure. shock associated with the higher tax burden that con-

The reduction in leisure in turn implies an increase in stitutes the lion’s share. Otherwise, most of the adjust-

labour supply, which increases output and lowers the ment in consumption and leisure is driven by

real wage. The second effect works through intertem- intertemporal substitution. To clarify this point, sup-

poral substitution of future for present consumption. pose that, over the long run, the growth rate is zero

If the increase in spending is temporary, interest rates and the real interest rate is 3 percent. All else equal, a

(long and short) rise on impact, reflecting the relative temporary increase in spending as high as, say, 10 per-

scarcity of current output due to the additional de- centage points of GDP for one year would generate

mand by the government. In response to real interest tax liabilities reducing households’ permanent income

rate movements, households postpone their spending 4

by a mere 0.3 percentage points of GDP

plans. Similarly, real wages may temporarily rise in the – quite a

short run, creating an incentive to work more on small amount, relative to the size of the upfront


impact. spending expansion.

The distinction between wealth and substitution

The relative weight of these two effects, wealth and effects is a key element in assessing the effectiveness

intertemporal substitution of consumption, depends of fiscal stabilisation policy. By its very nature, fiscal

crucially on the evolution over time of the change in

3 4

While consumption is typically crowded out by government spend- This result is obtained by calculating the constant flow of real

ing, investment can respond in different ways, depending on the spec- taxes, which is equal, in present discounted term, to the increase in

ification of the model and especially on the persistence of the shock net debt financing the spending expansion. In the example in the

to public spending. There are also a number of extensions of the text, the increase in debt is 10 percentage points of GDP.


neoclassical model which could also accommodate a positive effect Hence 10=Σ(1+r) x=x(1+r)/h implies that the additional tax pay-

of the rise in government spending on consumption. ment (x=.3/1.03) must be approximately equal to 0.3 per period.


EEAG Report 2010 Chapter 3

stimulus is temporary. The wealth shock associated higher if a short-run expansion in spending is even-

tually offset, at least in part, by a decline in spend-

with changes in the tax burden will affect house- ing below trend, rather than exclusively by a rise in

holds’ consumption decisions in a limited way. The taxes. This is because the reversal in government

focus should instead be placed on “intertemporal spending generates expectations of a decline in

substitution”. short-term interest rates in the future, which has an

immediate effect on long-term rates. With sticky

As stressed by the Keynesian literature, an important prices (and a relatively accommodative monetary

argument in favour of fiscal stabilisation is provided by stance), it is possible that this effect may dominate

models allowing for financial frictions. A fiscal stimu- the upward pressure on long-term rates resulting

lus is likely to be effective, for instance, when some from the additional government spending. It may

households are credit-constrained, so that their spend- well be possible that consumption would be crowd-

ing decisions become sensitive to disposable income, as ed in, rather than crowded out, on impact (see also

opposed to permanent income. If current income Chapter 1 in the 2009 EEAG Report).

increases due to either a government expansion which

raises economic activity and therefore wage payments, Note that monetary and fiscal interactions in both the

or a cut in taxes, these households are likely to spend short and the long run work mostly through the

more. Depending on the proportion of credit-con- intertemporal substitution channel already discussed

strained households in the economy, the positive early on in this chapter, in particular through their

response of their demand may drive up overall con- influence on the path of the long-term rates relevant

sumption. Similar results may be predicted by models for private demand decisions.

where firms (entrepreneurs) are credit constrained,

although the transmission mechanism is different, see A new generation of models building on Eggertsson

e.g. Villaverde (2010) for a recent discussion. and Woodford (2004) suggest that the fiscal expan-

sions may be extremely valuable in deep recessions

Models with nominal rigidities call attention to an in which monetary policy is constrained in setting

additional important element, that is, the interactions interest rates by the zero lower bound. In this case,

among monetary and fiscal policy. In both the tradi- absent fiscal policy, deflationary pressures from

tional and the new Keynesian models, the effect of a large recessionary shock may give rise to a defla-

fiscal stimulus is largely determined by the stance of tionary spiral: with the interest rate at zero, insuffi-

the central bank. The fiscal multiplier is indeed deter- cient demand causes firms to cut prices; to the

mined by the targeting rule (interest or exchange rate) extent that pricing decisions are staggered, falling

pursued by monetary authorities. For example, in the prices generate expectations of lasting deflation; for

classical Mundell-Fleming model, fiscal policy is a given nominal interest rate, these translate into

more effective if the country adopts a fixed exchange higher real rates; and higher real rates further weak-

rate regime, so that the domestic policy rate is en demand, reinforcing the fall in output. A fiscal

anchored to the foreign interest rate by the uncovered expansion can however stop this adverse mecha-

interest parity condition. Similarly, in the new nism, by raising demand and therefore contrasting

Keynesian model, if the central bank could (and the pressure towards lowering prices – a case dis-

would be willing to) target a constant interest rate in cussed by Christiano et al. (2009), Corsetti et al.

real terms, under standard assumption this monetary (2010), Erceg and Lindé (2010) and Eggertsson

stance would completely determine the evolution of (2009) among others. These contributions are of

consumption: any variation in government spending particular interest in the current situation, not only

would exclusively be reflected in changes in output because they explicitly address issues in fiscal stabil-

(Woodford 2010). The general point here is that some isation when interest rates are already effectively at

degree of monetary accommodation in the short run zero, but also because they provide theoretical

raises the macroeconomic impact of an increase in instances of very large multipliers for government

government spending. 5

spending (although not necessarily for tax cuts).

However, as consumers and firms are forward look- 5 Eggetsson (2009) emphasises that, when monetary policy is stuck at

ing, the impact of fiscal stimulus also depends on the zero lower bound, fiscal policies should aim directly at stimulat-

ing aggregate demand. These policies include temporary increases in

(private expectations about) how fiscal consolida- government spending and tax cuts, such as an investment tax credit

or a cut in sales taxes (by virtue of their direct effect on aggregate

tion will take place in the future. Corsetti et al. demand rather than aggregate supply). Tax cuts that lower marginal

(2009a), for instance, show that fiscal multipliers are costs may instead exacerbate the risk of a deflationary spiral.

