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EEAG report 2011

Dispensa al corso di Economia dell'integrazione europea della Prof.ssa Lilia Cavallari. Trattasi del rapporto dell'EEAG 2011, parte del programma d'esame per i capitoli 1-4. Al suo interno sono affrontati i seguenti temi: conseguenze della crisi economica mondiale, politiche fiscali e monetarie in... Vedi di più

Esame di Economia aziendale docente Prof. L. Cavallari



Chapter 1

11.1 percent in 2009). Albeit still well below the

cent last year. Construction investment declined fur-

ther. Hardly any impulses were provided by private European average, the government debt-to-GDP

consumption. Weak growth in disposable income and ratio will have increased to around 64 percent by the

consolidation efforts of the Italian government made end of last year.

consumption basically stagnate in the course of the

year. The rapid increase in public debt and the continuing

economic weakness in the autumn of 2010 raised

Despite only moderate growth, the situation in the doubts about the solvency of the Spanish state. This is

Italian labour market is relatively stable. This can be reflected in a rising risk premium on Spanish govern-

attributed primarily to the government’s short-time ment bonds, especially as compared to German gov-

working programmes. Although the unemployment ernment bonds. The promises made by China early

rate rose to 8.7 percent in November 2010, it is only this year to buy Spanish government bonds – after

about 2 percentage points above levels seen shortly having already done so in the cases of Greece and

before the crisis. Due to higher energy prices, the rise Portugal – did not appear to have a lasting effect on

in consumer prices has accelerated slightly in October Spanish yields. Though China has not specified the

2010, having reached 2 percent. size of its investment in Spain, the Spanish media

reports suggest it could far exceed the investments

Although officially came out of recession in

Spain already made in Greek and Portuguese debt.

early 2010, its economy hardly grew during the year.

After GDP expanded by only an annualised 0.4 and the recession has deepened significantly.

In Greece,

1.1 percent in the first and second quarters of 2010, it GDP shrank by more than 4 percent last year. This

stagnated in the third quarter. This renewed econom- was accompanied by expenditure- and revenue-side

ic slowdown is primarily due to a strong decline in consolidation measures of the government. Despite

domestic demand, in particular private consumption the severity of the economic downturn, these mea-

and private investment. sures already had a noticeable effect on the fiscal bud-

get balance. The fiscal stimulus, as measured by the

Consumer spending experienced the expected back- change in the primary deficit, reached in 2010

lash to the expansion in the second quarter, which was –6.7 percent of 2007 GDP levels. A significant pro-

caused by advanced purchases in anticipation of the portion of consolidation consists of an increase in

VAT increase that took effect in July. Weak investment excise taxes. VAT was raised in several steps by a total

activities are a direct consequence of the continuing of 5 percentage points to currently 23 percent.

consolidation in the construction sector. Foreign Accordingly, consumer prices rose sharply. Excluding

trade provided a strong positive impulse. Although these tax effects, prices almost stagnated. Together

exports only increased by an annualised 0.3 percent, with the simultaneously implemented structural

imports dropped by close to an annualised 20 percent reforms, this suggests an improvement in price com-

in the third quarter of 2010. The inventory cycle still petitiveness in the coming years.

managed to contribute positively to growth through-

out last year. rose for the first time since

After the GDP in Ireland

the end of 2007 during the first quarter of last year, it

The situation in the Spanish labour market contin- turned negative again afterwards. In particular, pri-

ued to deteriorate further during the year. The vate and public consumption declined. The spreads

unemployment rate peaked at 20.7 percent in on Irish government bonds rose sharply during the

October last year and is by far the highest of all year. Although the Irish government pursued a con-

euro-area member countries. 2 Since the start of the solidation strategy, it had to spend considerable

crisis, the unemployment rate has risen by more than amounts of resources to rescue its banking sector and

12 percentage points. Both due to the VAT increase to compensate for write-downs of guarantees made

and a base effect resulting from deflationary tenden- earlier. As a consequence, the fiscal deficit is expected

cies in 2009, inflation was relatively high at the end to be over 30 percent of GDP in 2010. In relation to

of last year. It reached 2.3 percent in October 2010. its GDP, Ireland is bearing the greatest burden of the

The public deficit is expected to have slightly banking crisis in Europe.

decreased to 9.3 percent in 2010 (as compared to the economy presented itself relatively

In Portugal,

2 Within the European Union only Latvia with an average unem- strongly in the first quarter of last year. Subsequently

ployment rate of 20.9 percent in 2010 shows a worse performance. 31 EEAG Report 2011

Chapter 1 it reduced its pace again. The increase during the first had expanded strongly during the crisis, in most coun-

tries significant steps towards consolidation were

half of the year resulted from a rise in domestic taken last year. Except for Estonia, which wanted to

demand. After the budget deficit amounted to 9.3 per- make sure that it could enter the euro area, fiscal

cent of GDP in 2009, it fell to about 7.3 percent last deficits nevertheless exceeded 3 percent of GDP last

year. Most of this reduction took place during the year.

second half of the year, after the risk premiums on

Portuguese government bonds rose dramatically. In

response, the government decided in May to raise 1.3 Fiscal and monetary policy in Europe

value added, income and corporate taxes. Sub-

sequently, the inflation rate rose. For the year 2010

GDP is expected to have grown by 1.7 percent. 1.3.1 Fiscal policy

the economic recovery

In Central and Eastern Europe, Economic and political discussion in Europe last year

that began in the second half of 2009 has stabilised. centred on the sovereign debt crisis. Concerns regard-

Nevertheless, the picture remains mixed. In Poland, ing the solvency of countries like Greece, Ireland,

where the economy did not go into recession during Portugal and, to a lesser extent, Spain, have brought

the financial crisis, economic growth increased its the need for fiscal restructuring of the national

pace and reached 3.8 percent last year. Meanwhile, finances to the fore. As a consequence, throughout the

production levels in other countries of the region that year problems associated with government bonds

did experience severe drops in economic activity are escalated time and time again.

now also clearly pointing upward. In Slovakia and the

Czech Republic, the recovery of the car industry The cyclically-related public spending increase and

became apparent. In the Baltic States, where in the tax revenue shortfalls together with the economic

wake of the financial crisis particularly drastic drops stimulus packages implemented in 2009 led to a dra-

in economic activity had occurred, the recession also matic deterioration in public finances in most

came to an end last year. In the case of Estonia, sound European countries. The consolidated budget balance

public finances and the decision to adopt the euro at of the European Union rose to –6.8 percent of GDP

the start of this year built up investor and consumer in 2009 and is likely to have remained there last year

confidence, which supported the economic recovery. (see Table 1.2). Accordingly, the public debt reached a

On the other hand, there are also countries where the record high of nearly 79.1 percent of economic out-

economic recovery has not yet materialised. put last year.

Production stagnated in Bulgaria, while in Romania

and Latvia it continued to decline. Given the difficulty of coming up with detailed, but

still comparable, estimates of fiscal impulses and aus-

Impulses came first, above all, from an increase in terity measures induced by the public sector, we prefer

demand from abroad. In countries with flexible the use of a relatively straightforward summary mea-

exchange rates, a depreciating currency seemed sup- sure: the change in the primary deficit of the general

portive. Later on also the competitive position of government relative to a pre-crisis measure of the eco-

those countries and the region that had pegged their nomic size of a country, i.e. its GDP in 2007.

3 It

currencies to the euro improved. The weak euro sup- includes both discretionary measures taken by the

ported their trade relationship with countries outside general government as well as the automatic stabilis-

Europe, in particular Asia and Latin America. In ers, both during the expansionary and consolidation

Poland domestic demand also increased substantial- phase.

ly. However, in other countries it picked up only

slowly. Last year stimulus measures began to be gradually

reduced and thereby initiated the consolidation of

After a sharp decline in 2009 as compared to the years government finances in Europe. Nevertheless, in

before, the inflation rate initially increased somewhat

last year. However, with the exception of Hungary 3 As it is generally believed that changes in interest payments by the

and Romania, the observed levels remain historically government do not have a strong impact on the economy and are not

intended as such, the primary balance – which excludes these – is

low. As a consequence, there are no signs yet that likely to be a better measure than the change in the fiscal balance per

se. Note, however, that increased interest payments can have a sub-

those countries that follow an inflation target will stantial effect on government debt levels and therefore are important

soon increase their interest rates. After budget deficits in judging the sustainability of public finances.


EEAG Report 2011 Chapter 1

Table 1.2 Public finances

a) a)

Gross debt Fiscal balance

1999–2007 2008 2009 2010 1999–2007 2008 2009 2010

Germany 63.3 66.3 73.4 75.7 –2.1 0.1 –3.0 –3.7

France 61.5 67.5 78.1 83.0 –2.6 –3.3 –7.5 –7.7

Italy 106.8 106.3 116.0 118.9 –2.7 –2.7 –5.3 –5.0

Spain 49.2 39.8 53.2 64.4 0.1 –4.2 –11.1 –9.3

Netherlands 51.7 58.2 60.8 64.8 –0.5 0.6 –5.4 –5.8

Belgium 98.8 89.6 96.2 98.6 –0.4 –1.3 –6.0 –4.8

Austria 64.8 62.5 67.5 70.4 –1.6 –0.5 –3.5 –4.3

Greece 101.2 110.3 126.8 140.2 –5.2 –9.4 –15.4 –9.6

Ireland 32.4 44.3 65.5 97.4 1.6 –7.3 –14.4 –32.3

Finland 42.1 34.1 43.8 49.0 3.8 4.2 –2.5 –3.1

Portugal 55.9 65.3 76.1 82.8 –3.6 –2.9 –9.3 –7.3

Slovakia 41.0 27.8 35.4 42.1 –5.3 –2.1 –7.9 –8.2

Slovenia 26.7 22.5 35.4 40.7 –2.3 –1.8 –5.8 –5.8

Luxembourg 6.3 13.6 14.5 18.2 2.5 3.0 –0.7 –1.8

Estonia 5.0 4.6 7.2 8.0 0.7 –2.8 –1.7 –1.0

Cyprus 60.9 48.3 58.0 62.2 –2.7 0.9 6.0 –5.9

Malta 63.5 63.1 68.6 70.4 –5.4 –4.8 –3.8 –4.2

Euro area 68.4 69.7 79.1 84.1 –1.8 –6.3 –6.3


United Kingdom 41.1 52.1 68.2 77.8 –1.4 –5.0 –11.4 –10.5

Sweden 51.2 38.2 41.9 39.9 1.4 2.2 –0.9 –0.9

Denmark 44.3 34.1 41.5 44.9 2.5 3.2 –2.7 –5.1

Poland 43.2 47.1 50.9 55.5 –4.1 –3.7 –7.2 –7.9

Czech Republic 26.2 30.0 35.3 40.0 –4.0 –2.7 –5.8 –5.2

Hungary 59.3 72.3 78.4 78.5 –6.3 –3.7 –4.4 –3.8

Romania 19.5 13.4 23.9 30.4 –2.6 –5.7 –8.6 –7.3

Lithuania 20.6 15.6 29.5 37.4 –1.8 –3.3 –9.2 –8.4

Bulgaria 46.2 13.7 14.7 18.2 0.5 1.7 –4.7 –3.8

Latvia 12.7 19.7 36.7 45.7 –1.6 –4.2 –10.2 –7.7

EU27 61.2 61.8 74.0 79.1 –1.7 –2.3 – 6.8 –6.8

a) As a percentage of gross domestic product; definitions according to the Maastricht Treaty. For Slovenia, the euro

area and the EU27 the data on gross debt start in 2001.

Source: European Commission, Directorate General ECFIN, Economic and Financial Affairs, general government data,

general government revenue, expenditure, balances and gross debt, part II: tables by series, autumn 2010.

countries such as Austria, Denmark, Germany, costs. 4 Accordingly, domestic demand was greatly

Luxembourg and the Netherlands, fiscal policy con- attenuated in these countries.

tinued to be expansionary in

2010 (see Figure 1.17). The Figure 1.17

countries of the European pe- Changes in primary deficits relative to pre-crisis GDP

riphery (Greece, Ireland Por-

tugal and Spain) together with % of GDP in 2007

% of GDP in 2007

30 15

Belgium and the United King-

dom, however, were forced to 10


take sharp austerity measures in

the summer of 2010 in response 5


to doubts about their solvency

and sharply rising refinancing 0


4 As Figure 1.17 shows, Ireland is a special -5


case. By rescuing its banking sector, the

Irish government experienced a huge

increase in its deficits, substantially reduc-

ing the willingness of financial markets to -10


buy Irish government bonds, which subse- c any


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Sp to

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ov Po

Cy r un


Ire Fr

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en G

th Slo er

Fi A


in Be

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try to draw on the European Financial K xe

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Stability Facility. As these bailout costs are Cz



(except for the induced interest payments 2008 2009 2010 2011 Cumulative over 2008-2010

and amortisation) one-off, an automatic, Source: European Commission, DG ECFIN, General Government Data, Autumn 2010, Tables 54A and 56A.

strong correction will be seen this year. 33 EEAG Report 2011

Chapter 1 An important reason for the Figure 1.18

large union-wide deficit last year Government structural budget deficits

is the high level of spending on % of GDP

% of GDP

10 10

unemployment benefits. This

year, without exception, all coun- United States

8 8

tries will consolidate their public Japan

finances and thereby take a 6 6

restrictive fiscal policy stance.

The negative effect on public 4 4

spending and disposable income

will significantly slow down the 2 2


recovery in domestic demand. period

United Kingdom Euro area

Particularly exposed to the nega- 0 0

tive momentum will be those

economies that are perceived to -2 -2

01 02 03 04 05 06 07 08 09 10 11

be on the brink of insolvency, i.e. Source: OECD, Economic Outlook 88, December 2010.

Greece, Ireland, Portugal and

Spain. All in all, the induced sav- no signs of a reduction in structural deficits. At best it

ing efforts will reduce the overall deficit in the has managed to stabilise its structural deficits at the

European Union to 5.1 percent of GDP this year (see alleviated levels seen earlier this century.

Table 1.A.3 in Appendix 1.A). After the general government budget in was


Part of the increase in deficits in recent years has been nearly balanced in 2007 and 2008, the economic crisis

due to the automatic stabilisers built into our systems, in 2009 led to a deficit of 3 percent of GDP. Although

such as the progressive tax system and unemployment the automatic stabilizers, as a result of the economic

and welfare benefits that depend upon economic con- recovery, aided the consolidation of the state budget

ditions. Another part has been due to fiscal stimulus significantly, the deficit-to-GDP ratio is expected to

packages that were intended to be “timely”, “target- have risen again to 3.7 percent last year. This was

ed” and “temporary”.

5 If these rules had been fol- largely caused by the prevailing economic stimulus

lowed, then the only increase in structural budget packages that led to declines in income and property

deficits we would have seen would have been due to taxes. Due to the economic upswing, general govern-

increased interest payments caused by the jump in ment expenditure increased moderately in 2010.

government debt associated with the stimulus mea- Unemployment and other monetary benefits only

sures. Although not negligible, the need for substan- rose slightly. The acquisition of assets and liabilities of

tial austerity programmes would have been circum- Hypo Real Estate have led to an increase in wealth

vented. Unfortunately, it is basically impossible to transfer. On the other hand, Germany benefited from

adequately measure structural budget balances. very low interest rates. Despite the increase in govern-

Experience tells us that we can produce rough guides ment debt, it is likely that government interest expens-

that still depend – at least when cycles are as pro- es declined again last year.

nounced as they have been in the last few years – on

short-term economic conditions. Keeping this caveat This year, fiscal policy in Germany will turn restric-

in mind, Figure 1.18 shows estimates of structural tive. The consolidation efforts are supported by the

deficits in the four large economic blocks in the world. working of automatic stabilizers in the context of the

The sharp increase during the crisis year 2009 is on-going economic upswing. The budget deficit may

unmistakable. Also the predicted decline next year is fall back to about 2.5 percent of GDP this year.

clearly visible in the United States, the United Somewhat more than half of this improvement is like-

Kingdom and the euro area. Only in Japan are there ly to be of a structural nature. Government revenues

will be driven here by opposing forces, which will

induce the overall tax rate and the share of social

5 The timely principle says governments apply their stimulus as early

in the downturn as possible. The targeted principle says the stimulus security contributions to GDP to remain largely sta-

should go to areas where the crisis hits the hardest and which are

most likely to subsequently spend a large share of the stimulus ble. The consolidation will mainly be achieved on the

means. Finally, the temporary principle says everything governments expenditure side. Although growth rates are much

do must be a one-off (even if spread over a few years) so that it leaves

no impediment to getting the budget back in line once the economy lower than in previous years, government consump-

is out of recession. 34

EEAG Report 2011 Chapter 1

tion will nevertheless continue to develop relatively significant contributions to this. Since January this

strongly. The quantitatively most important consoli- year, VAT has been raised by 2.5 percentage points

dation effort is achieved by reducing social security and the time restriction on the bank levy introduced

benefits. Unemployment expenditures will decrease in early 2010 has been abolished. Moreover, contri-

due to the favourable development of the labour mar- butions to public pension schemes will be increased,

ket. The ending of specific investment packages will the child allowance for high-income earners will be

cause government investment to fall slightly this year. abolished and social benefits capped at the house-

Despite further rising debt levels, interest expendi- hold level.

tures are expected to rise only slightly. It is assumed

that Germany will maintain its privileged financing Most of the consolidation will, however, take place on

conditions. the expenditure side. The austerity programme

includes savings of 81 billion pounds (97 billion

The government debt-to-GDP ratio is expected to euros) across all departments, except health and

change only marginally this year. However, there is development aid, up to fiscal 2014/2015. Public sector

large uncertainty with respect to the expected increase wages will be frozen for two years and significant falls

in debt caused by the rescue packages for distressed in government investment, consumption and transfers

EU countries. As part of the European Financial are envisaged. As a result, fiscal headwinds are set to

Stability Facility, Germany has committed to a maxi- strengthen – the negative fiscal impulse this year will

mum aggregate liability of almost 150 billion euros. be around 2 percent of GDP. The fiscal deficit is pro-

These figures are not included in this forecast. jected to fall to 8.6 percent of GDP this year. had –

an important step towards reducing the

In Even before the recession started in 2008, Italy

France, by European standards – a high government debt bur-

structural government deficit was taken in October den of over 100 percent of GDP to deal with. During

2010 with the decision to increase the minimum retire- the crisis the Italian government therefore decided

ment age from 60 to 62 years. Already this year, this against comprehensive economic stimulus measures.

reform will be beneficial to the debt dynamics of the This explains why the government deficit situation

country and provide a positive signal to financial mar- saw a relatively small increase from 2.7 percent in

kets. The government deficit in 2010 will turn out to 2008 to around 5 percent last year (see Table 1.2) and

have been 7.7 percent of GDP. It is projected to fall Italian bonds have performed relatively well as com-

back to 6.3 percent this year. Accordingly, the govern- pared to those of other southern European countries.

ment debt-to-GDP ratio is expected to rise from The Italian government has announced a further

83 percent in 2010 to close to 87 percent this year. The tightened fiscal policy for the years to come. Measures

main risks to the economic recovery of France are include a freeze of public-sector wages and significant

again the flaring up of turmoil on the European gov- cuts in transfers to local governments. As a conse-

ernment bond market, which would then be reflected quence the fiscal deficit is scheduled to be reduced to

in a rise in risk premiums for securities from Euro- 4.3 percent of GDP in 2011. Government debt is

pean core countries. In the case of France, given that expected to peak at around 120 percent of GDP this

a large fraction (17.7 percent) of the outstanding debt year.

expires this year, such a scenario would have substan-

tial consequences for its public finances. Fiscal policy in Greece, Ireland, Portugal and Spain

fiscal consolidation is

Also in the United Kingdom The global financial crisis and the ensuing economic

underway. Since the United Kingdom will have had collapse in 2009 resulted in a sharp deterioration of

the largest deficit-to-GDP ratio in Europe – except for public budgets in the countries of the European

Ireland – last year, the fiscal tightening is highly nec- periphery that turned out to be much more dramatic

essary and will have to be substantial in nature. than in the core of Europe. A series of country-spe-

According to the Spending Review, published at the cific and common factors were decisive for this devel-

end of October last year, it is the intention of the gov- opment. Thus, the collapse of real estate markets in

ernment to achieve a structurally balanced budget by Ireland and Spain led to a more than doubling of the

the end of 2016. respective unemployment rates and to severe shocks

Tax increases, including higher social security con- to the banking sector. The government budget situa-

tributions and a hike in the VAT rate are the first tion of Greece was already unsustainable before the

35 EEAG Report 2011

Chapter 1 GDP ratios would have been around 12 and 78 per-

crisis. Also Portugal already recorded deficits that

were significantly higher than in most other European cent, i.e. much lower.

countries. Rigid labour markets in Greece, Portugal

and Spain prevented a swift and efficient adaptation To avoid a further increase in uncertainty and

to changing conditions. Furthermore, the export sec- renewed turmoil on European bond markets, the gov-

tors of Greece, Portugal and Spain are not well-posi- ernment in Dublin agreed to a rescue package by the

tioned on the dynamic markets in East Asia and face European community, the European Commission and

strong competition from emerging countries. the IMF, by which Ireland is able to draw upon the

European Financial Stability Facility (EFSF). To

This combination of a quickly deteriorating debt achieve the savings targets for the years to come,

position and structural weaknesses created doubts Ireland had to sharpen its original consolidation plan

about the sustainability of government debt in these considerably. In November 2010, additional savings of

peripheral countries. As a result, risk premiums on 10 percent of GDP were decided on. The largest share

their government bonds skyrocketed. Greece in par- will come this year, in which nearly 3.7 percent of

ticular was affected. The high returns demanded by GDP will have to be saved. Around 75 percent of the

financial markets made it almost impossible for the cuts will be made on the expenditure side. This con-

country to meet its current financing needs, and drove cerns in particular public investment, many social

it to the brink of insolvency (see Box 1.1). This was benefits and the number of civil servants. However,

averted by establishing a rescue fund for Greece. the deficit targets are based on the growth forecasts of

However, the rescue package could only calm finan- the Irish government, which appear to be quite opti-

cial markets temporarily. The risk premiums rose mistic. The additional cost-cutting efforts will weigh

again in June 2010 and forced Ireland, Portugal and heavily on the economy and slow down its recovery

Spain to adopt major consolidation measures as well. significantly. The government deficit is expected to

The austerity plans are intended to bring back the decline in 2011 to 10.3 percent of GDP, while govern-

public finances of the affected countries to a sustain- ment debt is likely to grow to nearly 107 percent of

able path. In Spain and Portugal, profound structural GDP.

labour market reforms have also been adopted. was not hit by a real estate crisis

Although Portugal

Despite these consolidation efforts, savings targets and its deficit developed less dramatically than in

that were set in spring last year will not be achieved in other European periphery countries, it nonetheless

most of these countries. An important reason for this had already accumulated a large public debt before

is that the negative effects on economic growth have the recession. Together with structural problems of

turned out to be stronger than expected. its economy, this led to a loss of confidence in finan-

cial markets. As a result, refinancing costs increased

In the deficit was scheduled to be reduced by

Greece, sharply and forced the government in Lisbon to

seven percentage points (from 15.4 percent of GDP in adopt an austerity package in March. However, not

2009 – using current data – to 8.1 percent of GDP in least because of the reluctance with which certain


2010). Despite tax increases and drastic cuts in pub- consolidation measures were addressed, this did not

lic services, this target will be missed by more than calm the financial markets. To counteract the ongo-

1 percentage point. Last year’s deficit is currently ing increase in the country’s risk premium, the

expected to equal 9.6 percent of GDP. Especially rev- Portuguese government presented a new and far

enues have turned out to be lower than projected. more ambitious consolidation plan in May.

According to this plan, a public deficit of 7.3 percent

The government budget of was strongly

Ireland of GDP was envisaged for 2010, instead of the origi-

affected by the rescuing cost of its ailing banking sys- nally planned 8.3 percent. The deficit target for 2011

tem in autumn last year. Accordingly, the public was also significantly adjusted downwards: from

deficit probably reached 32.3 percent of GDP last 6.6 percent to 4.6 percent of GDP. The budget for

year, while government debt rose to 97.4 percent of this year, which was adopted last November, includ-

GDP. Without bailout costs, the deficit- and debt-to- ed almost all measures listed in this revised consoli-

dation plan. It is scheduled to cut spending and

6 When the bailout package was agreed upon in May 2010, the bud- increase revenues by 2.2 and 1.2 percent of GDP,

get deficit for 2009 was thought to be 13.6 percent. Eurostat revised

this figure to 15.4 percent November last year. Hence, the targeted respectively. Various social benefits and wages in the

reduction in May was supposed to lead to a deficit of 6.6 percent last public sector will be reduced and pensions frozen. At

year. 36

EEAG Report 2011 Chapter 1

continues to adhere to its predetermined saving tar-

the same time, VAT has been raised again by two per- get, then it is to be expected that further consolida-

centage points and income tax deductions are to be tion measures will have to be taken. The budget

reduced. However, the GDP forecast of 0.2 percent deficit will then fall from 7.3 percent to 4.9 percent of

growth for 2011 published by the Portuguese govern- GDP this year. Gross debt is likely to reach almost

ment seems to be too optimistic. A decline in GDP of 89 percent of GDP this year.

0.3 percent appears more likely. If the government

Box 1.1 1)

Solvency of the GIPS countries

Despite the establishment of the European Financial Stability Facility (EFSF) – a special purpose vehicle for

providing financial assistance to countries threatened by insolvency – in spring 2010, concerns of investors about

possible insolvencies of some, if not of all, peripheral countries continued to increase. The main reason for

persisting turbulences on financial markets is the increasing levels of sovereign debt combined with a lack of

economic dynamics. Although some of the involved countries did face liquidity problems, this does not

necessarily imply that these countries are actually insolvent. In the following we examine the conditions under

which these countries are in fact exposed to the threat of insolvency.