77 EEAG Report 2010

Chapter 3 Yet, they mostly rely on restrictive assumptions The different approaches briefly summarized in the

Box have been used on aggregate data in a number of

regarding the origin of the shocks underlying the countries to identify the sign and size of the multipli-

global slowdown. er effect, and the effect on other variables, such as

consumption, employment, interest rates and ex-

As discussed in last year’s EEAG Report, a leading change rates.

explanation of the unexpected and strong drop in

demand during the last months of 2008 and through- Tables 3.7 and 3.9 summarise some of the estimates in

out 2009 attributes the recession to a rise in perceived 6 The estimates

the literature of the fiscal multiplier.

uncertainty (see Chapter 2 of the 2009 EEAG Re- shown in these tables are – where it is possible to iden-

port). Such an interpretation raises the issue of how tify – the cumulative peak effect on GDP of an exoge-

fiscal policy could stabilise inefficient and large fluc- nous shock to government spending (Table 3.7) or

tuations in economic activity in the face of rising taxation (Table 3.9). The cumulative peak effect can

uncertainty. This issue defines an important chapter occur immediately, or several quarters after the initial

in the economics of fiscal stabilisation, largely yet to shock.

be written. We will not discuss all of these papers. However, it is

It is indeed plausible that during a financial turmoil, worth exploring some of the results in a little more

when expectations are down, the role of fiscal policy detail. For example, in one well-known paper,

is to inject “optimism” in private markets, helping Blanchard and Perotti (2002) present results from two

people to re-gain confidence. Concretely, the govern- models, which vary according to whether a determin-

ment could commit to insure people against some istic or stochastic trend is added to the model. The

very bad outcomes: to the extent that the crisis is dri- results shown in Tables 3.7 and 3.9 are for the latter

ven by self-validating expectations, such a commit- case. Looking at point estimates, output rises by 0.9

ment can in principle coordinate expectations away following a unit increase government spending. This

from those outcomes. An advantage of this approach effect occurs in the first quarter, and thereafter

to fiscal policy is that the premise of the stabilisation declines. By contrast, with a deterministic trend, the

strategy would be fully consistent with the leading peak effect reaches 1.29, but occurs only after

diagnosis of what causes the crisis. 15 quarters. Since government spending is itself a

component of GDP, these two estimates generate dif-

The design of fiscal stabilisation coherent with this ferent predictions for the sign of effect on the other

view is however quite complex. Some of the trade-offs elements of GDP: negative under the stochastic trend,

are already debated heavily, by and large contrasting and positive for the deterministic trend, although

the interests of Wall Street with the interest of Main both are close to zero.

Street. Moreover, there is a budget constraint on the

stimulus: in light of the uncertainty surrounding their Blanchard and Perotti develop their model further, in

effects, actions must be such that they do not put fis- an attempt to identify the effects on the different com-

cal sustainability in peril. We will return to these ponents of GDP. Their results are shown in Table 3.8.

issues below. For both models, they find a positive effect on private

consumption, although the size of this effect is quite

3.1.2 Time series and panel analysis different between the two models. This is inconsistent

with the basic neoclassical model, which would pre-

Empirical work has generated a wide variety of esti- dict a reduction in consumption. They also find nega-

mates of fiscal multipliers – that is, of the effect on tive impacts on investment, exports and imports. Note

output of a fiscal stimulus. Certainly, we would expect that the peak effect on GDP is not equal to the sum of

the multiplier to depend on the type of fiscal stimulus. the peak individual components of GDP. This is

But the range of estimates generated in the literature because the peak effects occur at different times. For

probably owes more to the difficulty of identifying the example, the peak effect on GDP overall with the

effects, the variety of techniques used and the possi- deterministic trend is in quarter 15. But in that quar-

bility that the multiplier may vary over time and ter, the cumulative effect on each of the components

across countries. The Box gives an indication of the is not at its maximum.

different approaches used to identify the effects of an

exogenous discretionary shock to government spend-

ing or taxation. 6 These tables draw on the survey by Hebous (2009).


EEAG Report 2010 Chapter 3


x 3. 2 Estimatin g thee fiscall m ultiplierr

A variety of techniques have been used to estimate the effects of discretionary fiscal policy on the economy, including the

effects on output, consumption, employment and other factors.

The starting point for most models is a Vector Autoregression (VAR) model. This is of the form

X = A(L)X + U

t t1 t


where represents a vector of variables (typically, output, government spending and taxation, although more recent

t A(L)

approaches include variables such as the stock of debt, exchange rates and interest rates), is a distributed lag


function, and is a vector of error terms. The key issue in using a VAR model is to identify the effects of an exogenous


change to either government spending or to tax revenue. Four approaches have been used.

A recursive approach to estimating the effect of a shock to one variable (Sims, 1980) is to assume an ordering of the

variables such that one variable – typically government spending – does not react contemporaneously to other variables.

The second – typically tax revenue – responds contemporaneously only to the first, government spending. The third –

typically output – responds contemporaneously to both, and so on for more variables.

A structural approach (SVAR in Tables 3.7 and 3.9) is used by Blanchard and Perotti (2002), based on a particular

structure of the residuals from the estimated relationship. External is used to identify the contemporaneous effects of

output on taxation and government spending. These generate instruments which can be used to estimate the

contemporaneous effect of taxation and government spending on output. Essentially, the idea is that there are decision and

implementation lags which prevent new government spending decisions in a quarter (year) from responding to

contemporaneous economic circumstances. Hence, innovations to spending not systematically explained by the evolution

of the business cycle (contemporaneous and lagged output gaps), the own dynamics of spending (lagged spending), and

the state of the public finance (debt) can be treated as unexpected (structural) shocks to fiscal policy, whose effect on the

economy gives information about fiscal transmission. A potential problem in this approach is that the variation in public

spending defining these fiscal shocks may actually be the subject of a political debate prior to implementation. Hence they

are to some extent anticipated by the private sector, and thus they cannot necessarily be treated as unexpected. As a partial

solution to this problem Beetsma et al. (2006) use annual instead of quarterly observations.

A “narrative” approach aims to exploit some clearly exogenous shocks to one of the variables in the system. For example,

Ramey and Shapiro (1998) identify changes to government expenditure in several episodes of military build-up in the

USA. These episodes are exploited by introducing dummy variables into the VAR. The response of the system to these

dummy variables provides a direct estimate of the multiplier.

A clear advantage of a narrative approach is that anticipation effects can be accommodated in the estimation by tracing the

timing in which the political discussion about policies with clear fiscal implications (such as going to a war) begins. An

important open issue however is that the approach is more effective, the larger the variation in spending or tax changes to

be proxied by the dummies. Recent papers have encompassed both of these latter approaches: see Perotti (2007), Ramey

(2008). Perotti (2007) provides a useful comparison of these techniques.