The sustainability of public finances of a country crucially depends on the long-term relationship between

nominal debt growth and the average nominal interest rate on government bonds. A country is solvent if, and only

if, the former is lower than the latter. Intuitively, this condition of solvency states that the present value of all

future public revenues needs to be greater or equal to the sum of the present value of all future primary public

expenditures and the currently existing debt. In other words, the present value of all future primary surpluses must

not fall short of the current level of public debt.

To determine the long-run dynamics of government debt in Greece, Ireland, Portugal and Spain (the GIPS


countries), we construct a time path for nominal GDP and proceed similarly for the primary deficit. In addition

we make assumptions about the long-term development of nominal interest rates on government bonds. For 2010

and 2011 the EEAG forecasts for real GDP, the GDP deflators and the budget deficits for the four countries are

taken as a basis. Beginning from 2012 the growth rates of real GDP and the GDP deflators are both assumed to

gradually converge towards 2 percent. This value equals what can be considered the EU-wide potential growth

rate and the long-term inflation target of the ECB. Thus, after 2020, nominal GDP is assumed to increase annually

by 4 percent in each of these countries. Spain already attains its potential growth rate in 2014; for both Greece and

Ireland this is the case in 2015. By contrast, Portugal goes through a period of real growth rates of around

1.5 percent, before achieving its potential in 2030. The overall deficits in 2012, 2013 and 2014 are set to the target

values specified by the Stability and Growth Pact. Accordingly, in Portugal and Spain the overall deficit-to-GDP

ratio is expected to already reach the Maastricht level of 3 percent in 2013, whereas Greece and Ireland are

assumed to achieve this goal one year later. By assumption, all four countries maintain this level from 2014

onwards. To determine each country’s current need for refinancing, figures on public debt levels in 2010 are

broken down by bond categories. For new debt an interest rate of 5 percent is assumed.

Due to the assumed long-run symmetry, the primary surpluses of these countries all converge to 0.75 percent of

GDP. Hence, savings are in the long run identical across these countries. However, in the medium run they differ.

Portugal has to realize an annual primary surplus of about 3.5 percent between 2015 and 2030, which stands in

strong contrast to the average primary surplus of 0.2 percent achieved in the years 1992 to 2006. Also Greece will

have to save notably more than it did in the decade preceding the crisis. While its primary surplus averaged

1.4 percent between 1992 and 2006, it will have to obtain an annual primary surplus of close to 3 percent during

the next two decades to comply with the 3 percent limit for the overall deficit. With an annual primary surplus of

1.7 percent until 2030, Ireland needs slightly less severe saving efforts. In light of the average primary surplus of

3.8 percent between 1992 and 2006 this appears feasible. Even less demanding are the saving needs in Spain. The

country will have to obtain primary surpluses of less than 1 percent of GDP over the next 20 years. This is lower

than its historical average of 1.2 percent. However, all these statements only hold true for this baseline scenario in

which only an interest rate of 5 percent has to be paid on newly incurred debt.

Also the growth rates of (nominal) government debt levels will, with the passage of time, become increasingly

similar. In the long-run, they will equal 4 percent in all countries. This value is strictly less than the assumed

5 percent average interest rate which countries have to pay on their new debt. Consequently, in the baseline

scenario, all four countries are solvent: the countries will be able to generate sufficiently large primary surpluses

to ensure that government debt will accumulate slowly enough to keep the debt-to-GDP ratio constant or even

have it decrease. This, however, is no guarantee that actual financing of new debt is assured. For that, we need

investors to be patient in so far that they tolerate a medium-term rise in government debt as long as long-term

prospects remain sustainable.


1 This box is based on Carstensen et al. (2010), pp. 24–9.

2) The primary deficit is the difference between the total deficit and the interest payments.

37 EEAG Report 2011

Chapter 1 continued: Box 1.1

However, the uncertainty about the long-term funding costs and the medium-term growth prospect of these

countries is enormous. As recent developments on European sovereign bond markets have shown, yields can

strongly fluctuate and also differ persistently across countries (see Figure 1.24). At the same time, medium-term

growth prospects are unclear. Growth in the years before the crisis can hardly serve as indication for future

growth. For these reasons, the following will explore alternatives in these two dimensions to test the solvency of

the four peripheral countries.

Figure 1.19 illustrates for which theoretically possible combinations of the long-term financing costs (horizontal

axis) and long-term real GDP growth rate (vertical axis) the public finance situation in these GIPS countries can

be considered sustainable. Combinations along the depicted line describe situations in which the previously

defined criteria for solvency are weakly satisfied. Combinations above the line allow a strictly sustainable

financing of the public debt, while combinations below the line lead to insolvency. Thus a country can only

absorb higher financing costs if at the same time it is able to increase its long-term growth rate. Conversely,

higher growth allows for higher financing costs.

In the baseline scenario, in which financing costs were assumed to equal 5 percent and long-run growth to equal

2 percent, the public finances of all four countries are sustainable – assuming they will adhere to the Stability and

Growth Pact. However, the required growth rate increases rapidly with increasing financing costs. Consequently

an increase of the costs of borrowing from 5 to 6 percent does not endanger the countries’ solvencies if long-term

growth is able to reach 2.6 percent in Portugal, 3.3 percent in Spain, 4.2 percent in Greece and 4.4 percent in

Ireland, instead of the assumed 2 percent. While these growth rates are in a range that still might be considered

possible, although unlikely, an increase of the borrowing costs beyond 6 percent would especially bring Greece

and Ireland, but also Spain, into a problematic situation; required long-run growth rates lie well beyond any values

that appear realistic from today’s perspective. Only Portugal seems to be capable of absorbing financing costs of,

for instance, 8 percent.

Under current conditions, especially Greece and Ireland are unlikely to go back to the capital market without

implementing additional measures that go far beyond those demanded by the European Union so far. This is,

however, not implausible as both countries have lower tax and social security contribution ratios than e.g.

Germany. Hence, some scope for higher taxes and social security contributions exists. The situation is most

extreme in Ireland where the tax and social security contribution ratio is 11 percent below the German one. This

means that Ireland could sustain an additional public debt of 200 billion euros at the currently prevailing interest

rate if it had the tax and social security contribution ratio that Germany has. This sum is four times larger than the


estimated costs of recapitalizing the Irish banking sector.

3) See Sinn (2010).

Also in the government has made significant dence in financial markets. The government’s goal is


consolidation efforts to counteract the loss of confi- to reduce its deficit of 11.1 percent of GDP in 2009 to

first 6 percent in 2011 and subse-

Figure 1.19 quently 3 percent in 2013. To

achieve this, a comprehensive

Solvency of the GIPS countries austerity package was decided

Greece Ireland upon in May last year. It includ-

18 18

(%) (%)

16 16 solvent

solvent ed a freeze of wages for civil ser-

rate rate

14 14

12 12

growth growth vants and foremost massive cuts


10 10

insolvent in public investment spending.

8 8


6 6 Moreover, VAT was raised by

4 4

Real Real

2 2 2 percentage points in mid-2010.

0 0

5 6 7 8 9 10 5 6 7 8 9 10 Although considerable progress

Interest rate on government bonds (%) Interest rate on government bonds (%) in consolidating public budgets

Portugal Spain has been made, the Spanish gov-

6 14

(%) (%)

solvent 12

5 solvent ernment will fall short of its

rate rate 10

4 insolvent

growth growth objectives. Particularly due to the

8 insolvent

3 spending cuts and an increase in



2 4 tax revenues, Spain was able to


Real Real 2 reduce its public deficit signifi-

0 0

5 6 7 8 9 10 5 6 7 8 9 10 cantly last year. However, the

Interest rate on government bonds (%) Interest rate on government bonds (%) burden of rising unemployment

Source: Carstensen et al. (2010), p. 28. 38

EEAG Report 2011 Chapter 1

and a weak economy continues Figure 1.20

to be a drag on public finances. Central bank interest rates

The government deficit is expect- % % 7


ed to have fallen to 9.3 percent of

GDP last year and will be re- 6

6 Bank rate (BoE,

duced further to 6.4 percent this United Kingdom) 5


year. Consequently, the debt-to-

GDP ratio is expected to rise 4


from 53.2 percent in 2009 to 3


64.4 percent last year and Main refinancing

rate (ECB, euro area)

69.7 percent this year. The on- 2


going consolidation of savings Federal target rate

(Fed, United States) 1


banks, which might imply addi- Target policy rate (BoJ, Japan)

tional financial means to go into 0


the bank rescue fund FROB, 01 02 03 04 05 06 07 08 09 10 11

poses a significant risk to public Source: European Central Bank; Federal Reserve Bank of St. Louis; Bank of England; Bank of Japan.

finances in Spain. Last accessed 29 January 2011. creased. As part of the Securities Markets Programme

1.3.2 Monetary conditions and financial markets initiated in May 2010 to address tensions in particular

securities markets, the ECB has so far bought govern-

Monetary conditions ment bonds worth around 75 billion euros. The addi-

tional liquidity thereby supplied has been completely

Compared to the pre-crisis situation, central banks neutralized by the simultaneous collection of fixed-

are now forced to keep an eye strongly focused on the term deposits with a weekly maturity.

stability of the financial system. Although at first

glance the European sovereign debt crisis is about Especially during the first half of last year, money

illiquidity or potential insolvency of individual mem- market rates kept on indicating a limited functionali-

ber states, the interconnectedness in terms of cross- ty and associated segmentation of interbank markets.

holdings of sovereign debt within the European bank- Both the reference rate for short-term interest rates

ing sector also makes it a concern of inner-euro-area (EURIBOR) and the effective overnight interest rate

financial stability. Although progress has been made, (EONIA) remained well below the main refinancing

it is feared that the banking system is still not capi- rate. However, since summer, these rates have been ris-

talised well enough to withstand a debt restructuring. ing, but, relative to the main refinancing rate of the

ECB, are still at low levels.

The underutilisation of resources in most economies

will keep inflationary pressures low, and although the Private credit growth remained moderate last year.

large amounts of liquidity provided by central banks Only credit volumes of housing loans showed a steady

have raised fears that at some stage higher inflation increase throughout the year (see Figure 1.21).

will be inevitable, medium-term inflation expecta- Consumer credit and loans to non-financial corpora-

tions, at least in the euro area, remain well anchored tions, on the other hand, basically stagnated and com-

below 2 percent. pared to the average of 2009 even fell slightly.

According to the ECB’s bank lending survey, banks

For these reasons monetary policy has remained very expect a stable net tightening of credit standards for

accommodative throughout 2010. The European enterprises, a slight net easing of credit standards for

Central Bank (ECB) has maintained its low interest housing loans and a more sizeable net easing in con-

rate policy and left the main refinancing rate at 1 per- sumer credit.

cent throughout 2010 (see Figure 1.20). Open market

operations were still carried out as fixed rate tenders The relatively stable interest rates on money markets

with unlimited allocation of funds. Hence, the ECB are also reflected in overall stagnating lending rates

kept on providing unlimited liquidity to the banking for the non-financial sector (see Figure 1.22). Whereas

sector. However, the demand for euro operations, in the interest rate on long-term loans managed to fall

particular with longer maturities, significantly de- slightly over the course of the year, in recent months

39 EEAG Report 2011

Chapter 1 interest rates on loans with short-

Figure 1.21 er maturities have started to pick


Credit developments in the euro area up somewhat and surpassed lev-

Index (2005=100) % change over previous year´s month els seen early last year.

140 12

Corporate credit The sharp nominal and real

130 8 depreciation of the euro during


120 4 the first half of 2010 was only

partly reversed during summer

110 0 and autumn. During the winter

Bars: year-on-year growth months the euro again lost value

Lines: indexed levels

Consumer credit

100 -4 against the dollar. Overall this

has further loosened monetary

06 07 08 09 10 conditions within the euro area

a) I I L

These indexes of adjusted outstanding amounts are calculated according to = (1+F /L ), where stands

t t t t

-1 -1


for the outstanding nominal amount of credit and the amount of transactions (credit granted). The transactions considerably (see Figure 1.23).

are calculated from differences in outstanding amounts adjusted for reclassifications, other revaluations, exchange

rate variations and other changes which do not arise from transactions (see European Central Bank 2010 for details).

Source: European Central Bank, last accessed on 29 January 2011. For the time-being the ECB will

leave the main refinancing rate at

its current level of 1 percent. By

Figure 1.22 no longer conducting open refi-

Interest rates on new loans to non-financial nancing operations using maturi-

corporations in the euro area ties beyond one month and mov-

% %

7 7 ing away from fixed rate tenders

with full allotment probably in

6 6 April, it is scaling back its use of

5 5 non-standard monetary policy

measures. When this comes to a

4 4 stop in autumn, this will slowly

3 3 reverse the substantial increase in

<= 1 year, <= EUR 1 million narrowly defined concepts of

<= 1 year, > EUR 1 million

2 2

> 5 years, <= EUR 1 million money that has been observed

> 5 years, > EUR 1 million

1 1 since October 2008. As the eco-

3-month interbank rate (Euribor)

0 0 nomic recovery in the euro area is

expected to gain some momen-

06 07 08 09 10 tum again in the course of the

Source: European Central Bank, last accessed 19 January 2011. year and beyond, it is likely that

the ECB will increase its key rates

by 25 basis points by the end of

Figure 1.23 this year. For this reason, money


Monetary conditions index and capital market interest rates


1.5 are expected to slowly increase

1.0 further.

Real short-term

interest rate Real exchange rate

0.5 monetary


0.0 Bonds, stocks and foreign

exchange markets


-1.0 average Since 2008, the European govern-

-1.5 since 1999 ment bond yields have moved sig-

-2.0 Monetary Conditions Index monetary nificantly apart. Initially, this

-2.5 easing largely reflected a surge towards

-3.0 safe assets. After spreads fell

01 02 03 04 05 06 07 08 09 10 somewhat during summer 2009,

a) The MCI is calculated as a weighted average of real short-term interest rates (nominal rate minus core inflation

rate HCPI) and the real effective exchange rate of the euro. those of Greece, Ireland, Portu-

Source: European Commission, last accessed on 19 January 2011. 40

EEAG Report 2011 Chapter 1

the EFSF. The loans granted to

Figure 1.24 Ireland add up to about 85 billion

Regional disparties w.r.t. government bond yields in the euro area euros. As Ireland would have had

Differences between national government bond yields and German bond yield sufficient funding up to mid-


10 2011, it did not seek help itself.

However, the interconnectedness


8 of Irish and other European


Portugal banks led the European Union to


6 urge Ireland into the EFSF.


Belgium Given the increased yields on

Austria Portuguese government bonds

4 France and country risk spreads, it seems


Netherlands only a matter of time before

2 Portugal will also be put under

the shield of the EFSF.

0 08 09 10 The size of the EFSF is clearly

Source: Datastream, last accessed on 19 January 2011. sufficient to deal with liquidity

problems of these smaller econo-

mies. However, questions did arise as to whether the

gal and Spain started to increase sharply again in wings of this facility are large enough to be also able

spring last year (see Figure 1.24). The current high to offer sufficient shelter to larger economies if

interest rate spreads for the peripheral countries are deemed necessary. The spreads on government bonds

primarily due to an increase in their default probabil- of Spain and Italy have increased significantly. If

ities. With a spread between its government bond financial markets do not have sufficient confidence in

yield and the German one of more than 900 basis the future fiscal course of – first of all – Spain, then

points, as it was in December last year, financial mar- refinancing costs will become much more expensive in

kets assume that Greece is likely in future to default the future. Hence, despite the support of Ireland, the

on its outstanding government bonds. sovereign debt crisis in Europe is far from over. It will

be put to a test when Spain has to roll over part of his

After the funding problems of Greece had become debt in 2011. Also the recent decision by EU finance

more and more pressing in April 2010 and a stand- ministers to introduce a new and permanent crisis

alone solution for Greece was found, the finance min- mechanism in case of government default by having

isters of the euro-area member countries agreed in collective action clauses in future bonds was not real-

May together with the IMF on the establishment of ly able to calm financial markets. The agreed terms

an emergency fund, the European Financial Stability will only apply from 2013 onwards and it will pre-

Facility (EFSF). This facility amounts to up to sumably take another six to eight years until the

750 billion euros and is intended to restore confidence majority of the bonds will contain such clauses (see

in government bonds markets. Immediately thereafter, Chapter 2).

the ECB adopted a programme to purchase govern-

ment bond in the secondary market, the so-called Independent of this surge in risk premiums, long-

Securities Markets Program (SMP). term government bond yields have started to

increase after reaching a trough in September/

Although de jure compatible with the statutes of the October 2010. By the end of the year, the German

ECB, the SMP is not in line with the spirit of the yield on government bonds with a maturity of

Maastricht Treaty, as it facilitates the financing of 10 years had increased by close to 60 basis points.

budget deficits of countries in the euro area. Not only Similar patterns can be observed for the United

does this jeopardise the independence of the ECB in States, the United Kingdom and the aggregate euro

the future, the timing of its introduction has already area (see Figure 1.25). Albeit less pronounced,

led to discussions about its independence today. Japanese yields moved in the same direction. The

average return on 10-year European corporate

After Greece had to request financial assistance in bonds, since its trough in September, had increased

May last year, Ireland – due to largely political pres- by 80 basis points by the end of last year.

sure – was forced to be the first country to draw upon 41 EEAG Report 2011

Chapter 1 The financial crisis caused all Figure 1.25

major stock markets to drop by 10-year government bond yields

around 50 percent as compared % %

6 6

to their peaks in 2007. Troughs United Kingdom

United States

were reached in early 2009 and 5 5

markets have since recovered to 4 4

different extents (see Figu- a)

Euro area

re 1.26). After stock markets 3 3

experienced a substantial set- Japan

2 2

back during summer last year,

they improved again. In the 1 1

United States and in the United 0 0

Kingdom, the end-of-year rally

allowed stock markets to fur- 06 07 08 09 10

a) The synthetic euro-area benchmark bond refers to the weighted average yield of the benchmark bond

ther steadily approach their pre- series from each European Monetary Union member.

crisis levels. In contrast, Japa- Source: Datastream, last accessed on 19 January 2011.

nese and European markets

overall no more than stagnated

last year. Figure 1.26

The euro exchange rate against Developments in stock markets

the US dollar remains volatile. Index (Jan 2003=100) Index (Jan 2003=100)

220 220

Coming from levels around Nikkei 225

1.50 US dollars in December 200 200

2009, the euro first depreciated to Euro STOXX 50

180 180

below 1.20 in June last year to FTSE 100

160 160

then gain values of around

1.40 again in November (see 140 140

Figure 1.27). By the end of last 120 120

year, it returned to about 1.30 US DJ Industrial


dollars. The weakening of the 100 100

euro especially during the first 80 80

half of last year was associated 01 02 03 04 05 06 07 08 09 10

with the flaming up of the Euro- Source: Datastream, last accessed on 19 January 2011.

pean sovereign debt crisis. In a

historical perspective, however,

its value in both nominal and real

terms is still well-beyond levels Figure 1.27

seen during the first years of this a)

century. Exchange rate of the euro and PPPs

US dollars per euro


From a somewhat longer per- Exchange rate

spective of 10 years, of the larg- 1.4 German basket

er currencies in the world, espe-

cially those of the United 1.2

Kingdom and the United States OECD basket

appear to be relatively weak. As 1.0

a safe haven currency, the Ja- US basket

panese yen has gained value 0.8

again during the crisis. Also dur- 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

ing the second half of last year it a) The exchange rate is based on monthly data, while PPPs are given at an annual frequency. Different

strongly appreciated again PPPs are computed with respect to the different consumption baskets in the United States, the OECD

and Germany. See EEAG (2005), Chapter 1, footnote 8.

against its trading partners. The Source: European Central Bank; Federal Statistical Office; OECD. Data last accessed on 1 February 2011.


EEAG Report 2011 Chapter 1

Chinese renminbi shows a steady

Figure 1.28 real increase in its value since

Real effective exchange rates around the world early 2005 (see Figure 1.28).

Index (2001=100)

Index (2001=100)

130 130 Within Europe, exchange rates

Euro area

120 120 did not move in a synchronised

way. Although most of the

110 110 European countries that do not

United China

Kingdom have their exchange rates directly

100 100 linked to the euro saw an appreci-

ation vis-à-vis the euro last year,

90 90

United this does not hold for all of them


80 80 (see Figure 1.29). Throughout the

Japan year the currencies of Romania

70 70 and Hungary even depreciated

01 02 03 04 05 06 07 08 09 10 slightly. Especially Sweden,

Source: Bank for International Settlements, data last accessed on 19 January 2011. which also reached its pre-crisis

GDP again, witnessed a strong

appreciation. The depreciation of

Figure 1.29 these countries against the euro

Exchange rate developments in the European Union vis-à-vis the euro during the recession has helped

Index (Jul 2008=100) cushion the crisis in those

110 economies. Figure 1.13 shows

that the Baltic states – all having

100 their exchange rate fixed to the

euro – experienced the strongest

impact of the crisis.

90 Denmark



Czech Republic

80 1.4 Macroeconomic outlook

United Kingdom




70 1.4.1 The global economy

08 09 10

Source: Datastream, last accessed on 19 January 2011. Whereas economies during the

first half of last year still benefit-

ed from stimulus measures as well

Figure 1.30 as from a rebound in inventories

Economic growth and the Ifo economic climate for the world and a general recovery of the eco-

nomic climate, most regions of

% Index (2005=100)

8 140 the world recently witnessed

Real GDP growth some slowdown in economic

(left-hand scale) a)

Ifo World Economic Climate

6 120 growth. This pattern is also clear-

(right-hand scale) ly reflected in the Ifo World

Economic Climate (see Figu-

4 100 re 1.30). This indicator first



4.9 4.8

4.6 peaked in the second quarter of

2 80




2.3 2.8 2010 and fell during the subse-

quent two quarters. This drop

0 60

-0.6 was solely caused by a fall in

expectations. As Figure 1.31

-2 40

01 02 03 04 05 06 07 08 09 10 11 shows, the economic situation

a) Arithmetic mean of judgements of the present and expected economic situation. kept on improving throughout.

Source: IMF, World Economic Outlook, Database October 2010 (GDP 2010 and 2011: EEAG forecast);

Ifo World Economic Survey (WES) I/2011. 43 EEAG Report 2011

Chapter 1 Expectations have turned causing

Figure 1.31 the overall indicator to rise again

The Ifo economic clock for the world in the first quarter of this year.

better 2010:I 2004:I After having skyrocketed in all

major regions of the world econ-

2011:I 2006:I omy towards winter 2009/10,

Expectations 2003:I expectations did until recently


2005:I decline. Especially in Asia, after

Economic having climbed to a historical

high, the fall has been substan-

2008:I tial. However, as in Europe and in

North America, a turnaround

2009:I has been achieved in the first

worse quarter of this year: the econom-

Economic Situation

bad good ic conditions in half a year time

Source: Ifo World Economic Survey I/2011. are expected to improve again

(see Figure 1.32). Only in Latin

America this fall has not been


Figure 1.32 Ifo World Economic Survey Although many structural prob-

Economic expectations for the next six months lems remain unsolved or have

better been transferred to the public sec-

tor, the uncertainty concerning

Western Europe economic developments has

again diminished somewhat.

about the Nevertheless, it remains signifi-

same Asia cantly higher than in the years

North before the run-up to the crisis.

America Latin Although the huge fiscal stimulus

America measures together with the very

worse expansionary monetary policy

stance helped end the recession in

01 02 03 04 05 06 07 08 09 10 11 2009, they have now also turned

Source: Ifo World Economic Survey I/2011. into the root of the current prob-

lems. It is difficult to predict how

the sovereign debt crisis in

Figure 1.33 Europe and the unsustainable fis-

Economic growth by region cal developments in the United

Real GDP percentage change from previous year States will evolve.

% %

6 16

United States Austerity programmes in Europe


4 14

Union and the phasing out of fiscal

2 12 stimulus measures in the United

States are not the only reasons for

0 10

China the current slowdown in econom-

(right scale)

-2 8

Japan ic growth. The inventory cycle


-4 6 that was triggered by the liquidity

period search of firms caused by the de-

-6 4 leveraging process during the cri-

-8 2 sis has ended and will hence no

01 02 03 04 05 06 07 08 09 10 11 longer give the strong positive

Source: BEA; Eurostat; ESRI; National Bureau of Statistics of China; 2010 and 2011: forecasts by the EEAG.


EEAG Report 2011 Chapter 1

November of last year to further

Figure 1.34 increase its purchases of govern-


Regional contributions to world GDP growth ment bonds (Quantitative Eas-

% ing II). It intends to buy govern-

5 ment bonds worth nearly 900 bil-

4 lion US dollars on the bonds

3 market during the period

Other countries November 2010 to June 2011.

Latin America and Russia

2 Asia Not before mid-year do we

1 North America expect the Fed to slowly initiate

0 Western and Central Europe an interest-rate-increase cycle.

World GDP growth Hence it will stick to a very

-1 Forecast expansionary course throughout


-2 7

the year.

-3 01 02 03 04 05 06 07 08 09 10 11 The additional purchases of gov-

a) Based on market weights.

Source: IMF; calculations by the EEAG; 2009 and 2010: forecast by the EEAG. ernment bonds will partly sup-

press the upward pressure on

impulses to the world economy as it still did during long-term interest rates and will thereby reduce the

the first half of last year. financing costs of the US government budget deficit.

After the decision was taken in December 2010 to

After a strong growth last year, we expect world GDP extend the tax breaks introduced during the Bush era,

fiscal policy is likely to turn expansionary again, with

to increase by 3.8 percent in 2011, using purchasing- a budget deficit approaching 10 percent of GDP in

power-parity adjusted weights to aggregate the fiscal 2011. Despite the already strong increase in gov-

economies. Using market prices, world economic ernment debt – it surpassed 90 percent in relation to

growth will reach 3 percent. In either case, world eco- GDP last year and is bound to increase beyond

nomic growth will fall back to what can be considered 100 percent this year – the US government has time

its long-run average. and again made clear that it is determined to stimulate

economic growth. The expansionary impulses, howev-

Not all regions will contribute equally to this devel- er, will further increase the already great pressure to

opment. Of the four largest economies, Japan shows consolidate the government budget and will thus sig-

the highest level of volatility – after strong growth nificantly weigh on the economic outlook for the

last year, it will witness, as compared to the other years to come. They also increase the risk that finan-

regions, a relatively strong decline in its growth rate cial markets will begin to question the high credit rat-

(see Figure 1.33). Nevertheless, we expect that Asia ings of the United States.

will once more deliver the strongest contribution.

The two larger economic areas, North America and Besides the structural problems the US economy is

Europe, will remain below their potential (see facing, also some short-term factors will put a drag on

Figure 1.34). growth. First, despite the weak US dollar, exports will

suffer from the slowdown in world trade growth.

Second, the build-up of inventories has accelerated

1.4.2 United States steadily since the beginning of last year. This has

ended by now and will subsequently have some

Although a double-dip scenario is not likely to mate- growth-dampening effects.

rialise, growth will slow down somewhat. The contin-

ued low capacity utilisation rate and the remaining 7 Low interest rates and a weak US dollar are already leading to what

problems on real estate markets and consequently might turn out to be unsustainable developments in particular sec-

tors. Raw material prices expressed in US dollars have risen substan-

within the banking industry will allow a further tially. The resulting boom in agricultural trade – the US trade surplus

decline in inflation rates. The inflation rate will turn in agricultural products turned out to be around 40 billion US dol-

lars in 2010 – combined with low interest rates have triggered a

out to be around 1.3 percent this year (after 1.6 per- strong increase in agricultural land prices in the Midwest. During the

second half of the 1970s, expansionary monetary policy also led to

cent in 2010). To prevent the burgeoning threat of high agricultural land prices. Subsequently, during 1981–1985 the

Midwest experienced its most severe agricultural crisis since the

deflation and to shore up the sluggish economic Great Depression. Tens of thousands of farmers had to give up

recovery, the Federal Reserve already decided in because of unsustainable debt levels; their farms were foreclosed.

45 EEAG Report 2011

Chapter 1 porary support of private consumption via extended

The current private domestic investment share

(13 percent) is well below its 30-year average of unemployment benefits and other stimulus measures

16 percent. Furthermore, interest rates will remain will ultimately have to be cut back. To cope with all

low and profits, in particular of large corporations, this, private saving rates will continue to remain rela-

are currently high. Hence, there is a potential for tively high.

investment growth to pick up. However, while the

ISM purchasing managers’ index – which focuses on Overall, economic growth in the United States is

large companies – has reached elevated levels again, expected to decelerate somewhat. GDP is likely to

the NFIB indicator with its focus on small- and medi- increase by 2.3 percent this year (after 2.9 percent in

um-sized enterprises (SMEs) has only slightly recov- 2010).

ered from its all-time low. Hence, the general uncer-

tainty that still prevails in particularly in SMEs is like-

ly to keep investment growth suppressed. In addition 1.4.3 Asia

to the continuing bleak sales and earnings outlook,

SMEs suffer from their greater dependence on bank In growth is expected to slow down further. The


loans. Traditionally, especially smaller banks provide risks in the housing market and rising inflationary

these loans. However, these continue to suffer from pressures will prompt monetary policy to become

write-offs and losses on real estate mortgages and more restrictive. Additional interest rate increases are

therefore are forced to limit their lending activities. As expected. Furthermore, weak demand from the

noted above, still high foreclosure rates and low United States and the slow appreciation of the ren-

demand for real estate properties indicate that this sit- minbi will affect the important Chinese export sector.

uation is not bound to improve soon. Hence, financial

constraints will remain in place for many SMEs. In China’s trade surplus will remain at a high level.

previous recovery periods, it was precisely this busi- However, a gradual reduction is to be expected. On

ness segment that was responsible for about two- the one hand, world trade growth will stabilise at a

thirds of the newly created jobs. Currently, however, lower level given the expected economic slowdown in

the investment and employment plans of these com- the advanced economies. In addition, the gradual

panies remain close to their lows during the crisis. appreciation of the Chinese currency relative to the

US dollar will continue and – together with stronger

Another important factor on the part of labour sup- price and wage developments – will slowly deteriorate

ply that also speaks against a rapid decline in unem- Chinese competitiveness.

ployment is the participation rate. It has declined sig-

nificantly and reached its lowest level since the mid- On the other hand, the outlook for the domestic mar-

1980s. Many of the discouraged workers have most ket is still quite optimistic. Although growth will con-

likely only temporarily left the job market and will, tinue to slow down further, as the restrictive monetary

with improved employment prospects, be returning to policy measures will have negative effects particularly


8 Due to this and moderate economic growth, the on investment activity, private consumption growth

unemployment rate will decline only slightly and will will further increase. The favourable situation on the

average 9.5 percent this year (after 9.7 percent in labour market will lead to solid wage increases.

2010). Although growth of investment in housing and public

infrastructure will be slower than last year, the expan-

The persistently tense labour market situation that sion is likely to continue and to support growth. As

will also restrain income growth of households is like- the price increases in the property sector are partly a

ly to prevent private consumption from expanding result of a lack of alternative investment possibilities,

faster than what we have seen last year. Furthermore, a collapse in the housing market is unlikely. Overall,

households still face high financial losses as a result of the Chinese economy is expected to grow by 8 percent

the real estate and financial crisis. They are also in the this year which implies a slight decrease as compared

process of gradually reducing their debt positions in to last year (9.3 percent).

view of future interest rate increases. Finally, the tem- This winter, private consumption, which has been

8 During the crisis years 2008 and 2009, about 8 million jobs were particularly strong during the recent quarters, will

lost. Last year, 1.4 million were created. At the same time, however,

the working age population of the United States increased by The phasing

put a burden on the recovery in Japan.

1.9 million. To keep the unemployment rate constant, about 0.5 mil- out of fiscal measures will lead to a contractionary

lion persons had to leave the labour force last year alone. 46

EEAG Report 2011 Chapter 1

rebound effect. On top of that, the positive impulses for the manufacturing sector have picked up again

stemming from foreign trade, which – together with and increased significantly during the last quarter of

private consumption – were the key forces during the 2010. Moreover, in 2010 – unlike the year before – the

boom of recent quarters, will decrease considerably. monsoon season was very favourable, which will

Besides the general slowdown in world economic result in a big harvest. Given the importance of the

growth, mainly the sharp appreciation of the yen will agricultural sector in India, this will have substantial

dampen exports. For these reasons, a temporary effects on its business cycle.

stagnation of the Japanese economy over the winter In contrast, the tight monetary policy designed to

term is expected. contain inflation will have dampening effects on the

Both the government and the central bank are trying economy. As at the end of last year the central bank

to counteract this slowdown in economic momentum. already announced further hikes, more restrictive

In November, the government put forward a renewed measures are expected. However, the strong apprecia-

stimulus package worth 5 trillion yen (about 44 billion tion of the rupee and the burden it puts on the export

euros). However, at the time of writing it was still sector of the country will make it more and more dif-

questionable whether – given the huge government ficult to implement any further steps.

debt – this proposal will receive the required approval Overall, the increase in economic activity will slow

from Parliament. The central bank in turn is under down somewhat during the year. Due to the strong

public pressure to resolve the still-smouldering defla- endogenous dynamics of India’s domestic demand,

tion and to prevent further appreciation of the yen. growth rates will nevertheless remain comparatively

To this end, it has set up another purchase pro- high. For 2011, the increase in GDP is expected to be

gramme for securities worth about 84 billion euros. 8.2 percent.

For the first time since 2004, it also intervened direct-

ly in the foreign exchange market in order to weaken In the remaining emerging economies of Asia, i.e.

the yen. Indonesia, Malaysia, the Philippines, Singapore, South

and a reduction in growth

These measures together with sustainable develop- Thailand,

Korea, Taiwan

dynamics is expected. First of all this is due to more

ment in non-residential private investments are likely restrictive monetary policies in these countries. For

to assure that the stagnation during the winter will not instance, to prevent inflationary overheating central

result in a fall-back into recession. Order books have banks in South Korea, Taiwan, Thailand and

been recovering since mid-2009 and, thanks to rigor- Malaysia already have increased their main rates

ous cost-cutting programmes in recent years, the prof- repeatedly. Additional measures have already been

it situation of companies is in a sound state. announced. Second, the region will be impacted by

declining growth in China, the main buyers of inter-

The slow but steady improvement of the labour mar- mediate goods produced in these countries. Moreover,

ket situation will support future consumption and the high inflow of foreign capital in the region will put

hence also benefit households. Finally, although the domestic currencies under appreciation pressure and

rapid catching-up process in many Asian economies therewith slow down export growth further. This year

has slowed down due to more restrictive fiscal and growth is expected to return to its long-term trend.

monetary policy measures, its growth will remain high GDP is expected to increase by 5 percent.

enough to benefit the Japanese export industry.

Overall, the continued global demand will be strong

enough to support a sustainable development in

investment activity and allow the labour market to 1.4.4 Latin America

revive – despite continuing deflation. Nevertheless, a In 2011 the Latin American region, i.e. Argentina,

significantly lower rate of expansion is expected for and is


Brazil, Chile, Colombia, Mexico

this year. GDP will grow by 1.3 percent (after 4.4 per- expected to grow by 3.9 percent, driven by sustained

cent last year). growth of domestic demand and supported by high

remains favourable, even raw material prices as well as solid macroeconomic


The outlook for

though the exceptionally high growth rates of 2010 fundamentals. Despite the slowdown, this is still

cannot be maintained. Survey results suggest contin- somewhat above the long-term average for the region.

ued optimism in the economy. For instance, indicators Next to inflation, specific risks arise from the massive

47 EEAG Report 2011

Chapter 1 capital inflows. An unexpected significant outflow countries at the core of Europe. Chapter 2 of this

could induce substantial short-term economic fluctu- year’s report proposes a way forward.

ations. For Mexico, the weaker economic momentum

in the United States will be of particular importance, Another risk for global economic developments is

since about 80 percent of Mexican exports flow into another substantial correction in property prices in

its neighbouring economy. the United States. Although real house prices have

fallen back to levels last seen around 2001 and have

been relatively stable for almost two years now, some

fear that there still is a potential of falling further. The

1.4.5 Assumptions, risks and uncertainties rising supply of homes as a result of the high number

It is assumed that the oil price will fluctuate at around of foreclosures and the continued slow demand as

87 US dollars per barrel over the whole forecasting also indicated by the weak development of important

horizon and that the exchange rate of the euro will leading indicators of construction activity could lead

average around 1.33 US dollars this year. World trade to further price corrections. This could trigger a fur-

is expected to increase by 5.9 percent this year, after ther downward spiral in household wealth. Further-

having experienced a strong 11.8 percent growth in more, given the still fragile equity situation of many

2010. It is assumed that there will not be an escalation banks, in particular small ones, this could hit the US

of the sovereign debt crisis in the euro area that would banking sector particularly hard and thereby pose a

endanger its aggregate stability. The current level of liability to the United States and consequently the

uncertainty still witnessed in financial markets is global economy.

expected to only slowly abate. A similar threat comes from the Chinese real estate

A particular risk to the forecast is based on the on- market. The sharp rise in property prices as a result of

going tensions in the markets for European govern- government investment programmes in past years has

ment bonds. The forecast assumes that the European some parallels to the development in the United

authorities have adopted sufficient emergency mea- States. Also in China, a significant proportion of

sures to prevent a future escalation and dramatic portfolios of banks and firms consist of real estate

deterioration of the situation this year. Furthermore, assets. A sharp price correction would curb the expan-

it is assumed that the affected countries will be able sion of the Chinese economy significantly and – given

to carry out the consolidation measures decided the increased importance of China as a sales market –

upon. A further massive increase in uncertainty in could jeopardise growth in the rest of the world.

financial markets and continued concerns about the

solvency of not only the currently affected peripher- Of course, there are also upside risks to our forecast.

al countries could significantly increase the financ- In particular, for the United States we take a cautious

ing costs for all euro-area countries. The European position. The Quantitative Easing II programme of

Financial Stability Facility (EFSF) implies, if only the Federal Reserve and the recently initiated addi-

temporary, a financial commitment by all member tional stimulus measures of the federal government

states. The associated loss in value of the outstand- may not only be able to stabilise the banking sector

ing debt would lead to further problems in the but may also induce firms to start investing more

European banking sector. It would burden the bal- strongly in the future of the US economy. The non-

ance sheets of many banks and could slow the recov- farm corporate sector is currently sitting on large

ery in lending activities, which could in turn jeopar- amounts of liquid assets, enjoys wide profit margins

dise economic growth. and can borrow at historically low costs. A mood

swing to the better would also improve labour market

In addition, if larger countries are forced to draw conditions significantly and thereby further promote

upon the EFSF, then the present volume of 750 bil- private consumption.

lion euros might prove to be insufficient. A possibly

resulting restructuring of the affected public debt Also with respect to Europe, a mood swing, this time

would increase the burden on the banking sector fur- on financial markets, could create a more optimistic

ther. Fears exist that the European banking system is growth scenario. Although it is our belief that the

not well enough capitalised to withstand such a debt debt crisis in the European periphery is far from

restructuring. Setting up an even more comprehensive resolved and hence uncertainty and speculation

insurance scheme could dampen growth prospects of remain key factors on government bond markets,


EEAG Report 2011 Chapter 1

decisive and convincing action of Figure 1.35

government authorities might Real GDP in the European Union

calm down financial markets Seasonally adjusted data

Index (2003Q1=100) %

more than currently expected. 116 12


3.0 9


112 1.8 6


1.4.6 The European economy -4.2 3

108 0

The cyclical situation 104 -3


annualised quarterly growth

Although the recovery in the period -6

annual growth


European Union is set to contin- GDP -9

ue, it will initially lose momentum 96 -12

in 2011 (see Figure 1.35). Res-

ponsible for this is the current 06 07 08 09 10 11

slowdown in global economic Source: Eurostat; Ifo Institute calculations and forecast.

growth and the increasingly year, thus sustaining, particularly in the core countries

restrictive fiscal policy environment. Some leading indi- of the monetary union, the low refinancing cost of

cators already point towards such a development dur- firms. Also, lending standards of banks are likely to

ing the winter of 2010/2011. Relative to early 2010, slowly normalize with the advancing clean-up of their

Ifo World Economic Surveys indicate that expectations balance sheets. Furthermore, the improved profit sit-

have deteriorated (see Appendix 1.B). Furthermore, the uation of firms should strengthen investment incen-

inventory cycle will barely give any positive impulses. tives. However, public investment will remain weak

Throughout the year, and as indicated by the most due to the consolidation efforts of governments.

recent Ifo World Economic Survey, the European

economy will be on the mend again, in spite of contin-

uing public saving efforts. All in all, it is expected that Employment, sectoral output and inflation

GDP in the European Union will increase by 1.5 per-

cent this year, after 1.8 percent in 2010. Labour markets usually react with some delay to

changes in economic developments. Firms do not

Net exports will contribute positively to growth (see immediately reduce employment or hire additional

Figure 1.36). Later this year, the gradually recovering personnel when the environment in which they oper-

world economy will foster exports, whereas the rela- ate unexpectedly changes. Due to its lagging charac-

tively weak performance of domestic demand will teristic, employment in the European Union reached

cause imports to increase more slowly. Exports of its trough early last year (see Figure 1.37). Albeit

export-oriented member states like Germany and very moderate, employment growth has been posi-

Finland are likely to increase at

an above-average pace. Countries Figure 1.36

with lower relative competitive- a)

Demand contributions to GDP growth in the European Union

ness levels are likely to benefit to %

a much lesser extent from the 4

continuing global economic re- 3

covery, the pace of which how- 2

ever has slowed down. External balance

1 Change in inventories


The recovery of exports will also Gross fixed capital formation

lead to a strengthening of private -1 Government consumption

investment in 2011. Several other -2 Private consumption


factors are also likely to have a period GDP growth


positive impact on private invest- -4

ment. For instance, the ECB -5

interest rate policy will remain 01 02 03 04 05 06 07 08 09 10 11

a) Gross domestic product at market prices (prices of the previous year). Annual percentage change.

expansionary throughout the Source: Eurostat; EEAG calculations and forecast.

49 EEAG Report 2011

Chapter 1 tive since then. Nevertheless, the

Figure 1.37 unemployment rate continues its

Employment in the European Union slight upward trend. This high-

Seasonally and work-day adjusted data

Index (2000=100) % lights that it is not sufficient to

110 6

Forecast look only at employment move-

Annualised quarterly growth period

0.9 ments, i.e. the demand side of

Annual growth

108 4


Employment the labour market, to forecast


1.7 0.3

-0.6 unemployment developments.

106 2 Supply-side considerations also

need to be taken into account.

104 0


0.7 Hence, a more detailed analysis



102 -2 is worthwhile. For this we need

0.9 to introduce labour force devel-

100 -4 opments and developments of

the working-age population, i.e.

01 02 03 04 05 06 07 08 09 10 11 the potential labour force. A

Source: Eurostat; EEAG calculations and forecast. decrease in the number of unem-

ployed persons can, per defini-

tion, then be decomposed into

the increase in the number of

people employed, the reduction

Figure 1.38 in the working-age population

Decomposition of unemployment rates and the increase in the number

of discouraged workers. The lat-

Germany France

% % %


1.2 12 1.2 12 ter group consists of those that

decide to leave the labour force

0.6 9 0.6 9 but do not leave the group of

0.0 6 0.0 6 working-age population.

-0.6 3 -0.6 3 Figure 1.38 shows this decompo-

-1.2 0 -1.2 0 sition for the large European

2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 countries and the United States

United Kingdom Italy in recent years. It becomes obvi-

% %

% % 1.2 12

1.2 12 ous that, besides developments in

employment, also demographic

0.6 9

0.6 9 factors and the movement in and

0.0 6

0.0 6 out of the labour force can be

quite important for understand-

-0.6 3

-0.6 3 ing unemployment statistics.

-1.2 0 -1.2 0

2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 For instance, in Italy, the num-

United States

Spain ber of unemployed workers went

% %

% %

3.0 1.6 14 up by approximately 540 thou-

20 1.2 12 sand from the second quarter of

0.8 10


1.5 2008 until the end of last year.

0.4 8

10 0.0 6 At the time, employment de-

0.0 -0.4 4 clined by about 490 thousand

5 -0.8 2 people. This implies an increase

-1.5 0 -1.2 0 in the labour force of 50 thou-

2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 sand persons. However, Italy

Discouraged workers Employment reduction

Working-age population %-change in unemployment also experienced an increase of

Unemployment rate (right scale) 440 thousand persons in its

a) The bars are as percentage of previous period unemployment levels and therefore add up to the annualised

percentage change in unemployment. working-age population. There-

Source: OECD Economic Outlook, Volume 2010, Issue 2. 50

EEAG Report 2011 Chapter 1

On the European level, these changes in labour force

fore, since the start of the crisis, on top of the change participation coupled with the slowdown of the eco-

in unemployed workers, 390 thousand additional nomic recovery will most likely keep the unemploy-

persons have resigned or decided to not enter the ment rate from falling. It will reach an average of

Italian labour force. In essence similar stories can be 9.7 percent in the European Union this year (see

told for Finland, Ireland, the Netherlands, Portugal, Figure 1.39).

Sweden and the United Kingdom. All of these coun-

tries have experienced a strong withdrawal from the Developments of individual sectors will continue to

labour market and therefore a significant reduction remain different. It is important to distinguish

in labour force participation rates. It is likely that between sectors that focus on the domestic market

many of these discouraged workers have only left the and those that are export-oriented. The export-orient-

labour market temporarily and will return when eco- ed sector will depend heavily on the markets on which

nomic conditions improve again. Hence, although these focus. Although growth will also significantly

employment might pick up in these countries, this slowdown in the emerging markets, these markets will

will not necessarily mean that unemployment will structurally continue to outperform those of more

fall as quickly. advanced economies. Development of sectors that are

largely domestically oriented will very much depend

This phenomenon of a sharp increase in discouraged upon the home market. Regional dispersion will

workers hardly exists in countries like France or remain high if not increase this year. Although the

Spain. In Spain it is striking that the working-age recovery in many other sectors started in mid-2009

population has stopped increasing. A possible expla- and will slowly continue this year, the output of the

nation is that net migration into Spain has declined or construction sector is likely to stagnate.

even turned negative. In light of this, the German

labour market story has to be corrected somewhat as On average, consumer prices will rise to a similar

well. Although it is indeed true that – as compared to extent as last year, i.e. 1.7 and 1.8 percent in the euro

other countries – not many jobs were lost during the area and European Union, respectively. After an

crisis, the overall downward trend in unemployment increase during the winter months, it will come back

figures are also at least partly a consequence of a to levels below 2 percent. More moderate growth

declining population. It is the only European country dynamics will retard the slight upward tendency in

that has shown a consistent decline in its working-age core inflation observed in recent months.

population since the turn of the century. Nevertheless,

together with Poland, it is at the same time the only

European country that has seen a significant increase Differences across Europe

in the share of employed person in the working-age

population since 2008. Demographics alone are cer- The differences between the individual member coun-

tainly not able to explain labour market developments tries remain substantial (see Figure 1.40a). In export-

in Germany. oriented countries with relatively sound public

finances and without too many

structural problems such as

Figure 1.39 Sweden, Finland, Germany, Den-

mark, Austria and the Nether-

Unemployment rates in the euro area and the European Union lands, growth is expected to be

Seasonally adjusted data

% %

11 11 above average. Unemployment is

likely to fall during the year. In

10 10 the European periphery, however,

the massive crisis and the need

9 9 for consolidation of public and


period private budgets will continue to

Euro area

8 8 dampen growth (see Figu-

re 1.40b). The recovery will only

7 7

European Union come slowly, as in Italy Spain and

Ireland, or the economies will

6 6 remain in recession, as in Greece

01 02 03 04 05 06 07 08 09 10 11 and Portugal. In all of these

Source: Eurostat; EEAG calculations and forecast. 51 EEAG Report 2011

Chapter 1 countries, including the United Figure 1.40a

Kingdom and Belgium, the Economic growth in the EU member countries

labour market situation will Average real GDP growth, 2003–2009

worsen (see Table 1.A.2 in %


Appendix 1.A). 4

Next year, the economy


is likely to grow at an above-aver- 2

age rate. Favourable income European Union

prospects, job security and low

interest rates will support private 0 urg

k ny y

y s


om ia ia




den ia


l a c


s tria ia


a ia



consumption and residential a u

land i i


r gar

Ital lan

i ak



n bl

rtug n


giu a

ma pr

rma la

a e

p sto a

d bo



a e nl M lg

pu m ov

ov u


Ire Po




r Sw


en l

r G

F th


A Bu



Po E Ro

e Re

e Sl



Eu h Li


D K xe

investment. The favourable et h

d Lu

N c

te e

ni Cz


financing conditions and good Real GDP growth, 2010


market prospects in Germany 6

and – due to the weak euro – also 4

in the rest of the world will stim- European Union


ulate private investment in 0

machinery and equipment. -2

Nevertheless, growth will proba- -4

bly be considerably less than last -6

year. First, impulses coming ourg


ary ny

ly ium

s m

nia lik a

ria d

tvia en


nd d




ce nia a lta



e a

ypru land aki

nc oni

mar olan


i en ustr


Ita do


ree ar ed

from the world economy will a

la Ma



a rtu

ua g ra m


La lg ov

m ov

Ire S st

un g b Sw


l en up

G r


th er

C Fi P



Bu m


Po E


Ro he Sl

Sl H

i D G


K xe



abate. The strong world invento- h

d Lu

N ec



ni Cz


ry cycle resulting from the finan- Real GDP growth, 2011

cial crisis will have ended. %


Foreign trade will therefore, 4

unlike last year, no longer pro- European Union

vide a significant impulse to 2

gross domestic product growth. 0

Although exports are expected to -2

increase further, given the strong

domestic economy imports are -4 rg

ark y y

ly s m om

ia a

aria nd




gal a

d a

n a


e a nia

nds a


likely to expand at least as fast. ru aki


i i

reec c re t man

gar an

n ai an Latv


ustr n


Ita iu u


la la



p e

rtu Sp a to



d bo

rla e


M lg



m ov

ov u


Ire Po


ing Sw

o Es


G th

F er Fi

A Bu



o Ro r he Re Sl

Sl H



P Li



Second, the government has initi- xe

et h

d Lu

N ec


ni Cz

ated a consolidation path, which U

Source: Eurostat; 2010, 2011: EEAG calculations and forecast.

in itself will have dampening

effects. In total, GDP will expand

by 2.4 percent this year, which Figure 1.40b

implies that Germany will remain A map of economic growth in the EU member countries

in the group of frontrunners in Real GDP growth in 2011

Europe. 3.3 − 4.2

2.5 − 3.2

1.7 − 2.4

Although a number of tax ben- 0.9 − 1.6

0.1 − 0.8

−3.2 − 0.0

efits have been phased out, fis-

cal policy remained accom-

modative in last year.