A fourth approach is a sign restriction approach, proposed by Uhlig (2005), and used by Mountford and Uhlig (2009) and

Pappa (2009a). This involves imposing sign restrictions on the impulse responses of some variables.

A useful critical discussion of identification has recently been provided by Barro and Redlick (2009), who emphasize the

problem of reverse causation (output growth explaining more spending) in the macro literature. In their approach, the best

identification strategy consists of focusing on episodes of large variations in defence spending (for the US: World War II

and the Korean War).

How large is the government spending multiplier? tion crucially hinges on financial development, trade

Returning to Table 3.7, there is clearly considerable openness, the state of public finances, the exchange

variation in estimates of the impact of a shock to gov- rate regime and, last but not least, the health of the

ernment spending on overall GDP. Most, though not financial sector, see e.g. Perotti (1999), Giavazzi and

all, of the estimates are positive (with a few in excess Pagano (1990), Giavazzi, Jappelli, and Pagano (2000),

of 1). However, it is worth stressing that confidence Ilzetzki, Mendoza, and Vegh (2009), and Corsetti,

intervals are quite large: in most cases the point esti- Meier and Mueller (2009b). Linear estimations aver-

mates are not significantly different from zero. aging out multipliers across economic conditions

(which can vary over time) may hide large and signif-

From a theoretical perspective, this overall conclusion icant differences. For this reason, the fiscal transmis-

should not come as a surprise. Theory has long sion mechanism should be systematically analysed

emphasized that the effectiveness of fiscal stabiliza- conditional on different economic environments.

79 EEAG Report 2010

Chapter 3 Tabl e 3. 7 Estimat ess off t hee effe ctss off a g ov ern me ntt sp en din g in cre asee sh o ck

y Dataa Perio d Tec hni qu e Multipl ierr forr

Stud outp utt

Ramey and Shapiro (1998) USA 1947–96 Narrative approx 1

Fatas and Mihov (2001) USA 1960–96 Recursive 0.3

Blanchard and Perotti (2002) USA 1960–97 SVAR 0.9

Australia 1960–79 SVAR – 0.1

Australia 1980–01 SVAR 0.21

Canada 1960–79 SVAR 0.59

Canada 1980–01 SVAR – 0.28

Germany 1960–74 SVAR 0.41

Perotti (2005) Germany 1975–89 SVAR 0.4

UK 1960–79 SVAR 0.48

UK 1980–01 SVAR – 0.20

USA 1960–79 SVAR 1.13

USA 1980–01 SVAR 0.31

Heppe-Falk et al. (2006) Germany 1974–04 SVAR 0.62

Ravn (2007) Australia, Canada, SVAR 0.52


Giordano et al. (2007) Italy 1960–79 SVAR 0.06

Favero and Giavazzi (2007) USA 1980–06 SVAR 0.13

USA 1980–06 SVAR 0.02

Gali et al. (2007) USA 1954–03 SVAR 0.78

USA 1955–06 Recursive 1

Caldara and Kamps (2008) USA 1955–06 SVAR 1

USA 1955–06 Sign restriction approx 0.5

USA 1955–06 Narrative 0

Beetsma et al. (2006) EU14 1970–04 Recursive 1.2

De Castro and De Cos (2008) Spain SVAR 1.31

Ramey (2008) USA 1947–03 Narrative approx 1

Canada 1970–07 Sign restriction 0.18

EU 1991–07 Sign restriction 0.16

Pappa (2009b) Japan 1970–07 Sign restriction 0.13

UK 1970–07 Sign restriction 0.13

USA 1970–07 Sign restriction 0.74

Bilbiie et al. (2008) USA 1957–79 Recursive 1.71

USA 1983–04 Recursive 0.94

Mountford and Uhlig (2009) USA 1955–00 Sign restriction 0.44

fiscal transmission: output and consumption multipli-

Specifically, focusing on OECD countries, Corsetti et ers are small and positive; trade balance turns into a

al. (2009b) contrast average linear estimates of the deficit; the exchange rate experiences a short-lived real

government spending multiplier, with estimates appreciation, followed by a weakening. But these

explicitly allowing for “non-linearities”. In their average linear responses are not necessarily confirmed

analysis, the estimated linear effect of a government when the estimation is conditional on specific eco-

spending shock is in line with the VAR literature on nomic features/environments. In

accord with standard theory, the

study finds that spending policies

Tabl e 3. 8 are more effective in relatively

Effectss off go ver nm entt spe ndi ng

g sh oc k o n co mp on entss off GD P,,


m Bl an ch ard

d an d P erottii ( 200 2)) closed economies (“openness

Deterministic trend Stochastic trend matters”) and under a peg (“the

estimates estimates exchange rate regime matters”);

Peak effect Quarter Peak effect Quarter and less effective or even counter-

Government spending 1.14 4 1.00 1

Consumption 1.26 14 0.46 2 productive in economies with

Investment – 1.00 5 – 0.98 9 high public debt (“the state of

Exports – 0.80 9 – 0.37 13 public finances matters”).

Imports – 0.49 9 – 0.08 9


P 1.39

9 15

5 0.95

5 1 Most strikingly, multipliers are

significantly larger during years


EEAG Report 2010 Chapter 3

The extent to which multipliers change over time is

with financial and banking crises, identified using the also examined in other papers. For example, Perotti

information in Reinhart and Rogoff (2008). Indeed, (2005) finds that multipliers are not constant over

during such episodes the point estimate for the output time or across countries (see Tables 3.7 and 3.9). In

multiplier is a multiple of the other estimates. While, particular, this paper presents some evidence that the

given the reduced number of observations featuring a size of the multiplier has declined over time. A num-

crisis (Spain, Japan, Finland and Norway), confi- ber of possibilities for differences over time are dis-

dence intervals are large, these results appear to cor- cussed by Perotti, including countries becoming more

roborate the argument that fiscal support to econom- open and introducing flexible exchange rate regimes.

ic activity has been key to stabilising output during These explanations are consistent with the results in

the current crisis. Corsetti et al. (2009b). However, it should be kept in

mind that the export/GDP ratio is small in many

Table 3.9 summarises estimates of the multiplier countries, and also that the evidence of crowding out

arising from a change in taxation. Beginning with of net exports by fiscal shock is controversial.