This year, however, fiscal con-

solidation plans of the govern-

ment will significantly dampen

the economic expansion.

Spending cuts in the public sec-

tor as well as freezing transfers Source: EEAG forecast. 52

EEAG Report 2011 Chapter 1

to regional administrations are scheduled. Fur- GDP is expected to increase by only 1 percent

In Italy,

thermore, leading economic indicators signal a and therefore to stay below the euro-area average. Not

slowing of the recovery during this winter. For least due to the low interest rates, positive impulses

instance, new incoming orders have been falling and will arise from private investment, albeit the catching-

according to the Ifo World Economic Survey the up effect after the large drop during the crisis will

assessment of the first quarter of this year is still slowly phase out. In contrast, growth contributions

below its long-term average. Especially as the inven- from private consumption and foreign trade are likely

tory cycle will no longer deliver short-term impuls- to remain moderate. Private consumption will be

es, the French economy is expected to significantly attenuated mainly by cuts imposed by the Italian gov-

lose steam this winter. ernment in the area of public service. Lack of com-

petitiveness, an unfavourable export structure and the

Although growth will continue, it will be at a reduced slowdown of world trade will constrain export devel-

pace in France as well this year. Restrictive fiscal poli- opments. Weak domestic development, together with

cies will have a dampening effect on domestic a weak euro and a slow picking-up of world trade will

demand. The expansionary interest rate policy of the allow foreign trade to contribute positively to eco-

ECB will keep funding costs low and thereby stimu- nomic growth at the end of this year.

late private investment. As a consequence, the latter is

also expected to deliver the greatest growth contribu- The only moderate recovery of the Italian economy

tion this year. The growth impulse from foreign trade and the pending reduction in short-time work will

will be slightly negative as imports continue to grow prevent a sustainable recovery of the labour market

faster than exports. All in all, GDP will grow by this year. The unemployment rate will only decline

1.4 percent in 2011. Accordingly, inflation will turn slightly to an average of 8.3 percent. Consumer prices

out to be moderate and is expected to amount to will increase by 1.3 percent this year (after 1.7 percent

1.4 percent. The unemployment rate will remain sta- last year).

ble around a rate just under 10 percent. The high government debt level has so far not led to

This year, supported by the weak pound, the eco- serious doubts about the solvency of the Italian state.

is likely to be

nomic recovery in the Although the spreads of Italian government bonds

United Kingdom

borne by exports. Domestic demand will be retard- over German government bonds have risen slightly

ed by the drastic consolidation measures undertak- during the year, they stayed well below those of the

en by the British government. The decline in house crisis countries Greece, Ireland, Portugal and Spain.

prices is expected to continue with consequences for As the uncertainty in the international financial mar-

private consumption, especially given the restrictive kets, however, remains high, it cannot be ruled out

fiscal policy stance and the deteriorating labour that the sovereign debt crisis will encroach upon Italy

market situation. So far, the job market has proven during our forecasting horizon. This is one of the

to be surprisingly stable. The unemployment rate, biggest risks associated with this forecast.

which was at 7.8 percent as of September last year, is expected to show a moderate increase

has changed little since the spring of 2009. Now, GDP in Spain

of 0.6 percent this year. The consolidation of public

however, signs of a deteriorating situation are set- finances, initiated in response to the loss of confi-

ting in. The government has announced cuts of dence by financial markets, will have a strong negative

490,000 jobs in the public sector in the next five impact on the economic recovery of Spain. It is to be

years. It is unlikely that private labour demand can expected that in particular public investment will be

compensate for the layoffs in the public sector. In reduced significantly this year.

October, hiring activity in the service sector stagnat-

ed and even started to sharply decline in industrial Next to the high unemployment rate and weak wage

sectors. growth, the reduction of the public deficit is also the

largest negative factor affecting consumer spending.

For 2011, slower economic growth is expected; GDP Private consumption is therefore likely to stagnate or

will increase by 1.1 percent. Due to the VAT increase only increase moderately. A positive impulse is to be

early this year, the inflation rate, at 2.7 percent, is like- expected from foreign trade. The weak euro and

ly to stay above the target of the Bank of England. improved price competitiveness of the Spanish export

The unemployment rate will increase to an average of sector will stimulate exports. Moreover, Spain will

8.2 percent. 53 EEAG Report 2011

Chapter 1 benefit from the economic recovery of its trading foreign trade. All in all, GDP of this region will

partners in the euro area expected by the end of the increase by 3 percent this year.

year. Import growth will slow down due to weak – a Baltic country with

domestic demand and will lead to an improved trade On 1 January this year, Estonia

a population of 1.3 million – entered the euro area. It

balance. Investment, however, should remain weak as has become the 17th country overall, the third one of

adjustments in the real estate sector have not yet been the Central and Eastern European members of the

completed. European Union and the first member of the former

Soviet Republic to adopt the euro. Slovenia and

The weak economy will lead to a further rise in unem- Slovakia had already entered in 2007 and 2009,

ployment to an average of 21.3 percent this year. respectively. The currency conversion was completed

Improvements in the labour market can only be without difficulty.

expected towards the end of the year. The temporary

increase in inflation observed last year will abate, and

inflation is expected to average 0.9 percent this year. 1.5 Macroeconomic policy

will remain in a reces-

Throughout the year Greece

sionary state. Despite improved competitiveness, the

Greek export sector will not be able to deliver impuls- 1.5.1 Fiscal policy

es substantial enough to compensate for the reces- Chapter 3 of last year’s EEAG Report was entirely

sionary state of the domestic economy driven by the devoted to the passage from the policy emergency of

necessary consolidation measures. GDP will decline providing fiscal life-lines to an ailing global economy

by 3.2 percent, whereas the unemployment rate will to the policy consequences of a rapid accumulation of

climb to an average level of 15.5 percent. public liabilities (EEAG 2010, Chapter 3). As antici-

pated, fiscal consolidation has indeed become the pol-

Although the rescue of the banking sector in Ireland

can be considered a singular event, the structural icy priority, arguably for the years to come.

deficit has consequently increased permanently. It has

led to a severe increase in interest payments to be ren- In the latest IMF World Economic Outlook, the debt-

dered in the years to come. After the one-time emer- to-GDP ratio in the G7 countries is expected to

gency measures expire, the deficit for next year is increase by staggering 40 percentage points by 2015,

expected to still remain beyond 10 percent of GDP, as compared to the pre-crisis level in 2007. Of these

and is therefore still high. Nevertheless, Ireland will be 40 percentage points, about 20 points can be attrib-

able to slowly leave negative growth dynamics behind. uted to a drop in tax revenues because of the reces-

The increased competitiveness caused by falling prices sion. Another 7 to 8 points is due to the slowdown in

will stimulate exports. A lack of domestic demand growth relative to interest rates, affecting the dynamic

will, however, keep the average growth rate for this of the debt-to-GDP ratio, and another 8 points to fis-

year at around zero percent. cal initiatives aimed at “saving the banks” and lending

operations. Actual discretionary stimulus measures

will cause its

The consolidation measures in only amount to 4.5 percentage points. These figures


GDP growth to turn negative this year. It is expected may give the impression that the deterioration of the

that the annual growth rate will fall to –0.3 percent. fiscal outlook was not so much the result of outright

As a consequence, the labour market conditions will policy decisions, but rather followed from the

further deteriorate slightly and raise the average mechanical effects of “automatic stabilisers” in a

unemployment rate to 11.1 percent this year. (strongly) recessionary period. So, was the stimulus

small after all? A positive answer would be highly mis-

dynamics in domestic

In leading. It would overlook the fact that, in many of

Central and Eastern Europe

demand will most likely remain slow. Investment the past financial crises with large output conse-

demand is declining in many countries, and private quences, governments felt compelled to take a conser-

consumption is dampened by the austerity pro- vative fiscal stance. In part, a fiscal contraction in

grammes of governments and the generally strong some chapters of spending was meant to free

increase in unemployment. With only a modest resources for “saving the financial system”. In part,

expansion of the domestic economies, the forecasted especially for small countries with currencies histori-

recovery is mainly driven by impulses coming from cally exposed to the risk of speculative attacks, a fis-


EEAG Report 2011 Chapter 1

cal contraction complemented restrictive monetary policy may be understandable in a situation of high

policies in an effort to prevent large depreciation of uncertainty about the size and persistence of a slow-

the exchange rate. The key policy novelty in the cur- down in global economic activity, accompanied by

rent global crisis is that, relative to the conservative widespread malfunctioning of core financial markets.

strategy commonly followed in the past, policymakers Yet, there is hardly any justification in treating a fiscal

around the globe decided on the opposite course of expansion as a “different policy”, relative to the future

action. As interest rates were slashed almost every- correction measures that this eventually entails to

where, governments decided to let budget deficits ensure fiscal viability. The current macroeconomic

grow with the recession, without undertaking any off- conditions offer no room to downplay once again the

setting measures. If anything, discretionary measures, link between current and future policy actions.

however contained, were also expansionary. The stim-

ulus was large overall. Whether this strategy saved the How should fiscal consolidation proceed? Virtually

world from another great depression or not, its conse- everyone agrees on the need to undertake strong mea-

quences are now troublesome in themselves. sures to reduce deficits and stabilise public debt, espe-

cially in view of structural (i.e. largely demographic)

The recovery from the crisis is currently threatened by factors that would weigh on the fiscal outlook even if

an increasing level of fiscal risk. During the stimulus the crisis had never occurred. There is no doubt that

phase, in the context of an international panic in fiscal deficits are bound to be slashed by a combina-

autumn 2008, deficit financing was made easier by the tion of tax hikes and spending cuts. While the exact

“flight to quality” by international investors – partic- composition may and should vary across countries, a

ularly benefiting countries with a large GDP relative well-established literature suggests that debt consoli-

to the liabilities of their financial system, with robust dation is more likely to be successful when based on

fiscal shoulders and with a reserve currency. The spending cuts, rather than tax increases. This is natu-

opposite scenario opened up in the fiscal consolida- rally in the cards in countries where a strong political

tion phase, in 2010. Reacting to the increasing fiscal constituency defines caps on the tax rates which are

risk, markets have started to charge substantial considered politically acceptable – an instance given

default risk premiums to governments, especially in by the United Kingdom. Yet, the size of the fiscal cri-

countries with large, explicit or implicit, fiscal liabili- sis is likely to force cuts on virtually all governments,

ties relative to their perceived “fiscal capacity”. As raising sensitive issue in the reform of the public

these high risk premiums spill-over to the credit con- administration of countries with a particular poor

ditions faced by the private sector, fiscal risk trans- record as regards the productivity of public services –

lates into a strong recessionary impulse, worsening such as Italy.

endogenously the fiscal conditions of the country.

The flight to quality has now created a great divide In many countries, indeed, the crisis creates a window

between the handful of governments considered fis- of opportunity to fix inefficiencies on both the spend-

cally solid, some of which enjoy a negative risk pre- ing and the tax side of the budget. For any given tar-

mium allowing them to borrow extremely cheap get of tax revenue, for example, the crisis could pro-

(although they may also suffer from the consequences vide a strong incentive to change the tax code so as to

of strong capital inflows), and all other countries. But rebalance the share of revenues from direct and indi-

because of the low risk tolerance among market par- rect taxation, increase fairness and, most important,

ticipants, the border between the two groups is flexi- reduce tax elusion and evasion.

ble, and almost no country can consider itself com-

pletely insulated from financial turmoil: debt consoli- Independently of the policy debate on the content and

dation is the challenge that is facing all policymakers, intensity of fiscal correction measures, strong dis-

albeit in different ways and intensity. agreement is emerged about the timing of implement-

ing these measures. Some favour gradualism in imple-

What is surprising is the fact that the political debate mentation: correction measures should be decided

in recent years underwent a marked shift in focus, immediately but should be phased in over time, mak-

from one crisis situation – keeping the economy going ing sure that the strongest measures are only effective

through stimulus – to another crisis situation – keep- after the economy is comfortably out of recession – a

ing government viable through debt consolidation, as key indicator would be that monetary policy is no

if the two were unrelated to each other. The lack of a longer stuck at a near-zero interest rate. Others

coherent, forward-looking approach to stabilisation emphasise the need to act immediately, front-loading

55 EEAG Report 2011

Chapter 1 especially spending cuts, with the goal of enhancing increase) in spending would reduce (or raise) output

by two euros.

policy credibility. The same argument is actually strengthened by con-

Let us examine the arguments underlying these posi- ventional policy wisdom, according to which, while

tions in detail. Those in favour of gradualism in contemporaneous cuts are recessionary, anticipation

implementation essentially weigh the risk that early of cuts in the future might exert an expansionary

retrenchment could stem recovery. The premise here impulse in the short-run. The transmission channel

is that the recovery is still fragile while monetary pol- works through asset prices, in particular, through

icy is still constrained. Not only are policy rates still changes in long-term interest rates. The mechanism,

at their “zero lower bound”; financial and monetary explained in detail by Corsetti et al. (2010a), is

markets are still sub-optimally segmented, jeopardis- straightforward. Once the economy is out of the

ing the transmission of conventional monetary mea- worst recessionary state, demand will start driving

sures. Most important, the balance sheets of central inflation up, prompting the central bank to increase

banks are now heavily out of balance, raising the policy rates, consistent with the goal of maintaining

need to design a monetary exit strategy which may be price stability. On the way out of recession, policy

hard to keep clean of fiscal implications. To the rates will thus tend to increase with inflation and eco-

extent that we are not out of the financial and real nomic activity in both nominal and real terms. If a

crisis – the argument goes – an early implementation fiscal retrenchment is implemented sufficiently far

of cuts may re-ignite vicious circles whereas low eco- into the recovery period, it will not push the economy

nomic activity creates the premise for further con- back into a recession, but, everything else equal, will

traction in demand. According to the monetary mod- exert a deflationary impulse: comparatively, there will

els after Eggertsson and Woodford (2003) and be less demand, hence less inflation. As a result, the

Christiano et al. (2009), for instance, a fiscal contrac- central bank will tend to contain the increase in pol-

tion would produce deflationary pressures that, given icy rates. Now, from today’s perspective, in anticipa-

a zero nominal interest rate, would translate into an tion of future retrenchment, the financial market will

increase in the real interest rate faced by private therefore tend to forecast a prolonged period of rea-

agents. This effect would further depress aggregate sonably low rates (or more in general a period of

demand, creating additional deflationary pressure, macroeconomic stability), which will directly trans-

and another round of contraction. late into a drop of long-term rates. This has expan-

sionary effects already in the short-run, during the

By the same token, on the financial side, one may note recessionary period, for any given current policy rate.

that, per effect of the financial crisis, banks have While the strength of this channel in a crisis situation

arguably become more conservative in providing cred- is debatable, there are reasons to believe that it is not

it to enterprises. By cutting public spending and pub- negligible.

lic work, de facto the government is cutting cash flow

accruing to firms that could be used as “collateral” for Note that anticipation of fiscal retrenchment creates

obtaining credit. Hence, in a persistent state of finan- an incentive for firms to contain price increases, even

cial crisis, a fiscal contraction would end up exacer- before the retrenchment actually takes place. Other

bating further the financial constraints firms are fac- things equal, this means a lower expected path of

ing, with substantial (multiplicative) effects on eco- inflation and interest rates, from the end of the reces-

nomic activity, well above the size of the cuts them-

selves. There are indeed reasons to believe that the

transmission of fiscal impulses, usually quite mild 9 Specifically, these authors find that impact multipliers for govern-

ment spending on goods and services are on average quite low, con-

when the economy is operating in normal circum- sistent with the large empirical literature on the subject. But they can

stances, becomes much stronger during a financial become much higher – as high as 2 for output and consumption –

during financial and banking crises (Corsetti et al. 2010b). Un-

and banking crisis. Evidence in this respect is provid- expected changes in government spending on final goods and ser-

vices affect output, consumption and investment much more than


ed by Corsetti et al. (2010c) for the OECD countries. one-to-one, conditional on the economy experiencing a “financial

and banking crisis”, according to the classification of Reinhardt and

This study shows that the output and consumption Rogoff (2008). To be sure, the number of crisis observations in their

effects from changing fiscal spending is quite con- OECD sample is relatively limited, and the empirical method adopt-

ed in the study (identifying fiscal shocks from the residuals of simple

tained in general, but become strong during years of fiscal rules) is subject to on-going controversy, so that these estimates

should be taken with a grain of salt. Nonetheless, the empirical evi-

financial crises. During these years, the point estimate dence unambiguously points to large differences in the macroeco-

nomic effects of government spending between crisis and non-crisis

of the “impact spending multiplier” for consumption periods, which appear to be robust to many additional empirical

and output are as high as 2: one euro of cuts (or exercises.


EEAG Report 2011 Chapter 1

sion onwards. However, the opposite is true in the other words, a situation with no risk of default

short-run, during the recession, because the expan- priced by the markets is not the relevant “counter-

sionary effects of low, long-term rates on demand will factual” against which to assess the desirability of

tend to increase prices on impact. Everything else fiscal retrenchment.

equal, this would stabilize current output and help the

economy out of the recession and the zero-lower- The core issue is that immediate fiscal cuts may be

bound problem. critical in saving a country from “much worse things

to happen” by preventing financial tension in the debt

No doubt that these arguments have merits. Both may markets – including the possibility of a self-fulfilling

explain, at least in part, the macroeconomic success of run on public debt. This point is illustrated by an

countries in a relatively good fiscal standing, where extension of the already mentioned work by Corsetti

nonetheless the government has taken an explicitly et al. (2010a) that assess the effects of fiscal cuts in

conservative attitude, with budget deficit spread over economies in which private investors charge a risk

time. These arguments emphasize the stabilizing premium on public debt depending on (the expected

effects of a prudent fiscal conduct, where the with- path of) the debt-to-GDP ratio, realistically affecting

drawal of past stimulus measures, is matched by also the interest rates charged on private debt. The

reforms generating lasting cuts in the deficits, with a analysis contrasts the effects of a given fiscal retrench-

progressive reversal of spending even below the pre- ment package, implemented either immediately, or

crisis period. with some delay, in an economy currently in a deep

recession, in which the policy rate is stuck at zero, i.e.

Yet, these arguments work only under the assumption there is no room for monetary authorities to react to

that a government is able to pre-determine, in a cred- negative shocks by further cutting policy rates.

ible way, the timing and intensity of the fiscal

retrenchment over the medium term – the transmis- The macroeconomic outcome of implementing cuts

sion mechanism indeed rests on the assumption that immediately is the result of two competing transmis-

market prices are stabilised by expectations of sion channels. The first is the classical multiplier chan-

retrenchment. Many countries (some would argue nel from low demand, which is negative, and can be

most countries) may simply not be in the condition of quite strong if the economy is not out of the crisis (as

even trying out this strategy, because of the sheer size stressed by the supporters of gradualism). The second

of public debt, adverse cyclical development and/or a is the financial channel, which is instead positive, but

record of weak fiscal institutions. only to the extent that cuts are successful in reducing

the risk premium charged by investors to public and

The credibility risk in designing correction measures private resident debtors. Which effects prevail? The

is indeed the main argument against delayed imple- simulation model used in that study suggests that, for

mentation. Especially after the events of 2008/2009, standard values of the parameters of the model, an

market risk tolerance is low, and investors are ready to immediate implementation of retrenchment has actu-

withdraw at the least sign of trouble. A lack of imme- ally limited or no effects on output, according to most

diate adjustment, reassuring investors, exposes coun- exercises: the two channels offset each other. Small

tries to the highly dangerous risk of losing market gains in output are produced only when the initial

access at reasonable terms, and back precautionary debt-to-GDP ratio for the country is very large (above

but significant steps towards fiscal correction also in 100 percent), so to make the gains in risk premiums

the short run. the overruling concern. In other cases, there is a very

small contraction. With the caveat that the simulation

These cuts will be contractionary in the sense that model is highly stylised, an outcome of neutrality of

the negative impulse of cuts will dampen demand spending cuts is actually good news.

and therefore economic activity, with respect to an

ideal, virtuous situation in which no immediate cuts Conversely, the macroeconomic outcome is much

are implemented, yet no risk premium is charged by more worrisome when the government delays the

international investors. Relative to this benchmark, implementation of fiscal retrenchment for a few quar-

it is difficult to expect so-called “non-Keynesian ters. A small delay in starting debt consolidation at

effects”, where cutting public demand magically pro- best makes the current recession worse – in general it

duces a boom. But assuming away risk premiums creates room for unstable market dynamics and/or

virtually amounts to assuming away the problem. In indeterminacy.

57 EEAG Report 2011

Chapter 1 There are in fact major risks in delaying fiscal countries with an even moderate imbalance in public

retrenchment, if this ends up being implemented over finance will take a precautionary stance on the timing

a horizon in which the economy may not be safely out of contractionary measures.

of the recession. An instance of which can be illus-

trated as follows. Suppose that, in response to the While fiscal consolidation of the crisis is inescapable,

news of a retrenchment a few quarters in the future, the above considerations nonetheless suggest that the

private agents arbitrarily developed gloomy expecta- appropriate strategy is not the same everywhere.

tions about economic activity. As a lower output Obviously, sharp corrections are needed in countries

means less tax revenues and higher budget deficits, that already face high and increasing risk premiums

they will start charging a higher risk premium on gov- on their debt. Failure to consolidate would not only

ernment debt. Since the cost of private debt is corre- raise the cost of borrowing for the government; it

lated to that of public debt, in equilibrium adverse would also undermine macroeconomic stability with

credit conditions will also hit private agents, with con- widespread economic costs. In these cases, immediate

tractionary effects. In normal circumstances, the cen- cuts in spending and tax hikes would signal the gov-

tral bank could react to this development by cutting ernment’s commitment to consolidation, even if, other

interest rates. But this is not possible if monetary pol- things equal, their short-run costs in terms of output

icy is already constrained by the zero lower bound – are not negligible (but would be much higher in the

and alternative strategies such as quantitative easing absence of correction).

do not offer an efficient substitute. Adverse credit

conditions in the private market then cause demand Yet it is important to emphasise that the credibility

and therefore output to contract, fulfilling ex post the and success of fiscal correction measures will not be

initially arbitrary expectations of a cyclical downturn, judged by their capacity to generate a positive cash

enhancing fiscal risk. flow for a few quarters, but on the grounds of their

sustainability, and their budget and growth effects in

How likely are these types of scenarios? The model the medium to long run. Now is not the time for

and simulations by Corsetti et al. (2010b) single out a accounting tricks and budget gimmicks.

few critical parameters. First, the output elasticity of

tax revenues must be realistically high, roughly in line In countries where risk premiums have remained low,

with the OECD estimates, i.e. around 0.34. This sim- improving the fiscal outlook is no less urgent, but it

ply means that the budget deficit is realistically sensi- would be advisable to design consolidation strategies

tive to the cycle. Second public debt, including explic- that foresee more steady adjustment. Adopting

it and implicit liabilities, must be large enough. In the strongly frontloaded strategies, to signal immediate

simulations, the adverse scenario occurs when debt is improvement in fiscal cash flows, can be tempting as

above 100 percent of GDP. Third, the government an extra insurance against market jitters. However,

risk premium must be realistically correlated to pri- under the present circumstances, it would be wise to

vate risk premiums – according to a well-established also assess the downside risks very carefully. Through

empirical fact. Finally, the risk premium must be sen- their effects on aggregate demand, excessive contrac-

sitive to the stock of public debt. In the simulations tionary measures may actually be bad for the fiscal

presented in that paper, such sensitivity is estimated outlook, and inconsistent with the overall goal of pro-

through an empirical fit of the cross-country evidence viding a stable macroeconomic environment for

on credit default spreads in April 2010. Un- households and firms to recover confidence.

fortunately, however, this parameter is quite difficult

to nail down, and, most importantly, appears to be

extremely volatile. In view of this consideration, the 1.5.2 Monetary policy

conditions under which policymakers may find their Since the launch of the monetary union, significant

country vulnerable to market turmoil can be much macroeconomic imbalances have developed between

less extreme; the debt threshold may be much lower the euro-area countries, taking the shape of massive

than 100 percent, for instance. current account deficits in the peripheral countries

and significant surpluses in other countries, specifical-

We believe that it is the risk inherent in the above sce- ly Germany. In principle, such imbalances can have

nario that provides the most compelling argument in positive effects if current account surpluses or deficits

favour of front-loading deficit cut measures. We trigger cash flows that lead to higher investments in

therefore expect that, at least in the industrial world, 58

EEAG Report 2011 Chapter 1

the countries in which the marginal productivity of rate the ECB would have chosen had the conditions in

capital is high. The problem in the euro area does not the respective country been prevalent in the entire

consist of the asymmetries per se but in the fact that euro area. Where the difference between the two inter-

capital inflows in many countries have financed a con- est rates is positive, the country’s situation requires a

sumption boom, non-sustainable levels of govern- higher interest rate than the one set by the ECB. If, on

ment and private debt as well as real estate bubbles. the other hand, the difference is negative, the ECB’s

This in turn has led to substantial price increases with target interest rate is too high.

drastic effects on the countries’ competitiveness. The ECB target rate is estimated to be 0.75 percent

What the deficit countries need – not least to stabilise by the end of last year. Comparison of the devia-

their debt situation – is to increase their competitive- tion between the individual appropriate interest

ness in order to reduce their current account deficits. rates and the ECB interest rate shows that, in the

However, as members of the euro area, raising com- years before the crisis, the ECB interest rate was

petitiveness via currency devaluation is no longer an systematically too low in Greece, Ireland and Spain

option. Consequently, various price trends – and thus (see Figure 1.41). In contrast, the ECB interest rate

the real exchange rate – must play this role here. This was almost consistently too high in the case of

process has already started: excluding various tax Germany. Since the outbreak of the crisis, however,

increases, inflation rates in the peripheral countries the situation in numerous euro-area countries has

are now well below the euro-area average. been reversed. If, for example, the recession were as

serious in all countries as it is in Greece, Ireland

The price adjustment process may be expected to con- and Spain (and no zero interest rate barrier exist-

tinue. The crisis in the peripheral countries is substan- ed), the ECB would currently opt for a significant-

tially more serious and tenacious than in other euro- ly lower interest rate. Germany represents the other

area countries, not least due to the acrimonious fiscal extreme: if the ECB was guided by the German

consolidation packages. In this context, persistently economy, the target interest rate would currently be

high unemployment will place a significant strain on around 2 percent.

wages. In contrast, due to continuous improvements

on the labour market, private domestic demand is However, since the ECB’s decisions are based on

expected to make a more significant contribution the situation of the entire euro area, the discrepan-

towards growth than in the pre-crisis years, especially cies are expected to persist, with price trends con-

in Germany. tinuing to diverge substantially in the coming years.

On the one hand, expansive interest rates in

Given this background of persistent asymmetries Germany will stimulate economic activity and will

between the euro-area countries, the formulation of tend to result in price increases. On the other hand,

monetary policy remains a challenging task for the the restrictive interest rates in the peripheral coun-

ECB. Nevertheless, monetary framework conditions tries will contribute towards slowing down their

in the coming years are expected to promote a further economic activity.

decline in foreign trade imbalances via relative price

trends in the euro area. Monetary policy in the euro Although these developments are certainly not wel-

area is guided by the inflation prospects of the entire come from an economic policy point of view, as well

euro area. As a consequence, the decisive ECB inter- as increasing the risk of a deflationary spiral, they

est rate may be too restrictive for some countries and also put a lid on inflation rates. In the long term, this

too expansive for others. would boost the competitiveness of the countries in


One way of researching this diverging economic effect

of monetary policy consists in estimating the ECB’s The estimated ECB reaction function can also be used

interest rate setting behaviour for the entire euro area to forecast the interest rate policy in the near future.

with the help of a so-called reaction function and Assuming that the current ECB interest rates again

comparing it with an analogously calculated counter- follow the model applicable to the first decade of the

factual target interest rate for each member state. 10 single monetary policy, this rule indicates that the

The country-specific interest rate indicates the interest appropriate interest rate since August, 2010 has

assumed positive values again. In December 2010, the

10 The approach taken here is based on Sturm and Wollmershäuser estimated target rate for the euro area equals 0.75 per-

(2008) and used in the 2007 and 2009 EEAG reports. 59 EEAG Report 2011

Chapter 1 Figure 1.41 Deviations of country-specific optimal policy rates from the ECB rate

Germany France Italy

%-points %-points

%-points 3

4 2

2 1

2 1 0

0 0 -1

-2 -1 -2

-4 -2 99 00 01 02 03 04 05 06 07 08 09 10

99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09 10

Spain Netherlands Belgium

%-points %-points %-points

4 4


2 2 2

0 0

-2 0



-6 -4 -2

99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09 10

Austria Greece Finland


%-points %-points

3 6 4

2 2


1 0

0 -6 -2


-2 -12 -4

99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09 10

Ireland Portugal



10 6


0 0

-10 -3


-20 99 00 01 02 03 04 05 06 07 08 09 10

99 00 01 02 03 04 05 06 07 08 09 10

Source: European Central Bank; Consensus Economics Inc.; EEAG calculations and estimates.

an incentive to increase short-term debt positions.

cent. Its difference with the actual main refinancing

rate and the interbank market rate has been reduced This increases their liquidity risk that may materi-

substantially. alise at a later stage. In addition, market partici-

pants might expect that the effects of future liquidi-

Given that inflation will remain below 2 percent and ty crises in the banking sector will again be alleviat-

no strong growth is expected, the ECB should keep its ed by monetary policy measures. This effect could

main refinancing rate at 1 percent. In view of increas- also increase the incentives for banks to choose

ing capacity utilisation rates in 2012, it should imple- riskier lending strategies.

ment a first interest rate adjustment by the end of this

year. Using our forecast to extend the estimated reac-

tion function indeed suggests a first hike by the end of References

2011. Carstensen, K., Nierhaus, W., Abberger, K., Berg, T.,

Buchen, T., Breuer, C., Elstner, S., Grimme, C., Henzel, S., Hristov, N.,

Also for other reasons such a rise is to be favoured. Kleemann, M., Mayr, J., Meister, W., Paula, G., Plenk, J., Wohlrabe,

K. and T. Wollmershäuser (2010), ifo Konjunkturprognose 2011:

Notwithstanding its influence on production and 14 December 2010.

Aufschwung setzt sich verlangsamt fort,

prices, a continuing very low interest rate is also asso- Christiano, L. J., Eichenbaum, M. and S. Rebelo (2009), “When is the

Government Expenditure Multiplier Large?”, NBER Working Paper

ciated with risks to financial stability. Negative real 15394.

lending rates imply that also banks without a sustain- Corsetti, G., Kuester, K., Meier, A. and G. Mueller (2010a), “Debt

able business model will continue to be supported and Consolidation and Fiscal Stabilization of Deep Recessions.”

100, pp. 41–5.

American Economic Review

compromise the functioning of the interbank money

market. Another problem may arise when insurance Corsetti, G., Kuester, K., Meier, A. and G. Mueller (2010b), “Timing

Fiscal Retrenchment in the Wake of Deep Recessions”, mimeo,

and pension funds, engaged in long-term financial Cambridge University, presented at the International Monetary

Fund Eleventh J Polak Research Conference in Washington D.C.,

obligations, cannot earn the required returns by 4–5 November 2010.

investing in safe securities. This will raise the incentive Corsetti, G., Meier, A. and G. Mueller (2010c), “What Determines

to take on excessive risks. Government Spending Multipliers?”, presented at the conference

‘Global Dimensions of the Financial Crisis’, Federal Reserve Bank of

New York, 3–4 June 2010.

Furthermore, banks that expect low interest rates to European Central Bank (2010), “Euro Area Statistics, Technical

remain at the short end of the term structure have December 2010.

Notes”, Monthly Bulletin,


EEAG Report 2011 Chapter 1

EEAG (2007), CESifo,

The EEAG Report on the European Economy,

Munich 2007,

EEAG (2009), CESifo,

The EEAG Report on the European Economy,

Munich 2009,

EEAG (2010), CESifo,

The EEAG Report on the European Economy,

Munich 2010,

Eggertsson, G. B. and M. Woodford (2003), ‘The Zero Interest-Rate

Bound and Optimal Monetary Policy’, Brookings Papers on Economic

1, pp. 139–211.

Activity 70th Euro-

Euroconstruct (2010), 70th Euroconstruct Summary Book,

construct Conference, 2–3 December 2010.

Reinhart C. and K. Rogoff (2009), This Time is Different. Eight

Princeton University Press, Princeton

Centuries of Financial Folly,


Sinn, H.-W. (2010), “Irland kann sich selbst helfen”, in Handelsblatt,

29 November 2010,


Sturm, J.-E. and T. Wollmershäuser (2008), “The Stress of Having a

Single Monetary Policy”, 2251.

CESifo Working Paper

Appendix 1.A

Forecasting tables

Table 1.A.1 GDP growth, inflation and unemployment in various countries d)

GDP growth CPI inflation Unemployment rate

Share of

total GDP in % in %

in % 2009 2010 2011 2009 2010 2011 2009 2010 2011



EU27 31.9 –4.2 1.8 1.5 0.8 1.9 1.8 9.0 9.6 9.6

Euro area 24.2 –4.0 1.7 1.4 0.3 1.6 1.5 9.5 10.1 10.1

Switzerland 1.0 –1.9 2.7 1.9 –0.7 0.6 0.8 4.3 4.7 4.2

Norway 0.7 –1.4 1.9 2.1 2.3 2.6 2.1 3.2 4.8 4.8

Western and Central Europe 33.6 –4.0 1.8 1.6 0.8 1.9 1.7 8.8 9.5 9.5

United States 27.6 –2.6 2.9 2.3 –0.3 1.6 1.3 9.3 9.7 9.5

Japan 9.8 –6.3 4.4 1.3 –1.4 –0.9 –0.4 5.3 5.8 5.6

Canada 2.6 –2.5 3.2 2.6 0.3 1.8 1.8 8.3 8.7 9.0

Industrialised countries –3.7

(total) 73.6 2.6 1.9 0.1 1.4 1.3 8.4 9.0 8.9

Newly industrialised


Russia 2.4 –7.9 4.4 4.3

China and Hongkong 9.9 8.2 9.7 8.0

India 2.4 6.7 9.3 8.2


East Asia 4.9 0.2 7.2 5.0


Latin America 6.8 –2.1 5.9 3.9

Newly industrialised

countries (total) 26.4 2.5 7.7 6.1

c) –2.1

Total 100.0 4.0 3.0

–1.1 11.8 5.9

World trade, volume

a) Weighted average of Indonesia, Korea, Malaysia, Taiwan, Philippines, Singapore. Weighted with the 2009 levels


of GDP in US dollars. – Weighted average of Argentina, Brasil, Chile, Columbia, Mexico, Peru, Venezuela.


Weighted with the 2009 levels of GDP in US dollars. – Weighted average of the listed groups of countries. –

d) Standardised unemployment rate.

Source: EU, OECD, IMF, National Statistical Offices, 2010 and 2011: forecasts by the EEAG.

61 EEAG Report 2011

Chapter 1 Table 1.A.2 GDP growth, inflation and unemployment in the European countries

a) b)

GDP growth Inflation Unemployment rate

Share of total in % in %

GDP in % 2009 2010 2011 2009 2010 2011 2009 2010 2011

Germany 20.4 –4.7 3.7 2.4 0.2 1.2 1.8 7.5 6.9 6.2

France 16.3 –2.5 1.5 1.4 0.1 1.7 1.4 9.5 9.8 9.9

Italy 12.9 –5.0 1.0 1.0 0.9 1.7 1.3 7.9 8.5 8.3

Spain 8.9 –3.6 –0.2 0.6 –0.2 1.7 0.9 18.1 20.1 21.3

Netherlands 4.8 –3.9 1.7 1.7 1.0 1.0 1.4 3.7 4.5 4.3

Belgium 2.9 –2.8 2.0 1.6 0.0 2.3 1.6 7.9 8.4 8.9

Austria 2.3 –3.9 2.0 1.8 0.4 1.6 1.9 4.9 4.7 4.3

Greece 2.0 –2.3 –4.3 –3.2 1.3 4.7 1.7 9.5 12.4 15.5

Finland 1.4 –8.0 2.9 2.7 1.6 1.7 2.2 8.2 8.4 8.0

Ireland 1.4 –7.6 –0.5 0.0 –1.7 –1.6 0.0 11.9 13.5 14.8

Portugal 1.4 –2.6 1.7 –0.3 –0.9 1.4 0.9 9.6 10.9 11.1

Slovakia 0.5 –4.8 4.0 3.2 0.9 0.7 2.3 12.0 14.5 14.0

Slovenia 0.3 –8.1 0.9 1.8 0.9 2.1 2.5 5.9 7.2 7.0

Luxembourg 0.3 –3.7 2.5 2.2 0.0 2.8 2.1 5.1 4.7 4.7

Cyprus 0.1 –1.7 0.6 1.1 0.2 2.6 2.4 5.3 6.8 7.2

Estonia 0.1 –13.9 2.2 3.7 0.2 2.7 3.2 13.8 17.5 16.0

Malta 0.0 –2.1 3.4 2.3 1.8 2.0 2.4 7.0 6.8 6.4

c) 76.1

Euro area –4.0 1.7 1.4 0.3 1.6 1.5 9.5 10.1 10.1

United Kingdom 13.3 –4.9 1.4 1.1 2.2 3.2 2.7 7.6 7.9 8.2

Sweden 2.5 –5.1 5.0 3.4 1.9 1.9 2.0 8.3 8.4 7.5

Denmark 1.9 –5.2 2.2 1.9 1.1 2.2 2.5 6.0 7.4 6.6

c) 93.8

EU20 –4.2 1.8 1.5 0.6 1.8 1.7 9.1 9.6 9.7

Poland 2.6 1.7 3.8 4.2 4.0 2.7 2.9 8.2 9.6 9.2

Czech Republic 1.2 –4.1 2.4 2.3 0.6 1.2 1.9 6.7 7.2 7.0

Romania 1.0 –7.1 –2.0 1.0 5.6 6.0 5.1 6.9 8.3 8.7

Hungary 0.8 –6.7 1.0 2.4 4.0 4.7 4.1 10.0 11.0 10.7

Bulgaria 0.3 –4.9 –0.1 2.4 2.5 3.0 2.9 6.8 9.8 9.4

Lithuania 0.2 –14.7 0.3 2.9 4.2 1.1 2.1 13.7 18.1 17.5

Latvia 0.2 –18.0 –0.9 2.8 3.3 –1.2 1.0 17.1 20.9 18.6

d) 6.2

New members –3.3 1.8 2.9 3.5 3.0 3.1 8.2 9.8 9.6

c) 100.0

EU27 –4.2 1.8 1.5 0.8 1.9 1.8 8.9 9.6 9.6

a) b) c)

Harmonised consumer price index (HCPI). – Standardised unemployment rate. – Weighted average of the


listed countries. – Weighted average over Poland, Czech Republic, Romania, Hungary, Bulgaria, Lithuania, Latvia.

Source: EUROSTAT, OECD, IMF, 2010 and 2011 forecasts by the EEAG.

Table 1.A.3 Key forecast figures for the EU27

2008 2009 2010 2011

Percentage change over previous year 1.5



Real gross domestic product 0.5 1.1



Private consumption 0.7 –0.2



Government consumption 2.3 2.9



Gross fixed capital formation –0.8

a) 0.4



Net exports 0.2

b) 1.8




Consumer prices Percentage of nominal gross domestic product


Governmental fiscal balance –2.3 –6.8 –6.8 –5.1

Percentage of labour force


Unemployment rate 7.0 8.9 9.6 9.6

a) b)

Contributions to changes in real GDP (percentage of real GDP in previous year). – Harmonised consumer price

c) d)

index (HCPI). – 2010 and 2011: forecasts of the European Commission. – Standardised unemployment rate.

Source: EUROSTAT, 2010 and 2011 forecasts by the EEAG.


EEAG Report 2011 Chapter 1

Table 1.A.4 Key forecast figures for the euro area

2008 2009 2010 2011

Percentage change over previous year 1.4



Real gross domestic product 0.3 0.8



Private consumption 0.4 –0.1



Government consumption 2.3 2.5



Gross fixed capital formation –1.0

a) 0.5



Net exports 0.1

b) 1.5




Consumer prices Percentage of nominal gross domestic product


Governmental fiscal balance –2.0 –6.3 –6.3 –4.6

Percentage of labour force


Unemployment rate 7.5 9.5 10.1 10.1

a) b)

Contributions to changes in real GDP (percentage of real GDP in previous year). – Harmonised consumer price

c) d)

2010 and 2011: forecasts of the European Commission. – Standardised unemployment rate.

index (HCPI). –

Source: EUROSTAT, 2010 and 2011 forecasts by the EEAG.

63 EEAG Report 2011

Chapter 1 economic indicators. It has proved to be a useful tool,

Appendix 1.B since economic changes are revealed earlier than by

Ifo World Economic Survey (WES) 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

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

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

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

country. This allows for a rapid, up-to-date assess- tive answers prevail or that a majority expects trends

ment of the economic situation prevailing around the to increase, whereas grades within the range of 1 to

world. In January 2011, 1,117 economic experts in 5 reveal predominantly negative replies or expecta-

119 countries were polled. WES is conducted in co- tions of decreasing trends. The survey results are pub-

operation with the International Chamber of lished as aggregated data. The aggregation procedure

Commerce (ICC) in Paris. is based on country classifications. Within each coun-

try group or region, the country results are weighted

The survey questionnaire focuses on qualitative infor- according to the share of the specific country’s

mation: on assessment of a country’s general eco- exports and imports in total world trade.

nomic situation and expectations regarding important



World USA

Economic situation

Economic situation good/

good/ by the end of the


better at present

by the end of the next 6 months

next 6 months satisfactory/

satisfactory/ about

about the same

the same at present bad/

bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. Japan Asia

Economic situation Economic situation

good/ good/

better better

by the end of the by the end of the

next 6 months next 6 months

satisfactory/ satisfactory/

about about

the same the same

at present at present


bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. 64

EEAG Report 2011 Chapter 1

Latin America


Economic situation Economic situation


good/ Kazakhstan, Kyrgyzstan, Russia, Ukraine, Uzbekistan better

better by the end of the

next 6 months

satisfactory/ satisfactory/

about about

the same by the end of the the same

next 6 months at present

at present

bad/ bad/

worse worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Ifo World Economic Survey (WES) I/2011. Source: Ifo World Economic Survey (WES) I/2011.

European Union (15) Eastern Europe

Economic situation

Economic situation good/

good/ better

better by the end of the

next 6 months by the end of the

next 6 months

satisfactory/ satisfactory/

about about

the same the same at present

at present

bad/ bad/

worse worse

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Ifo World Economic Survey (WES) I/2011. Source: Ifo World Economic Survey (WES) I/2011.


Germany: Ifo business climate France

Seasonally adjusted data Economic situation


120 120 good/ by the end of the


Ifo business climate

115 115 next 6 months

110 110

Business expectations

105 105 satisfactory/

100 100 about

95 95 the same

90 90

85 85 at present

Assessment of business situation

80 80 bad/


75 75

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

a) Manufacturing industry, construction, wholesale and retail trade. Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo Business Survey, January 2011. 65 EEAG Report 2011

Chapter 1 United Kingdom

Italy Economic situation

Economic situation good/

good/ better

better by the end of the at present

next 6 months satisfactory/

satisfactory/ about

about the same

the same at present by the end of the

next 6 months


bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. Sweden

Spain Economic situation

Economic situation good/

good/ better

better at present

at present satisfactory/

satisfactory/ about

about the same

the same by the end of the by the end of the

next 6 months next 6 months


bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. Finland Austria

Economic situation Economic situation

good/ good/

at present

better better by the end of the

next 6 months

satisfactory/ satisfactory/

about about

the same the same

by the end of the

next 6 months at present

bad/ bad/

worse worse

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Ifo World Economic Survey (WES) I/2011. Source: Ifo World Economic Survey (WES) I/2011.


EEAG Report 2011 Chapter 1


Belgium Economic situation

Economic situation good/

good/ at present


by the end of the

better next 6 months satisfactory/

satisfactory/ about

about the same

the same by the end of the

at present next 6 months


bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. Ireland

Greece Economic situation

Economic situation

good/ good/

better better at present

satisfactory/ satisfactory/

about about

the same the same

by the end of the

next 6 months by the end of the

next 6 months

at present

bad/ bad/

worse worse

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Ifo World Economic Survey (WES) I/2011. Source: Ifo World Economic Survey (WES) I/2011.

Netherlands Portugal

Economic situation Economic situation

good/ good/

by the end of the by the end of the

better better

next 6 months next 6 months

satisfactory/ satisfactory/

about about

the same the same

at present

bad/ at present


worse worse

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Ifo World Economic Survey (WES) I/2011. Source: Ifo World Economic Survey (WES) I/2011.

67 EEAG Report 2011

Chapter 1 Hungary

Slovenia Economic situation

Economic situation good/

good/ better

better at present by the end of the

next 6 months

satisfactory/ satisfactory/

about about

the same the same at present

by the end of the

next 6 months

bad/ bad/

worse worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. Czech Republic


Economic situation Economic situation

good/ good/ by the end of the

better better next 6 months

by the end of the

next 6 months

satisfactory/ satisfactory/

about about

the same the same at present

at present

bad/ bad/

worse worse

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Ifo World Economic Survey (WES) I/2011. Source: Ifo World Economic Survey (WES) I/2011. Estonia

Slovak Republic Economic situation

Economic situation good/

good/ better

better at present

by the end of the

next 6 months satisfactory/

satisfactory/ about

about the same by the end of the

the same next 6 months

at present bad/

bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. 68

EEAG Report 2011 Chapter 1


Latvia Economic situation

Economic situation good/

good/ better

better at present

by the end of the

next 6 months by the end of the

at present next 6 months


satisfactory/ about

about the same

the same bad/

bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. Romania

Bulgaria Economic situation

Economic situation good/

good/ better

better by the end of the

next 6 months by the end of the

next 6 months


satisfactory/ about

about the same

the same at present at present


bad/ worse

worse 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Ifo World Economic Survey (WES) I/2011.

Source: Ifo World Economic Survey (WES) I/2011. 69 EEAG Report 2011

Chapter 2

EEAG (2011), "A New Crisis Mechanism for the Euro Area", CESifo, Munich 2011, pp. 71–96.

The EEAG Report on the European Economy, the EU regime, for up to a total of 440 billion euros.


EW RISIS ECHANISM Of this amount, Germany and France guarantee up


FOR THE URO REA to 147.4 and 110.7 billion euros, respectively. The pre-

requisite is unanimity in the diagnosis of impending

insolvency among the aiding countries and the IMF.

2.1 The European debt crisis Under Article 122 TFEU (natural disaster para-

The European debt crisis followed the US financial graph), additional loans for up to 60 billion euros may

crisis with a delay of one and a half years. While its be granted directly via the European Commission.

first signs were visible in November and December of The German and French contributions to these loans

2009 when the rating agency Fitch downgraded are also included in Table 2.1, on the basis of the con-

Ireland and Greece, it culminated on 28 April 2010 tributions by these countries to the total EU budget in

when the intra-day interest rate for two-year Greek 2009.

government bonds peaked at 38 percent. Since then

capital markets have been extremely unstable, show- In addition, the table accounts for the contributions

ing signs of distrust in the creditworthiness of the that Germany and France indirectly grant through the

GIPS countries: Greece, Ireland, Portugal and Spain. IMF, in proportion to their respective ownership

The European Union reacted by preparing volumi- shares. Germany, for example, contributes 6 percent

nous rescue plans that, at this writing (January 2011), or 14.9 billion euros via this channel. Of the partly

have been resorted to by Greece and Ireland. disbursed loans to Greece, the country bears a share

2.1.1 The rescue measures of Table 2.1

May 2010 Amounts of liability (in billion euros)

Country Germany France

Between 7 and 9 May 2010, the alliance

EU countries agreed on an exten- EFSF 440 147.4 110.7

sive rescue package targeted on EFSM 60 11.3 11.1

IMF aid (parallel to EFSM und

fiscally distressed countries in the EFSF) 250 14.9 12.3

euro area. At the same time, the EU aid Greece 80 22.3 16.8

ECB, referring to Article 123 IMF aid Greece 30 1.8 1.5

TFEU (Treaty on the Function- ECB government bond

Purchases (14 January 2011) 76 20.7 15.5

ing of the European Union), Total 936 218.5 167.9

began to purchase government Notes: 1st line: ECB capital quotas (euro area without Greece), raised

bonds of distressed countries. by 20 percent. 2nd line: Share in EU budget 2009. 3rd line: current IMF

Table 2.1 presents an estimate of capital quota (5.98 percent for Germany and 4.94 percent for France).

total financial commitments, 4th line: ECB capital quota (euro area without Greece). 5th line: like

line 3. 6th line: ECB capital share (euro area).

including ECB interventions, dis- Sources: EFSF Framework Agreement, 7 June 2010, www.bundes-

entangling the amounts of liabil-, 5 July 2010; EU, The European Stabilization

ities to be borne by Germany and Mechanism, Council Regulation (EU) No. 407/2010 of 11 May 2010

France, the two biggest guaran- establishing a European financial stabilisation mechanism, www.eur-

tors of the system., 7 July 2010; European Commission, EU Budget, 2009

Financial Report (Luxembourg 2010), p. 62; ECB, 1 January 2009 –

As part of the European Finan- Adjustments to the ECB´s Capital Subscription Key and the Contribution

Paid by Slovakia, Press release 1 January 2009; ECB, Consolidated

cial Stability Facility (EFSF), Record of the Eurosystem, several press releases,; IMF,

which was set up as a special pur- Updated IMF Quota Data – June 2010,, 5 July 2010. Ifo

pose entity in Luxembourg, cred- Institute calculations.

it aid is made available, outside 71 EEAG Report 2011

Chapter 2 crisis, have they been again drifting apart, as can be

of 28 percent (ECB quota) and 6 percent of the par- seen on the right-hand edge of the graph. In 1995, the

allel IMF aid for Greece, according to its IMF quota. weighted average of the Spanish, Portuguese and

The corresponding shares for France are 21 percent Italian bond rates were exactly 5 percent above the

and 4.9 percent. German rate, because the buyers of these bonds want-

ed to be compensated for the combined risk of depre-

By the same token, these two countries participate in ciation and default. The convergence phase began

the ECB government bond purchases, amounting to around 1996, when the Stability and Growth Pact was

76 billion euros, according to their respective quotas agreed upon, and expectations grew that the euro was

in the ECB capital. These are potential liabilities, for imminent and the exchange rate risk would vanish.

which, if the bonds end up not being serviced, the During this phase, the vanishing depreciation risk was

ECB will suffer write-downs that will reduce the associated with a vast underpricing of default risk.

seignorage dividends paid to the finance ministers of This phase ended in autumn 2008, when after the

the euro-area countries or force the ECB to demand a demise of Lehman Brothers, doubts about the credit-

capital increase. worthiness of individual European countries


As a consequence of the decisions of the ECB and the

EU countries of 7 to 9 May 2010, by January 2011 Investors recognised that the euro did not (and could

Germany’s potential liabilities amounted to 218.5 bil- not) guarantee that the interest payments promised to

lion euros and France’s liabilities to 167.9 billion investors would actually be paid in full by the debtors,

euros (out of 936 billion euros in total). and started to revise their assessment of default risk

of bonds issued by different governments. In a well-

As a special purpose entity, the life of the EFSF was functioning capital market, of course, default risk

initially limited until 30 June 2013. Of course, loans must be compensated for with an interest surcharge,

given before June 2013 could have been brought to since the expected interest payment is below the rate

maturity, de facto extending the effects of the EFSF agreed in the loan contract, as a function of the prob-

beyond its initial statutory end-point (the maturity of ability and the size of default.

the EFSF loans is not officially restricted). However,

on 17 December the EU countries agreed to extend The rescue actions agreed between 7 and 9 May 2010

the EFSF indefinitely under a new name and with were initially successful in reducing the interest spreads,

new governance rules and not to use the EFSM at all. but their success was short-lived. The political and insti-

This will be discussed below in Section tutional context of the rescue could do nothing but feed

Similarly the activities by the ECB have no official fundamental doubts about the credibility and the over-

time-limit constraint. This will be discussed in all extent of the commitment by EU countries. In any

Section 2.6.2. case, actions were limited to a three-year intervention

2.1.2 Interest spreads Figure 2.1

The extensive rescue measures %


were caused by rapidly rising 19 Jan.