Blanchard and Perotti (2002) again, they find that

GDP falls by 0.7 in response to unit increase in taxes. Another possibility is the gradual relaxation of credit

However, there is a large variation in estimates from constraints over time. Since credit-constrained indi-

other papers. The sign of the effect on output is not viduals are more likely to change their consumption

agreed, and neither is the size. One well-known in response to a change in the real income, relaxing

recent approach is that of Romer and Romer (2010), these constraints is likely to reduce any positive effect

who identify various exogenous shocks to taxes in on consumption of a positive fiscal shock.

the US, and trace out their effects in a single equa-

tion model of output. They find a very high effect of However, while credit constraints may have been pro-

taxation. gressively relaxed with the process of deregulation

and market liberalisation, their incidence can still be

These results are challenged by Favero and expected to fluctuate along business cycle move-

Giavazzi (2009). They point out various restric- ments. This observation raises a fundamental prob-

tions in the Romer and Romer approach – for lem of using the estimates in Tables 3.7 and 3.9 to

example, that only tax shocks are incorporated into identify the effects of a fiscal stimulus during the

the model. Relaxing these restrictions, they find recession, as the extent of credit constraints is itself

much lower estimates: before 1980 the estimate affected by the recession. As the financial crisis in

never exceeds 1, and after 1980 it is not significant- 2008–09 generally reduced the supply of credit, more

ly different from zero.

Tabl e 3. 9 Estimat ess off t hee effe ctss off a t ax

x i ncr eas e sho ck

y Dataa Perio d Tec hni qu e Multipl ierr forr

Stud outp utt

Blanchard and Perotti (2002) USA 1960–97 SVAR – 0.69

Australia 1960–79 SVAR 0.46

Australia 1980–01 SVAR 0.36

Canada 1960–79 SVAR 0.03

Canada 1980–01 SVAR – 0.30

Germany 1960–74 SVAR 0.22

Perotti (2005) Germany 1975–89 SVAR – 0.02

UK 1960–79 SVAR – 0.10

UK 1980–01 SVAR 0.23

USA 1960–79 SVAR – 0.69

USA 1980–01 SVAR 0.43

Favero and Giavazzi (2007) USA 1980–06 SVAR 0.02

USA 1955–06 Recursive 0

Caldara and Kamps (2008) USA 1955–06 SVAR 0

USA 1955–06 Sign restriction – 0.8

Romer and Romer (2009) USA Narrative – 3.0

Mertens and Ravn (2009) USA 1947–06 Narrative – 2.17

Mountford and Uhlig (2009) USA 1955–06 Sign restriction – 0.2

81 EEAG Report 2010

Chapter 3 individuals are likely to have moved into a position of mentioned above in regards to spending policy: the

being denied credit. That in turn would make a tax estimated parameters may vary according to econom-

cut, for example, more effective in expanding con- ic conditions, and so be an unreliable guide to the


sumption and hence GDP. Once again, the estimates multiplier in any other period or country.

by Corsetti et al. (2009b) regarding the effect of

spending expansions in crisis periods appear to sup- 3.2 Microeconomic factors

port this notion. The discussion of the macroeconomic evidence

implies that the strength of the fiscal multiplier, and

This is an example of a more general problem with its effects on economic welfare, depends on the partic-

empirical analysis based on VAR models, already ular measures used and the underlying state of the

7 Auerbach and Feenberg (2000) discuss the automatic stabilising economy. Table 3.10 summarises the fiscal stimulus

properties of the US income tax with reference to the proportion of

consumers who are credit-constrained. measures adopted by EU member states in 2009

Tabl e 3. 10

0 Fiscall sti mul uss m e asuress i n th e EU,, 200 9

Nett stim uluss Nett c ontr acti on


Country Percent of GDP Country Percent of GDP

Rev en uee 0.3



Personal income taxes, including Belgium 0.8



social contributions, capital gains Bulgaria 1.0



tax and dividends taxes Czech Republic 0.9



Denmark 0.8



Germany 0.2



Spain 0.5

Cyprus 0.6

Lithuania 0.2

Malta 0.3

Netherlands 0.6

Poland 0.2

Portugal 0.6

Slovenia 0.9

Finland 0.7

Sweden 0.3

UK 0.4



Corporate income tax and other Czech Republic 0.2



business taxes Denmark 0.4



Germany 0.4



France 0.3



Cyprus 0.1



Netherlands 0.2



Poland 0.1

Portugal 0.4

Slovenia 0.1

UK 0.3

VAT and other indirect taxes Belgium 0.1 Bulgaria 0.4

Spain 0.6 Ireland 0.2

Portugal 0.2 Greece 0.2

UK 0.5 Cyprus 0.7

Latvia 0.7

Lithuania 0.3

Malta 0.1

Netherlands 0.2

Poland 0.1

Romania 0.9

Slovenia 0.2

Slovakia 0.1

Finland 0.8



Other taxes Spain 1.1



France 0.7



Cyprus 0.5



Portugal 0.1

Italy 0.3

Luxembourg 0.2

Poland 0.1



EEAG Report 2010 Chapter 3

continued: Table 3.10

Exp en dituree Ireland 1.2


Public investment, support for Bulgaria France 0.2


business, infrastructure and research Czech Republic Netherlands 0.1


Denmark 0.4

Germany 1.0

Spain 1.3

Cyprus 0.7

Luxembourg 0.1

Hungary 0.9

Malta 0.9

Poland 0.6

Portugal 1.0

Romania 0.3

Slovenia 0.1

Slovakia 0.3

Finland 0.3

Sweden 0.4

UK Ireland 0.7


Social expenditure Belgium Hungary 0.6


Bulgaria Poland 0.2


Czech Republic 0.2

Greece 0.1

France 0.2

Italy 2.1

Latvia 1.4

Lithuania 0.6

Luxembourg 0.2

Portugal 0.1

Romania 0.5

Slovakia 0.2

UK Lithuania 0.7


Housing, labour market, education Belgium Netherlands 0.4


expenditure Germany 0.8

Estonia 0.3

Greece 0.1

France 0.1

Malta 0.8

Slovenia 0.1

Finland 0.1

Sweden 0.6

Czech Republic


Other spending Belgium 0.1



Germany 0.3



Greece 1.4



Cyprus 0.5



Slovenia 1.2



Finland 0.7


Source: European Commission (2009a)