Interest rates for 10-year 7 May


interest spreads on government government bonds Greece

28 April


bonds, as shown in Figure 2.1. Ireland


This figure reports interest rates Portugal


on 10-year government bonds of Spain



several euro-area countries France

% Germany

14 2

before and after the introduction 2008 2009 2010 2011

Introduction of

12 euro cash Greece

of the euro. It is evident that Italy

interest rates were widely dis- Introduction of

10 virtual euro Ireland

persed before the plan to create 8 Greece

the euro became completely cred- Portugal

6 Spain

ible, between 1996 and 1997, at Italy

4 Belgium

Irrevocably fixed

which point they converged France

exchange rates Germany Finland



rapidly and sharply. Only after 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2007, as a result of the financial Government Benchmarks Bid 10 year yield close

Source: Reuters Ecowin, , , , , , 20 January 2011.


EEAG Report 2011 Chapter 2

horizon. Even if fully credible, Figure 2.2

they could not really protect Prices of selected government bonds

10-year bonds. When investors a)

Prices of the first notation

120 Germany at the Frankfurt Stock

realised the deficiencies in the res- 110 Exchange=100


cue plan, spreads increased again 100 Italy


and on many days even rose above 90 Portugal

the level reached before the agree- 80 b)


ment of the EU countries. On 70 120 Greece

28 April 7 May 19 January

Friday, 7 May 2010, the average Germany

60 January 2010 April 2010 July 2010 October 2010 January 2011

110 France

interest spread over Germany’s for Italy


the countries protected by EFSF Spain

(all euro-area countries except 90 Portugal

Greece, weighted by the GDP of 80 b)

the respective country) amounted Ireland


to 1.08 percentage points. There- Greece

19 January


after, the average spread declined 2010

2006 2007 2008 2009 2011

for several weeks, but as early Note: Monthly moving average of daily closing prices of selected government bonds with 10-year maturity and an annual coupon payment

from the emissions in 2006 (upper left diagram: daily closing prices without smoothing). Trading place: Frankfurt Stock Exchange. Some

datapoints for which no prices could be identified have benn interpolated.

as June it had increased again to a) for the French bond: emission rate on 7-2-2006=100.

b) 16-year term and issue 2004.

1.10 points. In September it aver- Codes and Sources: Greece: ISIN GR0124028623, Hellenic Republic, Ministry of Finance, Portugal: ISIN

PTOTE6OE0006, Portuguese Treasury and Government Debt Agency, Ireland: ISIN IE0034074488, National Treasury

aged 1.08 points, and in Novem- Management Agency, Spain: ISIN ES00000120J8, Tesoro Público, Italy: ISIN IT0004019581, Dipartimento

del Tesoro, www.dt.tesoro.ti. Germany: ISIN DE0001135309, Bundesrepublik Deutschland, Finanzagentur GmbH, www.deutsche-

ber 1.27 points. These spread lev- France: ISIN FR0010288357, Agence France Trésor, Development at stock exchanges Frankfurt: Calculations by the Ifo Institute.

els are way above those experi-

enced during the initial, stable

period of the euro. In this initial 30 percent; longer-term Portuguese and Irish bonds

phase, the average spread was only 0.4 percentage were traded at discounts of about 10 percent. A few

points. Thus, relative to this early benchmark the new months later, the discounts on the Greek, Portuguese

spread levels were considered as an ominous crisis. and Irish bonds were substantially higher. By No-

vember 2010, the discounts on Irish bonds were

However, at no time were the spreads even close to approaching 25 percent.

those of 1995, i.e. before the final negotiations on the

introduction of the euro. That year the spread over The losses caused Ireland to be the first country to

Germany of the countries protected by EFSF had apply for help from the EFSF in November 2010.

averaged 2.60 percentage points. That was consider- This was clearly a relief both for commercial banks

ably higher than the peak in 2010, and more than dou- and for Ireland, as the country could then save on

ble the average spread on 7 May (1.08 points), when interest payments on newly issued government debt

the rescue packages were quickly assembled on the and keep its rescue promises. Against an ongoing

grounds that this was the only way to prevent a sys- market rate of interest between 8.3 percent and

temic crisis. 9.4 percent charged by private investors on Irish gov-

ernment bonds with a maturity of 5 to 10 years,

towards the end of November Ireland was given the

2.1.3 Who was hit and who has been rescued (so far)? opportunity to borrow funds with a similar maturity

from the EFSF at the substantially lower rate of

The large and volatile interest spreads emerging in 5.8 percent. It is debatable whether Ireland really

2010 in the euro area were considered particularly was in a crisis that justified the help from the rescue

dangerous not only because they sharply raised bor- funds. After all, Ireland has very low labour taxes in

rowing costs in many countries but also because a comparison to other EU countries that it could eas-

substantial share of the troublesome debt was held by ily have increased to solve the country’s liquidity

commercial banks in core European countries, which problems without jeopardizing the country’s own

thus found themselves potentially exposed to large “business model” explicitly based on low corporate

losses. As shown in Figure 2.2, the potential magni- (not low labour) taxes.

tude of the write-off losses was quite large. On 7 May

2010 10-year Greek bonds, issued four years before The ownership of government bonds issued by the

the crisis, were traded at a discount of more than crisis countries is shown in Figure 2.3, aggregating

73 EEAG Report 2011

Chapter 2 ernment securities from virtuous

Figure 2.3 countries is not available. How-

Claims of foreign banks on the public sectors ever, a back-of-the-envelope cal-

of Greece, Ireland, Portugal and Spain (GIPS) culation based on the informa-

End-Q1 2010, billion euros tion in Figure 2.2 suggests that

France aggregate capital gains on Ger-

Germany man and French government

Other euro area bonds were twice as large as the

United Kingdom aggregate capital losses on the

Japan Greece bonds issued by the GIPS coun-

United States Ireland tries – accounting for the fact that


Spain the outstanding stock of debt


Rest of World issued by Germany and France is

Italy about three times as large.


0 20 40 60 80

Source: Bank for International Settlements, BIS Quarterly Review, September 2010, p. 16. In addition, it may well be that

during the crisis aggressive in-

vestors laid the foundations for

data by banks’ nationality. France is clearly leading considerable profits. Whoever purchased bonds of the

the league. The French banking system went scot-free GIPS countries at very low prices at the peak of the

through the first wave of the financial crisis because it European debt crisis is bound to enjoy considerable

had invested relatively little in structured US securi- capital gains if rescue packages end up offering full

ties. Whereas German banks had lost almost one protection to their investments. On Greek bonds, for

quarter (23.9 percent) of their equity by 1 February instance, investors’ profits could amount up to 50 per-

2010 due to write-downs on financial products, the cent of their investment if the rescue packages of May

corresponding loss by French banks amounted to 2010 are extended indefinitely and unlimited – bring-


only one tenth (10.5 percent). However, the French ing the prices of these bonds back to the neighbour-

banking system was much more exposed to the hood of par.

European debt crisis. Before the rescue operations, the

stock of government bonds issued by GIPS countries

held by the French banking system was 55 percent 2.2 Monetary unification, capital flows and housing

bigger than that of German banks when measured in bubbles: an interpretation of the events

euros. In relation to GDP it was actually 95 percent

bigger. To fully understand the nature of the crisis and the

implications of alternative rescue strategies, it is

The key question is of course the extent to which the important to have a clear picture of how the intro-

banking systems of countries exposed to the duction of the euro affected the economies of the

European debt crisis were actually put at risk by the countries that adopted the new currency. With the cre-

large write-off losses on government bonds. It turns ation of the euro, for the first time in history there was

out that the answer to this question is far from obvi- a true European capital market, freed from the burden

ous. The reason is that commercial banks in core of currency risks. By demolishing the barriers

European countries typically hold a large amount of between the capital markets, a common currency in a

bonds issued by their own governments, which, as an single market allowed capital to flow almost friction-

effect of the crisis, generated huge capital gains. lessly from rich to poor countries. This speeded up the

During the financial turmoil, in fact, the flight to convergence process, boosting the growth of the

quality not only raised the spread charged to crisis countries that had previously lagged behind.

countries; it also reduced the level of interest rates

that markets charged to virtuous countries. As shown

in Figure 2.2, capital gains on bonds issued by coun- 2 By the end of 2009 the outstanding stock of German government

tries in good fiscal standing were on the order of bonds was 1.76 billion euros, that of France 1.49 billion euros, of

10 percent relative to the par values. Unfortunately, Spain 0.56 billion euros, of Greece 0.30 billion euros, of Ireland

0.10 billion euros and of Portugal 0.13 billion euros. If their respec-

detailed information on the banks’ holdings of gov- tive appreciation and depreciation relative to their nominal values

was the same as those considered in Figure 2.2 for the end of

November 2010, the government bonds of Germany and France had

a value of 316.1 billion euros above and those of the GIPS countries

1 a value of 148.6 billion euros below their emissions volumes.

Sinn (2010a), p. 177, Figure 8.6. 74

EEAG Report 2011 Chapter 2

Ireland the boom was so large

Figure 2.4 that it triggered a wave of immi-

Economic growth in selected euro-area countries gration which in part relaxed the

Chain linked volumes at 2000 prices, Index 1995=100

170 supply constraint on construc-


Ireland tion services. At the same time,



160 (growth 1995-2009) rising house prices not only made

Spain owners of real estate richer; it

150 50.2% also provided them with more

Netherlands equity capital against which they


140 could borrow even more. Foreign

Portugal Euro area

29.5% 29.5%

130 funds flowed abundantly into


27.4% these countries to finance new



120 16.2% enterprises, within and outside

29.2% the construction sector.


110 11.4% The sustained rise in house

100 1995 1997 1999 2001 2003 2005 2007 2009 prices, however, also fuelled

Economy and Finance, National Accounts,

Source: Eurostat, Database, 14 January 2011; Ifo Institute calculations. expectations of persistent appre-

ciation, way beyond what could

Figure 2.4 shows that from 1995 to 2009 Ireland grew have been reasonably predicted based on fundamen-

by 105 percent, Greece by 56 percent and Spain by tals. What could have evolved as a healthy conver-

50 percent, while the euro area on average was grow- gence process deteriorated into mispricing and turned

ing by 30 percent. Portugal matched the average of into a bubble that ultimately burst, leading to the cur-

the euro area. Germany and Italy, on the other hand, rent debt crisis. The development of house prices in

grew only by 16 percent and 11 percent, respectively. selected countries is shown in Figure 2.5. House prices

The two countries were the laggards not only of the typically grew much faster than GDP (see Chapter 4,

euro area but of Europe as a whole, including all Figures 4.5 and 4.6).

countries up to the Russian border. Households’ expenditure plans were driven by expec-

The creation of the common capital market not only tations of sustained high real growth, and they kept

led to the sharp interest rate convergence shown in borrowing under the mistaken belief that their real

Figure 2.1, it also fostered the creation of new seg- income would at least keep up with their rising inter-

ments of the capital market that formerly did not est bill. Except for Ireland, aggregate savings rates

exist. By way of example, in

Spain before the euro it was Figure 2.5

impossible to obtain fixed-rate House prices

loans with 20-year maturity. Over Index Q1 2006=100


long maturities, interest rates

were variable and, most impor- Germany

tantly, extremely high. With the 100

euro, rather abruptly, long-term a)

United Kingdom

loans at fixed interest rates

became widely available, at rates 80

that were strikingly lower than Italy

before, both in nominal and real 60

terms (see Chapter 4, Figure 4.4) Maximum price decline after the peak

The opportunity to borrow for France Ireland -38%

Spain United Kingdom -17%

long durations at low rates 40 Spain -13%

fuelled the real estate market, France -10%


generating a housing boom 20

which in turn created new jobs 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


and raised incomes. Spain went England and Wales.

House Price Index Permanent TSB/ESRI House

Source: Land Registry, ; The Economic and Social Research Institute; Irish Economy,

through a period often called the Price Index Statistical Data Warehouse - Residential property price indicator

; European Central Bank, ; Federal Statistical Office,

GENESIS database ( Statistical Appendix - Economic Bulletin no. 53

Wiesbaden 2010); Banca d`Italia, , July 2009; INSEE France,

“Golden Decade”. In Spain and loaded with EcoWin, 20 January 2011.

75 EEAG Report 2011

Chapter 2 28 percent. Diverging inflation

Figure 2.6 rates gradually improved the


Price developments 1995-2009 competitiveness of the German

% economy and undermined that of

Slovenia 115 the GIPS countries. Moreover,

Slovakia 80

Greece 67 the stagnation caused by the cap-

Spain 57 ital exports that were to a large

Cyprus 51

Portugal 48 measure induced by the euro kept

Ireland 47 imports down. This resulted in

Italy 44 growing current account imbal-

Luxemburg 43

Netherlands 37 ances in the euro area, which,

Euro area 28 comparing Germany with the

Belgium 26

France 25 GIPS countries, eventually grew

Finland 21 to the order of 200 billion euros a

Austria 19 year, as shown in Figure 2.7.

Germany 12

0 20 40 60 80 100 120 French finance minister Christine

a) GDP deflator.

Economy and Finance, National accounts,GDP and main components - Price indices

Source: Eurostat, Database, , 30 Lagarde and others argued in this

November 2010; Ifo Institute calculations. context that Germany was taking

advantage of the currency union,

dropped sharply in the GIPS countries, and became bearing a substantial responsibility for this develop-

even negative in Greece and Portugal, approaching ment. “It takes two to tango”, she said.

minus 12 percent and minus 8 percent respectively rel-

ative to GDP in 2009 (see Chapter 3, Figure 3.11). While the tango analogy is certainly a correct descrip-

tion of what happened, its moral connotation is mis-

As high demand created persistent overheating in leading as it overlooks the mechanisms that brought

these economies, rapidly rising wages and prices soon the divergences about. Namely, it overlooks the fact

undermined competitiveness, especially in those coun- that Germany’s depreciation was the result of a slump

tries that had enjoyed the greatest benefits from the of its economy, making Germany the laggard of

interest rate convergence. Figure 2.6 shows the rate of Europe, creating mass unemployment and raising the

growth of the GDP deflator in selected euro-area need for far-reaching reforms of the social system.


countries in the 14 years from 1995 to 2009. It is These reforms were aimed at taking away rights of the

apparent that Greece, Spain, Ireland and Portugal unemployed, which at that time were perceived as per-

increased their prices much faster than the average of manent entitlements. They were painful enough to

the euro-area countries. In trade-weighted terms the terminate a government and ignite an arduous politi-

real appreciation was 23 percent relative to their trad- cal discourse, which placed great strains on society.

ing partners. From a foreign trade perspective, had These recent economic and political developments in

national currencies still been in

place, this would be equivalent to

a sizeable nominal currency ap- Figure 2.7

preciation for unchanged prices. Net capital exports = current account balance

billion euros

Conversely, relative to its euro 200

trading partners, Germany Germany

underwent an internal real depre- 100

ciation as large as 18 percent – its

domestic price development 0

being compounded by those Sum of Greece, Ireland

(with an opposite sign) in the Portugal and Spain

GIPS countries. Relative to the -100

GIPS countries only, indeed,

Germany’s prices depreciated by -200 1995 1997 1999 2001 2003 2005 2007 2009

Note: No data published for Ireland and Spain until 1998.

Source: Eurostat, Database, Economy and Finance, Balance of payments - International transactions,

Balance of payments by country, 13 December 2010, Ifo Institute calculations.

3 See Sinn (2003). 76

EEAG Report 2011 Chapter 2

Germany hardly square with the notion of a country 11 percent, Spain 9 percent and Ireland about 4.5 per-

that had benefited from the euro more than others. cent. Only Ireland and Spain have now managed to


reduce this deficit significantly.

Germany recorded the second-lowest growth rates in

Europe and experienced a deflation of the real estate In line with this interpretation, Figure 2.8 provides an

market. A country drawing particular profits from the updated picture of capital flows in and out of the

euro can hardly be expected to fall from the third to euro-area countries along with long-term net invest-

the tenth rank in GDP per capita terms, as Germany ment rates, totalling up both private and public invest-

did in the period from 1995 to 2009. ment. The figure shows that investment is bigger in

capital importing countries: obviously these countries

The tango analogy also overlooks the fact that the had abundant and cheap funds to nourish high invest-

current account balance is the mirror of the capital ment rates. By contrast, Germany had the lowest rate

balance. By definition, a current account surplus is a of all European countries. In fact, in the period from

net capital export and a deficit is a net capital import, 1995 to 2008 Germany had the lowest net investment

as capital and goods flows balance out. Both the cur- share of all OECD countries, while being the world’s

rent account and the capital balance are determined second largest capital exporter after China. German

simultaneously in the economy. Sometimes the goods- banks collected domestic savings and invested them

flows take the lead and determine the capital flows as elsewhere in the world, including the GIPS countries,

residuals, as is described in conventional models of the United Kingdom and of course the United States.

the business cycle. Sometimes, however, the capital From 2002 to 2009, Germany had aggregate savings

flows determine the goods flows via supply-side (net savings by households, firms and government) of

effects. Due to the perceived reduction of uncertainty 1,621 billion euros. While this was the amount of

surrounding the introduction of the euro and the money available for net investment in equipment,

interest convergence this brought about, the capital buildings, homes, roads and other public infrastruc-

flows dominated the goods flows in the first few years ture, in fact only one third – 562 billion euros – was

in the life of the new currency. The interest conver- invested at home. Two thirds – 1,058 billion euros –

gence implied a huge capital export from the German was exported to other countries. Four fifths of this

economy into the economies of the GIPS, which over- capital export was financial investment and one fifth

heated the latter and cooled down the former. The was direct investment.

overheating reduced the competitiveness of the GIPS

countries via a real appreciation, while imports surged While these patterns in principle also characterize a

in line with real incomes. In Germany, by contrast, the fundamentally stable convergence process,

5 our analy-

cooling of the economy improved the competitiveness sis above suggests reasons to believe that the observed

via depreciation, while low growth rates slowed down imbalances were ultimately excessive and led to a vast

imports. misallocation of resources. Abundance of cheap

funds brought a period of “soft budget constraints”

While the interest convergence resulting from the to capital-importing countries, to cite a concept that

introduction of the euro quickly triggered an invest- Janós Kornai once used to predict the fall of

ment boom in the GIPS countries, it took, as always, 6

Communism. The soft budget constraints meant that

a few years until the current accounts reacted suffi- a credit-fuelled internal boom was spreading from the

ciently to actually result in net capital inflows (J-curve construction industry to the entire economy, pushing

effect). Before imports could rise, the interest-driven wages, prices and incomes from the provision of non-

expansion of real and nominal incomes had to take traded goods above the level sustainable in the long-

place. And export quantities could only react after the run, creating the bubble that ultimately resulted in the

rise in export prices, which itself resulted from the

wage increases that the economic boom brought

about (with ambiguous implications for export val- 4 While in the case of Greece, Portugal and Spain, the current

account deficit went along with substantial trade deficits, Ireland is

ues). Nevertheless, the pressure of the desired capital an exception inasmuch as it always maintained a trade surplus.

However, as Ireland had already imported very much capital in ear-

flows eventually opened the current account deficits lier years, it had to pay substantial interest and profit income to for-

in a measure necessary to actually allow for net capi- eigners, which also needed to be financed with capital imports, pri-

marily with directly “imported” capital in the form of profit reten-

tal inflows. In the years preceding the crisis, all GIPS tions of existing foreign firms operating in Ireland.

5 For a formal analysis and prediction of these developments in the

countries developed sizeable net capital imports. In sense of a beneficial convergence process, see Sinn and Koll (2001).

A less optimistic analysis of the same theme 10 years later can be

the years from 2005 to 2008, Greece had a current found in: Sinn (2010b).

account deficit of about 12 percent of GDP, Portugal 6 Kornai (1980).

77 EEAG Report 2011

Chapter 2 realised. This was indeed the

Figure 2.8 Net capital imports (-) and exports (+) (left) and main lesson from the crisis in the

net investment shares (right), 1995-2008 East Asian countries in 1997–98.

Economies that were apparently

15 10 5 0

Luxembourg* Germany

9.4 5.2 sound in regard to their public

Finland Finland

5.5 5.8 and external outlook before the

Netherlands Italy

5.5 6.5

Belgium* Malta

2.9 6.8 crisis, succumbed to large specu-

Germany Belgium

2.3 7.0 lative flows against their assets

Austria Netherlands

0.8 7.1

France France

0.6 8.1 and currencies, driven by the in-

Italy Austria

-0.5 9.8 vestors’ realisation of the large

Slovenia Portugal

-2.1 10.3

Ireland** Greece implicit commitment by the pub-

-2.4 10.9

Slovakia** Luxembourg

-6.0 11.0 lic sector.

Malta Cyprus

-6.1 11.0

Spain** Slovakia

-6.4 11.3

Cyprus** Slovenia

-7.1 13.9 The Irish case is, however, a re-

Greece Spain

-7.9 14.9 minder of the strict interconnec-

Portugal Ireland

-8.6 15.6 * 2002-2008

-15 -10 -5 0 5 tion between external, fiscal and

** 1999-2008 financial imbalances. Each crisis

Database, Economy and Finance, National Accounts Database National Accounts

Source: Eurostat, ; OECD, ; Österreichische

Statistik und Melderservice, Leistungsbilanz im Detail

Nationalbank, , 30 September 2010. country has its own mix of imbal-

ances in these three dimensions,

depending on specific circum-

European debt crisis. By the same token, Germany stances. For the euro area as a whole, however, the ques-

suffered from overly tight budget constraints as tion is to make sure that its institutional system can

resources were withdrawn, entering a period of low address potential sources of instability in all of them.

growth rates and near stagnation under the euro,

which ended abruptly when the debt crisis suddenly


changed risk perceptions. 2.3 Excessive public debt despite the Stability and

Growth Pact

The imbalances in the capital-importing countries do

not necessarily take the form of outstanding current In countries that benefited from the capital inflows,

account deficits. Even if Ireland had not had a size- private budget constraints were soft and financial

able current account deficit, mispricing and misallo- intermediaries took on too much risk, arguably cre-

cation might have been dangerous for economic sta- ating hidden public liabilities. But even independent-

bility, if they led to unchecked risk-taking by financial ly of hidden liabilities, governments also showed lit-

intermediaries. If the government does not supervise tle fiscal discipline under the euro, in spite of the

and appropriately regulate financial intermediaries ex

ante but lets them operate with

the expectations of public sector Figure 2.9

guarantees on their balance Debt-to-GDP ratios (left) and surplus-to-GDP ratios (right)

sheets, the resulting imbalance -56 -52 -48 -44 -40 -36 -32 -28 -24 -20 -16 -12 -8 -4 0

0 20 40 60 80 100 120

97 -0.9

Greece Sweden

may also take the form of exces- 140

122 -1.0

Italy Estonia

119 130 -1.8

Belgium Luxembourg

sive risk-taking, which systemati- 99

82 -3.1

Ireland Finland


56 -3.7

cally endangers both public and France Germany


61 -3.8

Portugal Hungary



external solvency ex post, when -3.8

Hungary Bulgaria



51 -4.2

United Kingdom Malta

78 2010

uncertainty about returns is 56 -4.3

Germany Austria


35 -4.8

Malta Belgium



68 -5.0

Austria Italy


76 -5.1

Netherlands Denmark


63 -5.2

Spain Czech Republic


7 Of course these imbalances are not spe- 41 -5.8

Cyprus Slovenia


cific to the euro area – large mispricing in 49 -5.8

Poland Netherlands


the real estate market at the root of the cri- 57 -5.9

Finland Cyprus


15 -7.3

sis was also experienced in Anglo-Saxon Latvia Romania

46 73 -7.3

Denmark Portugal

countries, for instance. See Sinn (2010a) 45

22 -7.7

Slovakia Latvia

and Sinn, Buchen and Wollmershäuser 42 -7.7

Slovenia France


(2010) for a related interpretation. Yet the 15 -7.9

Czech Republic Poland


introduction of the euro in the single mar- 72 -8.2

Sweden Slovakia

40 -3%

ket undoubtedly played a key role in deter- 12 -8.4

Lithuania Lithuania


mining the magnitude of the imbalances. 7 -9.3

Romania Spain


Moreover, consistent with the constitution- -9.6

Bulgaria Greece



al foundations of the euro, as discussed -10.5

Luxembourg United Kingdom


9 -32.3

Estonia Ireland

below, one would expect euro-area coun- 8

tries to have used appropriate policies to -16 -12 -8 -4 0


0 20 40 80 100

avoid the imbalances in the first place. Economic Forecast Autumn 2010.