(more details are shown in the Appendix), which is increasing its lifetime wealth. So, such a measure

would tend to generate some additional spending,

taken from European Commission (2009a). but also additional saving. In the context of the

increased uncertainty generated in a recession, it

It is easy to see how different measures with the same would be plausible to believe that much of the

fiscal cost could have different impacts on aggregate 8

increased wealth would initially be saved.

demand. For example, a credit-constrained house-

hold would generally like to increase its consump- To see how various measures may have different

tion, but is unable to do so because of the lack of effects, compare three forms of fiscal stimulus, say: (a)

opportunity for borrowing. A tax cut aimed at such an increase in social security benefits for the less well-

households would be immediately translated into an off, who are more likely to be credit-constrained; (b) a

increase in consumption, boosting aggregate de-

mand. The effect of the same tax cut on a household 8 Some evidence on households’ response to tax rebates after the

start of the crisis is provided by Parker, Souleles, Johnson and

that could already borrow as much as it wanted to McClelland (2009), who study the impact of the 90 billion dollar tax

rebates in 2008 on consumer spending in the US. This study finds

would be much smaller. Broadly, we would expect the response to be largest for lower-income households and home-

such a household to hardly regard the tax cut as owners.

83 EEAG Report 2010

Chapter 3 reduction in the general VAT rate; and (c) a reduction The apparent preference for measures targeted at per-

in the income tax rate. Neither (b) nor (c) need to be sonal consumption may not be surprising if it was

targeted towards groups that are more likely to spend believed that firms would be reluctant to undertake

the additional income. It is therefore likely that there significant investment in the midst of a recession:

would be a greater effect on aggregate demand per investment is generally more volatile than consump-

euro of a fiscal stimulus from (a). tion, and is perhaps less likely to respond to any form

of fiscal stimulus. Nevertheless, investment clearly has

As Table 3.10 indicates (and the Appendix sets out longer term benefits in creating conditions for greater

in more detail), many countries did enact increases output in the future.

in social expenditure, which are more likely to lead

to increases in aggregate demand. Unlike most of Public spending measures were more heavily targeted

the other categories in the Table, only three coun- towards such activity. Many countries increased pub-

tries actually reduced social expenditure. By con- lic investment or provided additional support for

trast, few countries sought to stimulate their infrastructure spending and research.

economies by reducing the VAT rate – and many

sought to offset the costs of a stimulus elsewhere by Overall, though, the Table suggests that there has

increasing the rate. Where the VAT rate was cut, it been no firm consensus amongst EU governments on

was sometimes a temporary measure: the UK, for the appropriate fiscal response to the financial and

example, introduced a lower rate for one year only. economic crisis. In each of the categories in the Table,

The fact that the VAT rate was due to rise again some countries created a positive discretionary stimu-

may have provided a greater stimulus to higher lus while others created a negative one. This to some

spending, as we discuss below. However, many extent may reflect differing conditions between coun-

countries also reduced income taxes and other taxes tries. But it also suggests that there has been consider-

on individuals. able uncertainty about the appropriate types of fiscal

policy required to best combat the crisis.

Similar considerations apply to business investment.

Here measures designed to create additional incen-

tives to invest, such as a more generous definition of 4. When and how should deficits be reduced?

taxable profit through increasing depreciation In some parts of the EU at least, the political debate

allowances, may have had some effect for firms that has moved swiftly on from the need for a fiscal stimu-

are not credit-constrained. Of course, even these lus to a recognition that fiscal deficits have grown sub-

firms may be unwilling to respond to such incentives, stantially and need to be reduced. This raises two

given the uncertainty surrounding the returns to related questions. First, how quickly should deficits

investment. be reduced? Second, how can they be reduced?

Such measures are unlikely to have any impact on the

investment of firms which cannot raise finance. By 4.1 The costs of maintaining high fiscal deficits

contrast, for such firms, measures which encourage A first point to note is related to the analysis above.

lending by banks would have a greater impact on The larger part of the fiscal deficits currently facing

investment. Alternatively, a simple cut in the tax rate EU governments does not result from discretionary

may achieve this, by allowing firms to retain a higher policy in response to the financial and economic cri-

proportion of pre-tax profit. However, this would sis. It is due to partly to an automatic response, and

only be true for firms that were profitable entering the partly to structural factors which would have created

recession. For firms making a taxable loss, a reduction larger deficits in any event. The automatic responses

in the tax rate may represent a cost, as the value of result from lower growth, which is translated into

any tax rebate would be lower. lower than expected tax receipts and higher than

expected costs of social transfers.

In general, in setting fiscal stimulus packages,

European governments appear to have targeted per- These automatic factors work in reverse as economies

sonal consumption more than business investment. move out of recession: economic growth will raise rev-

While 17 countries did make reforms to business tax- enues (and typically, coming out of a recession, rev-

ation, only 10 of these represented a cut, while 7 actu- enues rise more quickly than the underlying growth of

ally increased their tax take from business. 84

EEAG Report 2010 Chapter 3


x 3. 3 Creditt Def aultt S w apss

A credit default swap (CDS) is a financial instrument in which the buyer makes a series of payments to the seller in

exchange for a payoff if a credit instrument defaults. 100

This can be seen as a form of insurance. For example, suppose A lends to B. Then A could purchase a CDS on that


debt which would pay in the event that B defaults on the repayment. The CDS spread is the annual amount that A

pays to the insurer over the length of the contract, expressed as a percentage of the insured amount.

An important difference from a normal insurance contract, though, is that the purchaser of this CDS need not be A. That

is, other investors can purchase the CDS even though they do not bear the underlying risk. That implies that the CDS can

be used as a speculative instrument rather than as a means of insurance. Such opportunities for speculative investment

raise regulatory issues about such contracts.

The underlying credit instrument can be a government-issued security. For such assets, the spread can be used as a

measure of the price of the risk associated with that security by the market. However, there are caveats to using the spread

for such a purpose. The main caveat is that the CDS only has value if the seller of the security is able to make the

insurance payment in the event the government in question defaults. If, for example, the US government were to default,

then it is highly likely that many financial companies would also default, and the CDS insurance payment would not be

made. The spread should therefore be seen as reflecting the joint probability that the government defaults but that the

seller of the CDS does not default.

Leaving that aside, in a well-functioning capital market, the spread on the CDS should be equal to the annual risk

premium which the government would have to pay on issuing debt. The yield on such debt will also reflect other factors,


such as expectations of future interest rates. So the difference in yields will not exactly match CDS spreads. This is why

the CDS spread itself is potentially a useful measure of the risk premium.

1 The differences in yields across countries are shown in Figure 1.26 in Chapter 1.

the economy). And as unemployed and others find would not be reached until 2019, and the debt/GDP

work, social transfers are reduced and replaced by ratio would peak at 106 percent. On the other hand,

higher tax revenues. if expenditure were kept constant in real terms, and

growth were 2.5 percent per year, a fiscal surplus

It is possible to do some basic calculations to esti- would be reached in 2016, with debt peaking at

mate how long it would take for economic growth to 95 percent of GDP.

lift the EU back to a position of budget balance.

Take as a starting point the projections made by the While there is of course, considerable uncertainty

European Commission for revenue and public about future growth rates, and about the ability of EU

expenditure as a proportion of GDP in 2010; these governments to hold down public expenditures rela-

are 44.1 percent and 51.1 percent respectively, and tive to the rate of economic growth, these projections

would result in an overall stock of public debt of suggest that it will be some years – and possibly a

79.4 percent of GDP. decade or more – before the EU can reach a fiscal sur-

plus and begin to cut the aggregate stock of debt. Of

Now suppose that the EU returns to a steady state course, this will happen more quickly in some coun-

2 percent growth from 2011 onwards. Assume also tries than in others.

that revenues rise slightly faster than economic

growth (so that the elasticity of revenues with respect What are the costs of maintaining such high levels of

to GDP is 1.1) and that public expenditure is held debt? The most obvious cost is that of servicing the

constant in real terms. Under this scenario, the EU as debt through interest payments. At the end of 2009,

a whole would return to fiscal surplus in 2017, reach- the yields on 10 year bonds issued by EU govern-

ing a peak debt/GDP ratio in 2016 of approximately ments lie mostly in a range between 3.2 percent and

100 percent. 3.8 percent, although some countries lie outside this

range (for example, Ireland and Greece). Yields on

Obviously, the return to a fiscal surplus would be shorter-dated bonds tend to be lower than this. But

faster if economic growth were higher, and slower if very roughly, the nominal cost of servicing debt at

public expenditure rose in real terms. For example, the 2010 level of around 80 percent of GDP is

if instead, public expenditure grew at just 0.5 per- approximately 3 percent of GDP. For example, the

cent per year in real terms, then a fiscal surplus European Commission’s current projections of the

85 EEAG Report 2010

Chapter 3 Figure 3.1 shows the development of CDS spreads on

interest liability in 2010 are: 3 percent of GDP in 10 year bonds issued by a number of governments

Germany, 3.1 percent in France, 3.1 percent in the since the beginning of 2008. Prior to the development

UK, 1.9 percent in Spain, and 4.8 percent in Italy. As of the financial crisis, these spreads were typically less

the stock of debt inevitably rises, these costs will than 0.1 percent. They increased dramatically over the

increase further. course of the crisis, reaching much higher levels – and

in the case of Ireland, around 3.5 percent. Since then,

The cost will rise as interest rates rise above their cur- they have declined again, though they remain well

rent low levels. And the interest rate for the debt of above their pre-crisis levels.

any country will depend on how risky that debt is per-

ceived by financial markets. The risk of the debt The spreads at the end of 2009 differ considerably

depends on a number of factors. Clearly, it depends across countries. Spreads in Germany have fallen

on the size of the outstanding debt as a proportion of back considerably to around 0.3 percent. The

GDP. But it also depends on the rate at which that spreads in France and the USA are slightly higher at

debt is increasing, and the state and prospects of the around 0.4 percent. However, the UK’s spread is

economy. only a little under 1 percent, Ireland is at 1.6 percent

and Greece is at 2.6 percent. The higher spread in the

In addition, some countries have provided guarantees UK may reflect the high level of the current deficit in

to private sector bank debt which could result in large the UK, even though its stock of debt is not out of

liabilities but which are not reflected in the measures line with that in France or Germany. It may also

of the current stock of public debt. Some evidence on reflect the potential liabilities that the UK has in

the extent of the contingent liabilities taken on by providing guarantees to the UK financial system.

governments through their financial sector interven- The high spreads for Ireland and Greece reflect their

tions is shown in Table 3.10, which shows the size of a much higher risk.

number of different measures undertaken by EU gov-

ernments to stabilise their banking sectors. The cost to governments in terms of higher interest

payments due to the risk reflected in these CDS

Three forms of intervention are shown: capital injec- spreads is, however, modest. Most government debt is

tions, guarantees on bank liabilities, specific relief on issued at a fixed rate of interest. The selling price of a

impaired assets and other direct bank support. The new government bond will reflect the risk which the

Table also shows the extent of guarantees on market attaches to that bond, and this implicitly

deposits. As would be expected, these forms of inter- defines the premium which the government must pay.

vention varied considerably across countries. To take Also, as risk rises, the market price of existing debt

one notable example, the UK has injected capital into falls, reflecting the higher rate of return required by

banks worth around 2.6 percent of GDP; it has pro- the market. But it is the owners of existing bonds that

vided guarantees for bank liabilities of over 11 per- bear this cost through the reduction in the value of

cent of GDP, and has injected a further nearly 15 per-

cent of GDP in supporting

banks through relief for im- Figure 3.1

paired assets and other mea-

sures. As such, the UK clearly

has contingent liabilities that are

not reflected in the figures for

public debt presented in Section

2 of this chapter. Other countries

also have huge contingent liabili-

ties, notably Ireland, and to a

lesser extent, Belgium and the


One way of assessing the per-

ceived risk is to look at the

spreads of credit default swaps

on sovereign debt. 86

EEAG Report 2010 Chapter 3

their asset: the cash paid by the government on exist- ing a rise in income tax. If implemented at an early

stage, when the economy is still at the beginning of its

ing debt does not change. recovery path, the rise would be expected to generate

some reduction in spending, which would be a nega-

The cost to governments of the risk premia associat- tive shock to the economy. Now compare that option

ed with these CDS spreads therefore apply only to with an announcement that the rise in income tax will

new debt and not to the stock of debt. New debt take effect with sufficient delay – say in one or two

includes both new borrowing and the replacement of years’ time. In this case, the government would be

debt which matures, and so exceeds the fiscal deficit. delaying the reduction in the deficit, presumably in

(For example, a government with a new debt of say the hope of allowing the economy to recover further