Source: European Commission, 78

EEAG Report 2011 Chapter 2

Stability and Growth Pact agreed upon in 1996, 9

toothless. The Pact foresaw severe sanctions for vio-

which (following the Maastricht Treaty) imposed a lation of the deficit criterion, involving the breaching

60 percent threshold for the debt-to-GDP ratio and a contry having to put down a non-interest bearing

3 percent threshold for the deficit-to-GDP ratio. deposit equal to 0.2 percent of GDP, convertible into

a fee if the excess deficit persisted for more than two

As Figure 2.9 shows, in nearly all euro-area countries 10

years. Moreover, it was to pay a variable fee equal to

the debt-to-GDP ratio has increased considerably one tenth of the excess deficit-to-GDP ratio, con-

since 1995, and many countries that were below the 11

strained to a maximum of 0.5 percent of GDP. Up

60 percent threshold are now above it. Between 1995 to this day no sanction has ever been imposed on any

and 2010, only 8 out of 27 countries (Sweden, of the EU countries.

Belgium, Denmark, Netherlands, Finland, Hungary,

Italy and Estonia) managed to reduce their debt-to- With the widespread failure of surveillance exposed

GDP levels. All other countries, even those that by the Greek crisis, it became clear that the Pact had

underwent a rapid growth process, have now more been ignored in virtually all its dimensions.

debt relative to GDP than when the euro was

announced. In 2010, 14 countries had a debt-to-GDP

ratio above 60 percent, with the average ratio for all 2.4 The role of the Basel system

EU countries reaching 79 percent. In the euro area,

this average stood at 84 percent. It would be too simplistic to only blame the crisis on

the lack of “debt constraints” in the capital-importing

Despite the signs of recovery in 2010, the fiscal out- countries. After all, similar problems emerged in other

look is disturbingly far off the boundaries of the Pact: areas of the world. Arguably, one of the main drivers

in 24 of 27 cases, the deficit-to-GDP ratios exceed the of the European sovereign debt crisis was the ineffi-

3 percent mark. The Stability and Growth Pact obvi- cient and insufficient banking regulation provided by

ously has not been respected. the Basel system, whose rules were actually responsi-

ble for many types of distortions, but in particular

In fact, the Pact has never been taken seriously. Until created strong incentives for banks to lend to the gov-

2010, the records for the European Union show ernment sector.

97 (country and year) cases of deficits above 3 per-

cent. Less than one third of these cases (29) coincided In the Basel system, banks must meet minimum equi-

with a significantly large domestic recession, hence in ty requirements, above all the so-called Tier 1 ratio,

principle could even be justified on the basis of the which is defined relative to the sum of risk-weighted

original definition of the Pact.

8 Still, there was no assets in the banks’ balance sheets. The risk weights in

ground for justification in the

remaining 68 cases. Member

states were ready to “reinterpret Figure 2.10

and redefine”, again and again,

to make the conditions softer as Member states with excessive deficits

since 1999 or from year of entry

to match ex post the fiscal devel- Number of years

opment in some countries with Greece 11

Hungary 7

strong bargaining power. Italy 7

United Kingdom 6

Portugal 6

Poland 6

Whatever remains of the Pact, it France 6

Germany 6

is generally considered to be Malta 4

Slovakia 3 Deficit exceeding 3% of

Romania 3 GDP was allowed because

Austria 3

Netherlands 3

8 Resolution of the European Council on of recession (29)

Lithuania 3

the Stability and Growth Pact (1997), pp. Latvia Violations of the S&G-Pact


1–2. Only during a severe recession or if Cyprus 3 (68)

the deficit is caused by unusual events out- Spain 3


side its own control is a country allowed to 3 Sanctions: 0

Czech Republic 3

increase its debt by more than 3 percent Slovenia 2

of GDP (Council Regulation (EC) 2


No. 1467/97 of 7 July 1997, Article 2). 2


9 Council Regulation (EC) No 1056/2005 Denmark 1


of 27 June 2005, Article 1. 1

10 Council Regulation (EC) No 1467/97 of 0 2 4 6 8 10 12

7 July 1997, Article 13. Without excessive deficit: Sweden, Luxembourg and Estonia.

11 Council Regulation (EC) No 1467/97 of Economy and Finance, National accounts - GDP and main components; Government statistics- Government

Source: Eurostat, Database,

7 July 1997, Article 12. deficit/surplus, debt and associated data ; European Economic Forecast Autumn 2010, Annex Table 37; Ifo Institute calculations.

79 EEAG Report 2011

Chapter 2 this system are, for example, 0.5 for loans to normal led market investors to virtually eliminate interest

firms of the real economy and 0.2 for interbank loans, spreads, leading to excessive capital flows and trade

thus forcing the banks to hold corresponding imbalances, as described above. After the financial

amounts of equity capital. For government bonds, on crisis that swept from the United States to Europe, it

the other hand, the risk weights were zero, which became clear, however, that risk within the euro area

meant that there was no constraint at all on the banks’ was not as small as investors believed, as a rising risk

lending operations. Theoretically, banks were allowed of default was taking the place of depreciation risk.

to leverage the loans given to the government sector

infinitely. There were some exceptions for countries To be clear, some widening of interest rate spreads rel-

with extremely bad ratings, but these did not apply in ative to the excessively low levels before the crisis is to

Europe. Even for loans to Greece, which had never be welcomed and, as argued below, should be an

enjoyed an AAA rating from rating agencies, banks objective of European economic policy. In a well-

had not been required to hold equity capital before functioning capital market, interest spreads are the

the outbreak of the crisis. price of country-specific differences in creditworthi-

ness. When spreads are not adequate, despite different

The missing debt constraints were particularly prob- repayment probabilities, mispricing causes countries

lematic insofar as there were reasons enough for with lower repayment probabilities to import too

banks to leverage their operations excessively. These much capital (as explained above).

reasons range from tax advantages of debt over equi-

ty finance to explanations of why holders of bank The problem is that in crisis periods the self-correc-

deposits and bank securities did not punish high tion mechanism through which spreads balance out

leverage by demanding higher interest rates. The latter excessive borrowing and lending may typically come

include the opaqueness of banking operations and the into effect not only too late but also too sharply, with

implicit bailout guarantees of governments. Chapter 5 spreads swinging from too low to prohibitively high

discusses such reasons in more detail. levels in a matter of weeks – as often described by the

literature that stresses the danger of “sudden stops” in

Small wonder that under these conditions the credit international capital flows. Brakes that block the

flow from Europe’s savers into countries that lacked wheels of a car may actually cause accidents instead

internal debt constraints expanded rapidly in recent of preventing them. What Europe needs is an anti-

years and that European banks had such an enor- lock braking system for capital flows. This is the goal

mous exposure to the sovereign debt of the GIPS of a much-needed new economic governance system

countries, which made the rescue measures of May for the euro area as a whole.

seem inevitable to politicians (recall Figure 2.3). The new economic governance system needs to

address the deficiency of the current institutional

arrangements. As discussed above, misallocation and

2.5 A new economic governance system for the euro area mispricing create imbalances in three interconnected

As explained above, the trade and financial imbal- dimensions: fiscal, financial and external. The new

ances of the euro-area countries followed from exces- economic governance needs to address the roots of

sive capital flows which themselves were the result of misallocation and mispricing in all these dimensions.

soft budget constraints. Arguably, without the euro

the extent of misallocation from excessive capital What is the main deficiency of Europe’s current eco-

flows would have been more contained. Persistent nomic constitution? To put it simply, markets found

interest differentials, dictated by the risk of deprecia- ample reasons to disregard government defaults as a

tion and default, would have deterred capital flows real possibility. Investors knew that, at the end of the

within the area. day, the euro-area countries would go out of their way

to come up with resources to keep a troubled govern-

Under the euro the natural constraints of currency ment afloat, disregarding the no-bailout clause of the

premia on excessive capital flows no longer exist. A Maastricht Treaty.

country cannot inflate its debt away because its bonds

are denominated in a common currency whose value The lack of credibility of the no-bailout principle can

cannot be manipulated by national policymakers. be attributed to different factors. Commentaries on

Initially, the apparent immunity to a devaluation risk the Greek crisis, for instance, often stressed that cred-


EEAG Report 2011 Chapter 2

tional setting some government will eventually save

itor countries would intervene with rescue packages

mainly to guarantee their own banking systems, them. In Europe, international banks were broken up

which were likely to lose money in a debt-restructur- in different institutions along national boundaries,


ing episode. There is also a more general formula- each institution saved by one government. In other

tion of the same issue. cases, some form of war of attrition – with each gov-

ernment waiting for the other to take the lead in bail-

As already examined in detail in early analyses of the ing out the bank – may have actually exacerbated the

Maastricht Treaty, a key factor systematically under- crisis, raising the bill to be footed with taxpayers’

mining the credibility of the no-bailout principle is money.

the fear of contagion and systemic consequences from


default. Greece was not abandoned in 2010 because, It is thus the fear of contagion that leads euro-area

in the perception of policymakers, Europe (and as a countries to bail out member states in crisis. A fiscal

matter of fact, the whole world) could not run the risk crisis in one country potentially affects the whole area

of “another Lehman”. through different channels. A fundamental channel

operates via the exposure of international investors to

Whether an early Greek restructuring would have cre- default risk depending on their portfolio of govern-

ated another wave of panic at a global level is debat- ment bonds and private assets issued by firms and res-

able. Probably the fears were vastly overstated given idents in the defaulting country. As is well under-

that bank rescue programmes worth 4,900 billion stood, in case of sovereign default, there are strong

euros that had been created in the autumn of 2008 spill-over effects from the government to the private

after Lehman Brothers to unfreeze the interbank mar- sector, apparent in the correlation of risk premia

ket were still in place. Because of Lehman, a second charged by markets to both. Threat of government

Lehman was unlikely to happen. Europe’s stable default in fact raises the riskiness of private firms

countries all had enough reserves to help their banks operating in the jurisdiction, as these may be taxed,

directly rather than indirectly via a bailout of the and in any case face a disrupted domestic market for

unstable ones. Nevertheless, the risk of another break- goods and credit. The empirical evidence however

down of the interbank market was enough of a polit- suggests that the strength of these spill-over effects

ical argument to keep default always last in the list of varies, depending on features of the firm: all else

the policy options under consideration. being equal, firms with large export markets appear to

be less affected than firms relying heavily on the

This is how unchecked fears of contagion can create a domestic market. On the other hand, in a panic fun-

deadly chain of events within the euro area. Fears of damental risk assessment may be swamped by other,

contagion underlie the too-big-to-fail doctrine: banks liquidity-related considerations.

and countries are saved because their default may

result in a liquidity and credit crisis that could stran- Unfortunately, however, with governments interven-

gle the real economy at a national and international ing to prevent a contagion via the banking system, the

level. Protected by the implicit insurance, then, finan- bailout itself becomes a channel of contagion. The

cial intermediaries take on too much risk, govern- Irish case demonstrates this clearly. The Irish govern-

ments issue too much explicit and implicit debt, with ment, with a stellar fiscal record in previous years, ran

the result of raising the likelihood of a crisis and into trouble in autumn 2010 and was forced to seek

therefore of generalised bailouts. help from the European rescue fund because it had

promised to bail out its banking system with guaran-

With fears of contagion, governments feel compelled tees two-and-a-half times the Irish GDP. Because

to insure the liabilities of their banks. Here the issue is Ireland gave a practically unlimited bailout promise

complicated by the fact that, at the wholesale level, rather than erecting a firewall around its banks, the

large financial intermediaries operate cross-border. Irish banking crisis became a crisis of the Irish state.

Before the crisis, the issue of which government would In a similar way, the bailout of endangered European

pick up the bill was often discussed. In light of the cri- countries may in future spread the risk of insolvency

sis, we know that, no matter how international the to governments that otherwise would be sound.

financial intermediaries are, without a proper institu- Intergovernmental bailout systems in Europe risk

opening up additional contagion channels through

12 One can also imagine financial help that is linked to political which the crisis of a single country could in the end

alliances and converging voting strategies on other issues. endanger the euro system as such.

13 Buiter et al. (1993). 81 EEAG Report 2011

Chapter 2 This problem is exacerbated insofar as bailouts create market by pooling the creditworthiness of the euro-

area countries. We can only warn that taking the

the moral hazard effects explained above. The govern- direction of issuing common eurobonds will exacer-

ments of over-indebted countries continue borrowing bate the problems we see as being at the root of the

and creditors continue providing cheap loans reck- crisis. Eurobonds could do nothing but strengthen

lessly. The interest spreads that would normally limit incentives for opportunistic behaviour on the part of

the incentive to borrow if investors feared a default debtors and creditors, given that they prevent the

risk are artificially reduced and hence there are exces- emergence of fundamental risk premia, by acting as

sive international capital flows, perpetuating the trade full-coverage insurance against insolvency. Euro-

imbalances that led to the current crisis. bonds entail an across-the-board equalisation of

interest rates regardless of the creditworthiness of

For Europe, there is no alternative but to create rules each debtor country and, for that reason, would be

and institutions that induce market discipline. tantamount to a subsidy to capital flows to those

Credibility of the no-bailout clause is the essential countries. Even if issued in small quantities,

prerequisite. As we emphasised in our analysis above, Eurobonds would give new debt excesses carte

Europe cannot afford to abandon market discipline de facto reproducing the problem at the root


vis-à-vis debtors; this is the cornerstone of its com- of the current crisis. The euro area would then surely

mon currency and common market. But this requires collapse in a system of soft budget constraints and

setting up rules and institutions that address the fun- face a similar destiny as the regimes for which Kornai

damental issue of containing the fears and thus the once made his predictions.

risk of contagion via the banking system.

A plausible system could stand on two pillars. One is 2.5.1 Political debt constraints

an EU-controlled public surveillance and supervision

process for public debt and the banking system. The The Maastricht Treaty and the Stability and Growth

other is a credible crisis mechanism that strengthens Pact centred around the idea that there would be no

market discipline by reducing the implicit bailout bailout and that surveillance and numerical rules

guarantee that characterised the previous situation could be enforced with pecuniary sanctions to prevent

under the euro while protecting the markets against fiscal crises altogether. This approach failed entirely.

speculative attacks and panic. There was a bailout, and despite 68 violations, sanc-

tions were never imposed.

To address the danger of excessive capital flows

analysed in the first part of this chapter, some politi- Despite or because of this frustrating outcome, the

cal voices in Europe have advocated a strategy of euro area has to try again, and now harder than before

direct controls on trade flows, with sanctions if these to overcome the deficiencies. A new Stability and

flows deviate from politically determined target levels. Growth Pact should provide tougher and more rigor-

The idea is that these controls would automatically ous government debt constraints, and in our judgement

force countries to adjust their wages (to enhance or the proposals of the Van Rompuy Commission are

reduce competitiveness) and use Keynesian policy worth pursuing. Some of the measures advocated by

measures to boost or dampen aggregate demand, the Van Rompuy Commission had indeed already been

when this is too low or too high. We find such pro- proposed by the EEAG in an earlier report.

14 Our sug-

posals naive and dangerous, because, by attempting to gestions for a revised Pact still hold.

mimic through controls the outcome of market disci-

pline, they are bound to confuse symptoms with caus- • The deficit limit should be modified in accordance

es and direct the attention to policy tools that are with each country’s debt-to-GDP ratio, in order to

entirely inappropriate as remedies against long-term demand more debt discipline early enough from

structural deficiencies of market economies. An the highly indebted countries. As an example, the

important lesson from the ongoing crisis is that trade limit could be tightened by one percentage point

flows resulted from capital flows and there is simply for every ten percentage points that the debt-to-

no way to agree on what excessive trade and capital GDP ratio exceeds the 60 percent limit. A country

flows actually are. with an 80 percent debt-to-GDP ratio, for instance,

Other voices advocate eurobonds, i.e. a procedure for

jointly borrowing for normal purposes in the capital 14 See EEAG (2003), Chapter 2.


EEAG Report 2011 Chapter 2

would be allowed a maximum deficit of 1 percent In view of the decisions at the EU summit of

16–17 December 2010, we propose a three-stage pro-

of GDP, while a country with a 110 percent debt- cedure that distinguishes between different degrees of

to-GDP ratio would be required to have a budget a crisis: illiquidity, pending insolvency and actual

surplus of at least 2 percent. insolvency.

• Sanctions for exceeding the debt limits must apply

automatically, without any further political deci- Step 1: A procedure to provide Community loans to a

sions, once Eurostat has formally ascertained the country that faces a temporary liquidity crisis because

deficits. The sanctions can be of a pecuniary nature of dysfunctional markets, assuming this country will

and take the form of covered bonds collateralised soon be able to help itself.

with privatisable state assets, and they can also

contain non-pecuniary elements such as the with- Step 2: A procedure serving the function of a breakwa-

drawal of voting rights. ter structure for a country that is threatened by insol-

• In order to ascertain deficit and debt-to-GDP vency, though not yet insolvent, giving grounds to hope

ratios, Eurostat must be given the right to directly that it will eventually recover and become solvent again.

request information from every level of the nation-

al statistics offices and to conduct independent Step 3: An insolvency procedure in the full sense of

controls on site of the data gathering procedures. the word.

They should also be held responsible for failure to

control. We place particular emphasis on the breakwater proce-

• In case all the above assistance and control systems dure, which we design in a way that comes close to a liq-

fail and insolvency looms, the country in question uidity help and makes a piecemeal approach to a coun-

may be asked to leave the euro area by a majority try’s problems possible without it defaulting on its entire

of the euro-area members. outstanding government debt. Given this breakwater

• A voluntary exit from the euro area must be possi- procedure, liquidity help according to Step 1 can be pro-

ble at any time. vided under very strict limitations, excluding countries

that are merely threatened by insolvency.

2.5.2 A credible crisis mechanism The EU decisions

While we endorse the attempt to rewrite the Stability

and Growth Pact, we are much more confident about On 16–17 December 2010 the European Union decid-

the discipline that markets would impose on debtor ed to extend the life of the Luxembourg rescue fund

countries. It is true that markets overreacted in this EFSF (European Financial Stability Facility) from

crisis. But unlike the political debt constraints, the the previously foreseen three years to an indefinite

market constraints were eventually put in place in length of time and to give this fund a the new name:

the end, limiting abruptly a non-sustainable develop- 15

ESM (European Stability Mechanism). The EFSM

ment course. No political mechanism would have (European Financial Stability Mechanism) that

been able to force Greece, for example, to carry out allowed the European Union to borrow up to 60 bil-

the present austerity measures in a way similar to lion euros (see Table 2.1) to fight what was perceived

what has now been enforced by market reactions, as a systemic crisis of the euro area in May 2010 will

even though these reactions were mitigated by polit- no longer be used.

ical influence. Like its predecessor, the ESM is supposed to borrow

The challenge to the euro area consists of defining a internationally at favourable rates, given that it is

crisis mechanism in which a credible rescue strategy jointly guaranteed by all countries of the euro area.

stringently binds private investors (they need to have However, to satisfy the requirements of the German

to bear some responsibility in case of losses) while at Constitutional Court, which is expected to declare the

the same time preventing a panic-like aggravation of decisions of May 2010 unconstitutional, a change in

market turbulences. In addition, this mechanism the Union treaty is necessary before Germany can

should contribute to the stabilisation of the banking actually provide the expected guarantees. The heads

system in order to avoid a spiral of actual or alleged

emergencies, raising the need, or the temptation, for

further rescue actions. 15 European Council (2010).

83 EEAG Report 2011

Chapter 2 of state agreed on the following amendment of Basic requirements for the crisis mechanism


Article 136 of the Union Treaty: To comply with the above-mentioned goals, a credible

crisis mechanism must meet a number of prerequi-

“The Member States whose currency is the euro may sites:

establish a stability mechanism to be activated if

indispensable to safeguard the stability of the euro

area as a whole. The granting of any required finan- • It should not mutate into a transfer mechanism.

cial assistance under the mechanism will be made sub- • It should foster efficient risk pricing by markets,

ject to strict conditionality” ensuring that adequate interest spreads prevent

further distortions in international capital flows.

• It should enable a country in need of help to con-

An important change relative to the EFSF is that “in tinue fulfilling its governmental responsibilities

order to protect taxpayers’ money”, the Community and to initiate a reform programme that will return

loans provided will be senior to any privately held

17 it onto an economically sustainable path.

country debt, though junior to IMF claims. • It should predetermine and limit investors’ maxi-

mum losses.

Moreover, unlike the EFSF, a “case-by-case participa-

tion of private sector creditors” in line with IMF rules Concretely, we propose the following modifications to

is foreseen, without any more detailed specification 18

and specifications of the Council decisions:

being given.

From 2013 onwards all euro-area countries must

endow their government bonds with Collective Action I) Liquidity help

Clauses (CACs) that make majority decisions between

an insolvent country and its creditors possible, which Along the lines of the current operations of the EFSF

then become binding for all other creditors. the new ESM should be able to provide short-term

loans to a country that faces a mere liquidity crisis

A country that appears to be insolvent must negotiate without creditors participating at this stage. As liq-

a comprehensive restructuring plan with its creditors. uidity and impending insolvency cannot easily be dis-

The ESM may provide liquidity help during this peri- tinguished, we propose a strict and short time-limita-

od if debt sustainability can be reached through these tion for this type of help. By its very definition, a liq-

measures. uidity crisis cannot last forever.

Decisions about help coming from the ESM must be As foreseen in the decision of 17 December 2010, the

unanimous, as was the case with EFSF decisions. Given loans provided by the ESM should be senior to any

that the use of the EFSM (the 60 billion euros in private claims. In addition the loans could be collater-

Table 2.1) which would have been possible after a quali- alized with marketable state property. This is a safe-

fied majority decision has been ruled out by the Council guard against the liquidity help turning into a

(it probably is illegal), the unanimity rule for the ESM resource transfer. It also makes sure that private cred-

means that in future all help will have to be unanimous- itors continue to bear the default risk so as to show

ly decided. A systematic redistribution of funds from prudence and charge an interest mark-up to cover the

minorities to majorities is therefore ruled out. risk.

Assistance will, moreover, only be provided to a trou- There is no point in having huge or even unlimited

bled member state if the IMF, the European Union credit lines for liquidity funds as is sometimes pro-

and the ECB have come to the conclusion that the posed. What is required are facilities large enough to

state will be solvent again after a stringent internal cover the debt that needs to be replaced in the period

restructuring programme. under consideration plus possibly an allowance for a

limited budget deficit, not more. The funds needed for

In the following we both interpret as well as modify that purpose are contained. Larger funds would only

the EU decision so as to generate a workable eco- be necessary if the task of the fund was to support the

nomic governance system for the euro area. market value of outstanding government bonds. That,

16 18

European Council (2010), Annex I, Article 1. In doing this we make use of a proposal by Sinn and Carstensen

17 (2010), extended in Sinn, Buchen and Wollmershäuser (2010).

For this and the following see European Council (2010), Annex II. 84

EEAG Report 2011 Chapter 2

however, cannot be the function of the ESM because apply only to those creditors whose debt is maturing

simultaneously, and of course the decision is only

it would be effectively equivalent to bailouts. binding for them. Creditors with later maturities will

have to cross the bridge when they come to it.

II) Replacement bonds Waiving the right to call in the claims prematurely is

indispensable for the crisis mechanism, because it per-

The crisis mechanism should help a country that is mits solving the payment problems step by step as

acutely threatened by insolvency by guarantees of the they emerge. It prevents a temporary payment crisis

ESM to continue refinancing itself on the financial from becoming a sovereign bankruptcy. A crisis

markets, albeit at higher rates of interest properly mechanism that defines a procedure that applies only

reflecting the country’s default risk. Toward this end to either a liquidity crisis where no haircut is imposed

the concerned country can offer its creditors, after a or a full insolvency where the full outstanding debt is

limited haircut, newly created replacement bonds, to at risk is not credible and therefore as useless as the

be partially guaranteed by the ESM, in exchange for no-bailout clause of the Maastricht Treaty. Before it

maturing bonds. The term “haircut” refers to the low- applies there will always be new bailout activities to

ering of the value of a bond and a corresponding prevent the insolvency from occurring. Creditors will

relinquishing of claims on the part of the creditor. anticipate that and will thus return to the careless

lending behaviour that triggered the current crisis.

Limiting the haircut and partially guaranteeing the The interest spreads will disappear under such a

replacement bonds will prevent a panic on financial regime, and the excessive capital flows and trade

markets without allowing the protection by the ESM to imbalances that caused this crisis will continue.

become a full-coverage insurance against insolvency. We warn the heads of European states not to repeat

the fundamental mistake they made when designing

III) Modified collective action clauses (CAC) for all the Maastricht Treaty.

government bonds Some may fear that these proposals will increase the

The guarantees preceding the haircut are not to per- credit costs of all countries, including those that are

tain to the government securities currently in circula- relatively creditworthy. But this fear is unfounded. As

tion (for which the haircut would be tantamount to a empirical studies have shown, the introduction of

breach of contract), but to all newly issued govern- such clauses has only moderate effects on the returns

ment securities, including the replacement bonds. All demanded from the financial markets. Interest rates

new public debt contracts will include a CAC for this may actually decline for debtors with good credit

purpose. The receipts from the sale of new securities standing (as they did at the peak of the current crisis).

with CACs is to serve the orderly servicing of the old Only debtors with poor credit standing will have to

credits, which may also include loans by the ESM pay higher interest rates, on average; as explained

granted under the current or new rescue programmes above, this is indispensable for a functioning capital

(EFSF and ESM). market.