10 percent of GDP and a risk premium of 0.5 percent before implementing the change. The problem with

would need to pay an additional 0.05 percent – i.e. one this is that individuals who face a future rise in their

twentieth of one percent of GDP – a year to service income tax perceive a reduction in their lifetime

this debt.) While these amounts may still be signifi- wealth immediately. They therefore consider them-

cant – especially for governments with high current selves to be worse off now, and consequently would

deficits – they are small relative to the overall costs of be likely to reduce their spending now. There is of

servicing the stock of debt. course the possibility that individuals would seek to

bring income forward from the following year in

Of course, the longer that these risk premia are main- order to benefit for the lower tax rate while it lasts.

tained, though, the more their cost will build up as This could provide a stimulus to the economy. But

more and more of the stock of debt has been issued at shifting income across years is generally much harder

relatively high risk premia. To reduce these risk pre- than shifting consumption. So it seems implausible

mia in the short, medium and long term, it is neces- that this effect could outweigh the effects on the

sary for governments to demonstrate that they have economy of the reduced spending.

credible plans to reduce the deficits in the medium

term, thereby reducing the possibility of eventual The main lesson here is that, from the vantage point

default. of the effect of changes in taxes on permanent

income, the announcement of a future income tax rise

One option here would be simply to point to the type may not have specific advantages over the announce-

of calculations set out above: that with economic ment of an immediate income tax rise. The timing of

growth and holding down expenditure rises, then the fiscal adjustment, however, can and does make a

deficits will eventually be closed. But other policies large difference through channels other than perma-

may also be required. We now discuss options for such nent income.

policies. A clear instance is provided by taxes on consumption,

4.2 Options for reducing deficits such as VAT and excise duties. Suppose the govern-

ment announced that the rate of VAT would rise in

The most obvious problem facing governments that one year’s time. This would also reduce the lifetime

wish to reduce their fiscal deficits is that doing so may wealth of individuals in the sense that, for a given

generate a negative fiscal stimulus, reducing or even income, they would be able to afford to buy less goods

overturning any economic recovery. The evidence for and services. The higher tax burden would tend to

this is summarised above in Section 3. Given the depress the economy, as would be the case with other

depth of the recession which faced the EU in 2008 tax rises.

and 2009, governments should be cautious in raising

taxes or cutting expenditure to reduce their deficits. However, the announcement could provide an impor-

The costs associated with a delay in such policies are tant fiscal stimulus, since there would be a clear incen-

relatively small compared with the possible costs of tive to bring forward spending to take advantage of

restricting economic growth. the lower VAT rate before it was increased. This would

provide an immediate stimulus to current private

But there is an important timing issue. As discussed demand, despite raising additional revenue in the

in Section 3, timing works mostly through intertem- medium term.

poral substitution effects. Consider, for example, the

possibility that a government may try to develop a In some ways such a policy mirrors the fiscal stimulus

measure announced by the UK government in

credible strategy for reducing its deficit by announc- 87 EEAG Report 2010

Chapter 3 December 2008: to reduce the VAT rate from 17.5 per- ness of current fiscal stimulus, as their deflationary

cent to 15 percent for a fixed period of about one year. impact materialises when the economy is still strug-

Arguably the most effective element of this stimulus gling with the aftermath of the recessionary shock. A

was its fixed time period. A permanent reduction in credible plan gradually phasing in spending cuts over

the VAT rate may not have had a large effect at the a two year horizon not only can reduce this risk: it can

point at which the country entered a recession. But also enhance the expansionary impact of the ongoing

the fact that the rate increased again a year later is fiscal stimulus.

likely to have had a more significant impact on con-

sumption in 2009. A final point to note here concerns the need for coor-

dination across countries. As noted in the introduc-

A second important instance (already discussed in tion, in 2008 there was general agreement that enact-

Section 3) is the possibility of designing consolida- ing a fiscal stimulus would be more effective if all (or

tion packages including cuts of government spending at least many) countries followed a similar policy,

below trend. Anticipation of lower public demand in increasing demand everywhere. By contrast, a single

the future tends to contain long-term interest rates country enacting a stimulus on its own would see

(as future short term rates will be lower). Lower real much of the stimulus flowing abroad through the pur-

rates in turn stimulate current demand. The effect of chase of imports.

anticipated cuts is expansionary because, to the ex-

tent that firms set prices subject to nominal rigidities, But in light of the need to consolidate debt, mea-

today’s prices will already optimally incorporate ex- sures to reduce public deficits across the world sum

pectations of the path of future demand and infla- up to a global recessionary impulse. In this case,

tion. With sticky prices, prospective spending cuts (all international policy coordination may still be benefi-

else equal) lower prices, containing the dynamic of cial insofar as it would be a way to internalise the

inflation, and thus allowing the central bank to be negative demand spillovers on foreign output created

more expansionary. by fiscal adjustment in a country. To wit: the same

way in which coordination leads to stronger global

For the above mechanism to work, however, the cen- stimulus at the start of a recession, coordination

tral bank must be able to control policy rates, i.e. the would lead to gradualism in fiscal consolidation

economy cannot be in a situation in which the central once the initial stimulus is withdrawn. If all coun-

bank would like to lower policy rates, but it cannot, tries simultaneously reduced their deficits by increas-

because these are already at zero. In these circum- ing taxes and reducing spending ignoring spillovers,

stances, as shown by Corsetti et al. (2010), the timing aggregate demand would fall everywhere too much,

of fiscal adjustment is crucial. and adjustment would create a much greater reces-

sionary impulse, possibly harming the nascent world

With a near-zero nominal interest rate, implementing recovery.

spending cuts too soon would add to the deflationary

pressure of the ongoing recession. These pressures However, coordination is not necessarily desirable.

may end up raising inefficiently the interest rates in The risk is that gradualism in the name of coordi-

real terms, and may possibly exacerbate the zero- nation could provide an excuse to delay the adop-


lower-bound problem. In contrast, a tion of the necessary measures to preserve stability.


mentation of spending cuts can be quite beneficial, as Appealing to the need for a coordinated fiscal con-

it would help the central bank maintain an expan- solidation, for instance, incumbent governments

the economy exits from

sionary monetary stance may leave unpopular decisions for future govern-


the zero-lower-bound constraint (and it may shorten ments to make.

the period of the zero lower bound episode). Conversely, in the current circumstances it makes

These considerations are important in light of the fact sense that the worst hit countries or the countries with

that the large rise in public debt requires fiscal consol- the most fragile public finances should adjust upfront

idation to be substantial. Households reasonably and most deeply so as to prevent the spreading of

expect adjustment not to take place exclusively via concerns about fiscal sustainability. The benefits from

increases in taxes but also via some cut in spending. coordination, which may be small initially, can quick-

With interest rates still close to zero, anticipation of ly turn largely negative if this ends up interfering with

early spending cuts may actually harm the effective- the most efficient path of debt consolidation.


EEAG Report 2010 Chapter 3

• There are costs of maintaining high levels of debt,

5. Conclusions though these should not be exaggerated. Especially

In this Chapter we have discussed a number of issues at low interest rates, the cost of servicing debt is of

surrounding the large rises in fiscal deficits in Europe. the order of 3 percent of GDP, though again there

The key points raised are as follows. is considerable variation across member states.

Two factors could increase this cost in the short to

• There have been large increases in budget deficits medium term. First, interest rates are likely to rise.

throughout the EU, leading to considerable rises in Second, public debt appears increasingly risky to

the stock of public debt as a percentage of GDP. In the market, which implies that higher risk premia

2009, the total deficit in the EU was around 6 per- could be charged.

cent of GDP, and it is expected to rise further in • Although these risk premia are currently not large,

2010. There has been a corresponding increase in they could be lowered – or at least prevented from

outstanding debt, rising to 72 percent of GDP in growing – if governments announced credible

2009 and to nearly 80 percent of GDP in 2010. strategies to reduce deficits over the medium term.

• There are also wide variations across countries. A downside of such a strategy is that announce-

The UK, Ireland and Latvia have particularly high ments of future tax rises may hamper the economy

deficits, though in all three cases their outstanding immediately as individuals perceive their lifetime

debt is moderate. Italy, Greece and Belgium have income to be lower.

much higher outstanding debt, though all three • One way of reconciling the need for a credible

have had high debt for some years. deficit-reduction strategy with the need to avoid

• These high deficits have generally not reflected dis- harming a fragile economy is to announce rises in

cretionary changes by EU governments. While taxes on spending – such as VAT – to take effect

most governments introduced a discretionary fiscal from some future period, say in one year’s time.

stimulus in 2008 and 2009, these were small relative This would induce individuals to bring spending

to the overall deficits. The form of these discre- forward, which would provide a temporary stimu-

tionary changes (and even their sign) has varied lus to the economy.

considerably between countries. • Another way consists of announcing well-designed

• There is considerable empirical evidence that a fis- measures bringing government spending on goods

cal stimulus has a positive effect on output, and services below trend, to be implemented suffi-

although there are many problems in measuring ciently far in the future as to avoid the risk of

the effect, so that the size of the fiscal multiplier is exposing the economy to additional deflationary

not known with any certainty. In any case, there is pressures when policy interest rates are still close to

little reason to suppose that effects estimated on zero. Provided that they are not implemented too

historic data are likely to be valid in the midst of a early, future spending cuts are beneficial to the

recession. This is particularly the case when inter- recovery, as they contain the rise in long-term

est rates are effectively at zero and the economy is interest rates (as well as attenuating concerns about

shaken by an ongoing financial and economic cri- debt sustainability).

sis, when there may be very large multipliers for • A final point concerns co-ordination. In attempt-

government spending. There is also little reason to ing to stimulate the economy there were gains from

suppose that different forms of fiscal intervention co-ordination. For an individual country, a stimu-

have similar effects. lus to spending might be largely reflected in

• The scope for reducing deficits depends crucially increased imports, creating demand for goods and

on the rate of economic growth achieved over the services produced elsewhere. A coordinated policy

next few years, and the degree to which real public reduces this risk. In principle, the same argument

spending can be curtailed. For example, a simple also applies (with a different sign) to fiscal adjust-

calculation suggests that if spending is kept con- ment. If all countries implemented a contrac-

stant in real terms throughout the EU, then eco- tionary fiscal adjustment simultaneously and inde-

nomic growth of around 2 percent would see the pendently, without internalizing negative output

aggregate EU deficit reduced to zero by 2017, with spillovers abroad, then this would be likely to ham-

outstanding debt reaching a peak of around 100 per the economic recovery. This adverse effect

percent of GDP. Of course, some countries would would be reduced if such policies were introduced

need a higher growth rate to achieve fiscal balance in a coordinated way, possibly leading to more

within this period. gradualism.

89 EEAG Report 2010

Chapter 3 • However, coordinated gradualism should not Favero, C. and F. Giavazzi (2007), “Debt and the effect of fiscal pol-

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to preserve stability. The worst hit countries or the Effects of Government Spending on Consumption”, Journal of the

5, 227–70.

European Economic Association

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5, 75–111.

Macroeconomics Annual

the spreading of concerns about fiscal sustainabil- Giavazzi, F., T. Jappelli and M. Pagano (2000), “Searching for Non-

ity. If gradualism in the name of coordination Linear Effects of Fiscal Policy: Evidence from Industrial and De-

veloping Countries”, 44, 1259–89.

European Economic Review

feeds doubts about debt consolidation, then no Giordano, R., S. Momigliano, S. Neri and R. Perotti (2007), “The

coordination is a much better option. effects of fiscal policy in Italy: Evidence from a VAR model”, Euro-

22, 707–733.

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Hebous, S. (2009), “The Effects of Discretionary Fiscal Policy on

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Discussion Paper 2760. 90

EEAG Report 2010 Chapter 3




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91 EEAG Report 2010

Chapter 3 alcohol excises percent)

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EEAG Report 2010




16.65 MB




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Dispensa al corso di Economia dell'integrazione europea della Prof.ssa Lilia Cavallari. Trattasi del rapporto 2010 dello European Economic Advisory Group, all'interno del quale sono affrontati i seguenti argomenti: situazione economica europea nel 2010, conseguenze della crisi finanziaria sul mercato della finanza, crescita del debito globale, conseguenze della crisi statunitense dei debiti, rischi per l'area Euro.

Corso di laurea: Corso di laurea in consulente esperto per i processi di pace, cooperazione sviluppo
A.A.: 2011-2012

I contenuti di questa pagina costituiscono rielaborazioni personali del Publisher Atreyu di informazioni apprese con la frequenza delle lezioni di Economia aziendale e studio autonomo di eventuali libri di riferimento in preparazione dell'esame finale o della tesi. Non devono intendersi come materiale ufficiale dell'università Roma Tre - Uniroma3 o del prof Cavallari Lilia.

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Altri appunti di Economia aziendale

Turning the page? Eu fiscal consolidation
EEAG report 2011
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Role of independent fiscal policy institutions