As foreseen by the Council decision of 17 December Because of the great importance of CACs for a mean-

2010, the CAC permits a majority agreement of the ingful design of an effective crisis mechanism, what-

creditors that will then become generally binding. The ever this will eventually look like in detail, the heads

creditors will already agree at the time of purchasing of states are advised to agree that new government

their debt claims to subject themselves to a majority bonds issued from now on are to be endowed with the

rule (e.g. a 75-percent majority) with respect to all new provisions, rather than only from 2013 as is cur-

securities maturing at the same time. rently planned. Bonds with CACs should actually be

issued even ahead of the end of the negotiations on

However, in addition, the new clauses should make it the crisis mechanism. Postponing the issue of CAC

possible for a country to find an agreement with only bonds to 2013 would be a mistake in view of the fact

those creditors whose debt matures at a particular that these bonds would greatly facilitate the resolution

point in time without the owners of debt instruments

with other maturities being able to call in their claims

prematurely. Correspondingly, the majority rule is to 19 See Eichengreen et al. (2003).

85 EEAG Report 2011

Chapter 2 of any looming fiscal difficulty and that it will take V) Haircuts ahead of guarantees to ensure a correct

years before they have penetrated the market. pricing of risk (appropriate interest spreads)

The ESM guarantees the replacement bonds to be

The European countries should take action to enlarge issued only after the private creditors have waived a

the degree of market penetration for such bonds as substantial part of their claims. After all, one of the

quickly as possible. For that purpose they should at main purposes of providing support from the com-

least agree that until 2013 only very short-term bonds munity of states is to reduce the stock of outstanding

can be issued. public liabilities.

It is moreover important that not only the euro-area In addition, however, the participation of creditors is

countries but all EU countries immediately switch to absolutely necessary to ensure that they use caution in

the new type of bonds, because all of them have the engaging in risky credit transactions and apply appro-

right to join the euro and all but two are even obliged priate interest mark-ups ahead of time. The interest

to do so, the exceptions being Denmark and the mark-ups in turn ought to restrain debtors from

United Kingdom. engaging in excessive borrowing, so as to prevent a

new wave of inefficient capital movements and cur-

rent account imbalances within the euro area.

IV) Help only in a true liquidity or insolvency crisis

A crisis mechanism is meant to strengthen responsi- We stress that in the case of impending insolvency

bilities and thus reduce the probability of a crisis. under no circumstance should the countries in the euro

Thus, financial help does not have the function of area agree to a crisis mechanism that grants aid first

avoiding crises but only serves to solve a crisis when and only afterward, when the aid is ineffective or turns

it occurs. It is a separate issue whether new cohesion out to be insufficient, require private creditors to share

and stabilisation systems should be implemented that losses. For the participation of private creditors to be

strengthen the performance of weaker economies in credible, it must complement official help in a legally

general and would thereby make a crisis less proba- binding form. And only if it is credible will the interest

ble. Should an expansion be considered, this can be mark-up have the desired disciplining effect.

done with the use of EU funds outside the crisis

mechanism. As explained above, this principle should not be violat-

ed by a misinterpretation of the Council decision of

By the same token, financial resources may be essen- 17 December 2010. Liquidity help as described in Item

tial in stemming financial panics driven by self-fulfill- I of our set of proposals does not require a haircut, but

ing expectations and illiquidity. However, liquidity can only be provided under strict limitation in time and

assistance during turmoil should be carefully designed size, especially ruling out that the boundary of liquidi-

so as not to degenerate into a hidden bailout or inter- ty help is not trespassed by political initiative.

est subsidy. This point is important insofar as there is

the political risk that by bending the terms under One might fear that interest mark-ups would actually

which liquidity help is provided, the crisis mechanism translate into a higher, rather than lower, stock of

may degenerate into eurobonds, which we have dis- public debt, since some governments will face higher

missed above because of the disastrous consequences borrowing costs. But it is precisely such a possibility

they are likely to have for Europe. that creates the right incentive for governments to

implement fiscal corrections – ensuring that the deter-

It is debatable, as mentioned above, whether Ireland rent effect of higher interest rates dominate over other

was really in a liquidity crisis that justified providing considerations. In the negative, this is the important

funds from the EFSF. The country was neither credit lesson to be drawn from the experience of countries

constrained nor did it lack the power to increase its like Greece and Portugal, who benefited from the dra-

taxes on immobile factors of production to solve its matic interest rate reductions accompanying the intro-

problems on its own. Possibly the country took duction of the euro. These countries had the chance

advantage of the rescuing measures simply because it to contain and reduce their public debt because of the

wanted to borrow at lower interest rates. Such reasons combined effect of lower interest rates and in part vig-

should be rigorously blocked by the rules to be speci- orous economic booms. But in view of the allure of

fied. the low interest rates, governments (and private


EEAG Report 2011 Chapter 2

that all the new bonds in the market issued by all EU

agents) took on even more credit instead. Only countries include CACs of the described type, i.e. with

Ireland reduced its government debt temporarily to a the possibility of a piecemeal solution to impending

significant degree, although the fall in explicit govern- 21

insolvency problems.

ment debt corresponded to a mounting stock of On the one hand, the CAC

implicit public liabilities accumulating in the financial bonds make the risk of a haircut in case of threaten-

sector (of course under the presumption that banks ing insolvency explicit and structured (de facto, all


would be rescued). bonds bear the risk of a cut, although unorganised).

On the other hand, in case of impending insolvency,

these bonds have the advantage of being exchangeable

for replacement bonds, guaranteed to a considerable

VI) Limiting the total amount of guarantees extent (our proposal: 80 percent) by the ESM.

At any time, the total amount of guarantees and liq- The term “impending insolvency” denotes a state of

uidity help must be limited to 30 percent of current acute payment difficulty, which may be overcome, how-

nominal GDP of the aid-seeking country. If a coun- ever, after a limited waiver of claims and with the help

try exceeds this limit, either because of failure to con- of partially guaranteed replacement bonds. This is to

tain net borrowing (thus enlarging the numerator of be distinguished from actual insolvency that has far-

the debt-to-GDP ratio) or because of a drop in eco- reaching consequences for the independence of the

nomic activity (hence reducing its GDP), the ESM state and puts the entire government debt outstanding,

should no longer provide its help. Limiting the stock no matter its maturity, at the creditor’s disposal. And it

of loans and guarantees is necessary as a way to pre- is not the same as a mere liquidity crisis, which does not

vent an uncontrolled expansion of the burden for the pose the question of debt sustainability.

guaranteeing countries with possible contagion effects

to the whole euro area. It also serves as a threshold, The following course of the crisis may be imagined

the surpassing of which indicates that the country is after the CAC securities are in circulation.

in need of deeper and far-reaching measures of debt

restructuring – that is, beyond the debt-reduction Should a state be unable to service the CAC securities

implicit in the CAC. that are maturing, in the case of doubt it will first be

assumed that it is merely illiquid. The ESM will provide

loans of a limited size and for a limited time to coun-

VII) Guarantees and liquidity only with collateral or at tries whose debt-to-GDP level is not yet excessive.

market rates If the loans are insufficient, the time has expired and

Guarantees should be granted against insurance pre- the country continues to be unable to service its debt

mia at market rates, quoted in CDS prices, for exam- or the existing debt is already large, an impending

ple. Specifically, the interest mark-up charged to the insolvency can be assumed. The country then must

debtor country should be equal to the (GDP-weight- negotiate a haircut with the holders of its outstanding

ed) average interest rate in the euro area during the state bonds. Net of the haircut, the holders of these

months before the state of impending insolvency is bonds can then exchange them for replacement bonds

declared. The premium on the guarantees may be that are partially secured by the ESM.

waived if the grantor receives ownership of collateral

in the form of marketable state assets. Similarly, any Securities of the same issuer, which will not mature

liquidity help must come at normal market conditions until later, are not involved in this exchange, because

for similar risk classes, unless the country offers col- this is what the CACs establish in their bond contract.

lateral in exchange. The question of whether they are to be serviced in the

regular way or also be converted may be postponed to

their maturity date. How the crisis mechanism operates The haircut can be determined based on the dis-

Building on these basic rules, we propose a multi-step counts, observable in the market, on the nominal

crisis mechanism. The mechanism is based on the idea

20 21

While Ireland even reduced its debt in absolute terms, Spain was In general, CACs can only be included in newly issued bonds. For

able to substantially reduce it relative to GDP, from 63 percent in this reason, a diminishing percentage of the bonds in the market over

1995 to a low point of 36 percent at the end of 2007. time have non-CAC status.

87 EEAG Report 2011

Chapter 2 value of the bond during the whole three-month peri- taxes or cut its expenditure sufficiently in the mean-

od preceding the announcement of negotiations time. If not, it has to declare an impending insolven-

about restructuring measures subject to maximum cy and the second step applies.

and minimum percentage constraints. This provision

is aimed at preventing turbulence in financial markets. Should the country be liquid again, it may call on the

Since the relevant average for calculating the haircut liquidity help a second time after a break of at least

covers three months, the discount naturally charged five years. A country that again becomes illiquid ear-

by markets at any point in time in anticipation of loss- lier or more than twice in 10 years also has to declare

es during a possible crisis will be self-stabilising with- its impending insolvency.

in the limits. This should help prevent panic-driven

losses of market values shortly before the expected A country that claims to be illiquid but has a debt-to-

restructuring or during the negotiations about GDP ratio of more than 120 percent is unlikely to be

restructuring. merely illiquid. It also has to claim impending insol-

vency. According to this definition Greece, which has

Should the negotiating country find it impossible to a debt-to-GDP ratio of 140 percent, is already threat-

service in time the replacement bonds in accordance ened by insolvency and should therefore not receive

with the contract, it must bring itself, in a final step, the liquidity help.

to negotiate an agreement regarding the entire out-

standing debt. 2nd step: Market solution in the case of impending

Should it already face difficulties before having issued insolvency

the CAC securities, it will be saved by the already If a country cannot redeem its debt, because it is

existing rescue system EFSF, limited to three years, threatened by insolvency rather than merely illiquid-

and should be enabled to refinance itself again. ity, it must negotiate a debt relief programme with

the corresponding creditors of a particular maturity

If difficulties beyond a mere liquidity crisis emerge on the basis of the CAC. Extensions of maturities,

after EFSF has expired and if old securities without reductions of nominal values or reductions of the

CAC clauses become due, the old creditors should be interest rate (coupon) may be the outcome of such

offered attractive restructuring into replacement negotiation. During the period of negotiations,

bonds. which is not to exceed two months, newly emerging

funding needs for current government activities (pri-

mary and secondary deficits) will be met by the issue The procedure in case of a liquidity crisis of short-term, maximum one-year, cash advances by

and/or impending insolvency the ESM. The interest rate on these cash advances

For the case of a liquidity crisis or even an impending will be 5 percentage points above the average interest

insolvency with an exchange of the CAC bonds into rate level of the member countries for loans of the

replacement bonds, the crisis procedure by nature fol- same duration. The cash advances are also senior to

lows the steps outlined below. private credits.

1st step: Liquidity crisis 3rd step: Haircut and issue of replacement bonds

Suppose a country is unable to service its debt but If no agreement can be reached at the second step

claims to face only a liquidity crisis. If this is unani- between the debtor country and the creditors of the

mously confirmed by the guarantor states, the ECB maturing CAC bond, the third step of the crisis mech-

and the IMF, a two-year liquidity help in terms of anism is activated. The negotiation period is again

senior short-term loans of a maximum maturity of limited to two months. The funding needs emerging

two years is provided for the debt that needs to be during the negotiation period will again be met by the

replaced in this period and for a deficit in line with issue of senior cash advances at the interstate level.

what the renewed Stability and Growth Pact allows. Also participating in the negotiations are now rep-

Hopefully the country will again be able to service its resentatives of the ESM, the ECB and the IMF.

debt after the two years, as it should have raised its 88

EEAG Report 2011 Chapter 2

free of deductibles. A maximum haircut of 50 percent

There will be an automatic haircut on the nominal

value of the redemption amount of the maturing and the partial guarantee of replacement bonds at

CAC bond. 80 percent is a meaningful solution for addressing the

trade-off between the two goals. While it imposes a

The size of the haircut will depend on the average mar- potential loss on the creditors, it limits this loss to

ket discount of the previous three months before the 60 percent of the investment volume. Thus, a limited

start of the negotiations with the creditors. It should, interest surcharge is sufficient to compensate investors

however, amount to at least 20 percent. A minimum for their risk.

limit is necessary in order to restrict the chance for


strategic measures on the part of big creditors. If the negotiations between the ESM and the country

threatened by insolvency are unsuccessful, i.e. the

The maximum limit on the haircut is 50 percent of required 75 percent of the bondholders do not agree

the nominal value of the contractually agreed to the described exchange into replacement bonds

redemption size of the bond. This limit is to guaran- offered by the debtor country and the Community

tee that, while the market correctly anticipates the states within the negotiation period, the debtor coun-

possibility of a crisis occuring, a true panic of the try on its part must declare a restructuring plan of the

kind that would ensue if extreme or even total losses concerned bonds. But in this case the guarantees of

seem possible – is avoided. If the ceiling of the loss- the ESM are inapplicable.

es is defined and limited, the market may adjust to

the risks in time. 4th step: Adjustment period

The par value of bonds net of the haircut will then be

exchanged with replacement bonds on a one-to-one For an adjustment period of up to three years after an

basis. The replacement bonds in turn will be guaran- impending insolvency, the ESM may also permit the

teed by the ESM at 80 percent. The detailed design of debtor country the issuance of partially secured

the replacement bond (coupon, duration) is a subject replacement bonds that are guaranteed at 80 percent

of the negotiations. for new net borrowing – as long as the state complies

with the framework of the (new) Stability and Growth

Of course endangered states and their creditors will Pact.

always argue that the risk of market turbulences is

minimal if the haircut approaches zero and the The total sum of guarantees granted for the replace-

guarantee of the replacement bonds approaches ment of the outstanding debt and new borrowing (on

100 percent. But in that case the incentives for a net basis) is limited. As already explained, we con-

opportunistic behaviour on their part would be cor- sider it appropriate to set this limit at half of the debt-

respondingly maximised, undermining the stability to-GDP ratio permitted by the Maastricht Treaty, i.e.

of the entire euro system. The conduct of several at 30 percent of the prior year’s GDP. There will be no

European countries and their creditors during the guarantees beyond this limit.

years of low interest rates, and the European debt

crisis itself, has shown very clearly that the danger

of excessive debt should not be disregarded. Otmar Debt moratorium

Issing, the former chief economist of the ECB, has

called the idea that comprehensive insurance pack- The plan described above assumes that a country in

ages would increase the stability of the euro area crisis, after issuing partially secured replacement

“truly grotesque”. 23 bonds and receiving a reduction of the creditors’

claims on maturing bonds, will again be able to bor-

The optimal balance between the goals of the long- row in the financial markets. It could happen, how-

term political stability of Europe and the short-term ever, that a state’s guarantee limit of 30 percent of

stability of the financial markets consists of neither GDP is insufficient for the country to overcome its

eliminating all rescue measures nor setting up com- payment difficulties. Or the country may find itself

prehensive, full-coverage insurance against insolvency in a situation in which it is no longer able to service

the replacement bond, requiring the Community

22 For smaller discounts on the market value, the crisis mechanism states to step in and pay the guaranteed amount to

might not be activated anyway. the creditors.

23 Issing (2010). 89 EEAG Report 2011

Chapter 2 In that event, the debtor country must declare a debt al rule that the sum of all guarantees and ESM loans

must not exceed 30 percent of GDP. It is also essential

moratorium for its entire outstanding government that the principle that the haircut precedes the aid

debt. In this case it can by itself or after negotiations should not be given up, even in this, improbable, spe-

with its creditors restructure the bonds that are in the cial case. Those who do not accept the thus-specified

market. Here the ESM no longer offers protection aid offer and call in their loans prematurely may try to

against losses or risks. recover their claims in court, but receive no guarantee

whatsoever from the ESM.

During an adjustment period of up to three years

after a comprehensive debt moratorium, the ESM can However, the availability of the CAC bonds combined

permit the debtor country to issue replacement bonds, with the partially guaranteed replacement bonds has

which are guaranteed at 80 percent, for covering the the possibility to nip a formal default in the bud.

current primary deficit (government expenditures – After all, these bonds provide endangered countries

government receipts). A prerequisite for this is a strict with a financial instrument that should be attractive

conditionality within the Stability and Growth Pact. to investors, because their maximum potential loss is

limited to 60 percent of the investment volume in even

the worst of all possible cases. Thus, a limited interest The threat of insolvency before CAC bonds surcharge over safe assets should be sufficient for a

have penetrated the markets 24 We see

country to be able to find the funds it needs.

it as one of the main advantages of our proposal that

The crisis mechanism described above applies to it offers a ready-to-use solution to the financial prob-

bonds that have a CAC. In the transition period lems currently experienced by a number of euro coun-

before the new system becomes fully effective, bonds tries without jeopardising the prospects of reaching a

with and without CAC will coexist in variable viable long-term solution that would permanently sta-

amounts. The question arises therefore of how to deal bilise the euro area. In Chapter 3 we indeed suggest

with a pending insolvency involving bonds without this solution to Greece’s foreseeable financing prob-

CAC. lems after 2013.

As long as the rescue packages currently valid (Greece While the EU countries agreed in December 2010 to

and EFSF) are in force, the problem will not arise. But introduce bonds with CAC clauses in 2013, we suggest

difficulties may occur in an interim phase, during that any euro country should have the right to intro-

which these rescue packages no longer work and the duce such bonds before that date, so as to benefit from

conversion of the old government debt into CAC the option of converting them into partially guaran-

securities has not been completed. teed replacement bonds should it be unable to redeem

its debt. One reason for a country to be interested in

If a country defaults because it is unable to repay debt such an option is that it may whish to carry out a vol-

that has become due, nothing prevents owners of untary debt repurchase programme. Market discounts

standard bonds without CACs that will mature at a (see Figure 2.2) for some countries are currently sub-

later point in time from calling in their loans prema- stantial. Investors may prefer to sell their bonds now

turely, thus exacerbating the crisis and forcing renego- rather than wait to maturity if they fear that the coun-

tiation of the entire debt. With a unanimity require- try may default on these bonds because the advantage

ment, however, negotiations would be quite compli- of being exchanged into partially guaranteed replace-

cated. ment bonds is restricted to CAC bonds.

Nonetheless the plan already provides a workable

framework for negotiations between the affected cred- Stabilisation effects

itors and the ESM. Creditors ought to be offered

good terms, in order to reach agreement: it is conceiv- After all old bonds have expired or have been

able that, after a haircut on the order of the market exchanged into CAC bonds, the crisis mechanism is

discount within the above-mentioned limits (at least fully operative. It will instil more debt discipline and

20 percent, at most 50 percent), for their remaining

value bonds are exchanged into replacement bonds 24 With a ten year bond an interest surcharge of 4.8 percent over a

that are fully rather than only partially guaranteed by market rate of 5 percent would be enough to fully compensate for an

the ESM. This of course without violating the gener- overall loss of 60 percent of the assets nominal value.


EEAG Report 2011 Chapter 2

will help stabilize the markets. The risk of domino credit standing will be pushed down and their

effects, like those evoked in May 2010 in order to bond prices will be pushed up. As shown in

justify the discretionary rescue programmes Figure 2.2, this was also the case in the current cri-

amounting to billions of euros, will be effectively sis. Holders of government bonds earned about

minimised. Our optimism rests on the following twice as much on German and French bonds than

considerations: they lost on GIPS bonds.

• A strengthening of the Stability and Growth Pact, Related to the last point, we would like to emphasise

along the lines proposed by the Van Rompuy that the haircut is not in itself a destabilising ele-

Commission and largely accepted by the represen- ment of a crisis mechanism, as is sometimes claimed

tatives of the member states, ought to induce at by interested parties. According to our proposed

least some countries to reduce their budget deficits rule, the haircut is engineered such as to exert a sta-

and outstanding debt. bilising effect, as its size reflects – within the limits

• The announcement of the crisis mechanism will set – the discount on the issue price already realised

induce investors to continue to demand interest in the market. As shown in Figure 2.2, the discounts

spreads when buying new government bonds and on long-term Greek securities amounted to about

to reduce credit granted to less solid countries. 30 percent in early November 2010 and also in May

Higher interest rates will discourage deficit spend- 2010. If a haircut had been applied in that month in

ing and lead to sounder government finances. This such a dimension, no market turbulence would have

market-driven mechanism will have a stronger been triggered, because the expectations of the mar-

effect than all political debt limits. ket agents would have come true. In contrast, a con-

• The protective shields agreed in Washington and tinuation and expansion of the comprehensive

Paris on 11 and 12 October 2008 following the insurance rescue, which was agreed in May 2010,

Lehman bankruptcy of a volume of 4,900 billion would have resulted in a sudden increase of prices,

euros remain intact. That alone makes a break- speculation profits and a considerable destabilisa-

down of the interbank market like the one that tion of markets. Not only downward swings are

occurred after the Lehman bankruptcy on destabilising. Upward swings are destabilising, too,

15 September 2008 extremely improbable if not because they may create opportunities for oppor-

impossible. In Germany, for example, the SoFFin tunistic speculation.

(Financial Market Stabilisation Fund) still has

around 50 billion euros of unused capital aid avail-

able for a recapitalisation of the banks. Conditions 2.6 Supplementary reforms are needed

are similar in other countries. The introduction of a crisis mechanism, which defines

• The fact that a crisis mechanism exists, which in the participation of private investors in a possible

addition limits the maximum losses, helps banks restructuring of a euro-area country’s bonds in a cri-

and other investors in planning for a country’s pay- sis situation, must be the core of the reforms of the

ment crisis. This should limit any possible turbu- body of EU financial rules. In order to be able to

lence in the financial markets. function in the desired way, it should be supplement-

• Since, in the third and decisive step of the crisis ed by two additional reform measures.

mechanism, a haircut is stipulated, which con-

forms to the average market discount during the

last three months preceding the announcement of

restructuring measures, the risk of market turbu- 2.6.1 Bank regulation

lence is limited. Whenever the prices threaten to To date, financial institutions can expect to be rescued

diverge from the moving average of the last three by taxpayers in case of crisis, as their insolvency could

months, profitable and stabilising speculation lead to an undesired domino effect on the financial

becomes possible that will push the prices back to markets, which would be more costly in the end than

this average. In addition, strategic purchases or the rescue of an individual institution. It therefore

sales will hardly be able to affect the maximum makes sense for individual banks to incur high risks,

haircut during the negotiation period. as they can appropriate the high returns in a good

• A divergence of interest rates does not necessarily state of the world, leaving the possible losses to tax-

mean that the banks are losing capital, as in the payers. The potential risks of government bonds of

normal case the interest rates of states with a good 91 EEAG Report 2011

Chapter 2 some south and west European countries may also be The rescue system can be set up at national level for

underestimated for the same reason. banks operating locally. However, transnational banks

that induce inter-country externalities should become

The willingness to assume high risks when buying part of international schemes. As the help comes as

government bonds was boosted by the present equity equity help in exchange for shares that the fund will

rules of the Basel system. Accordingly, banks did not own, the international redistribution would be limited.

need to consider any risk weight for government

bonds in determining their risk-weighted assets and As we have noted earlier (EEAG 2009, Chapter 2), it

therefore did not need reserve equity backing for would also have been wise for the European Union to

them. This was one of the main reasons why banks have set up a common system of deposit insurance for

invested so heavily in government bonds, and banks with a sufficient scope of international activity,

arguably this was one of the main drivers of the when the risks to be insured had not yet materialised,

European sovereign debt crisis. i.e. before the crisis lifted the veil of ignorance. Some of

the problems that, for example, the Irish banking sys-

In the new Basel III system agreed at the meeting of tem suffered in this crisis could then have been avoided.

the heads of government of the G20 countries in The deposit insurance scheme could also have played a

Seoul, the situation will be improved to the extent that role in restructuring (the US model is the FDIC, whose

in future banks must hold equity in relation to the role in restructuring banks has been praised).

sum of their risk-weighted assets and on the amount

of 3 percent of their total assets. Since their stocks of Setting up such a scheme after the crisis is difficult

government bonds are part of total assets, there will and cannot be justified as insurance because of the

be the requirement, for the first time, of equity back- foreseeable redistribution between countries that this

ing of government bonds held by banks. Yet, the risk would involve. Nevertheless, when the dust of the cri-

weight of the government bonds in the risk-weighted sis has settled and the banking system has been sta-

assets will, as a rule, still be zero. Only if there is an bilised, a new effort should be made to establish an

extreme downgrading of a country’s credit standing actuarially fair deposit insurance system for banks

will higher risk-weights apply, as is already the case with truly transnational business. The fees paid by

today. banks in such a scheme should of course reflect their

risk position according to objective measures.

It is appropriate to change the risk weights in such a

way that lending to countries will also be reflected in Finally, national governments could also help their

the computation of the risk-weighted assets, since in respective banks directly, given that no fund has yet

this case the banks will become more circumspect in been built up. In Chapter 5, we discuss the potential

their lending. design of fees that would be able to provide the neces-

sary revenue.

Furthermore, it is necessary to develop a rescue sys-

tem, funded by the banks themselves, which will come

to the aid of a distressed bank by providing addition- 2.6.2 Detailing the responsibility of the ECB

al equity in exchange for stock in the case of crisis. Additional supplementary reforms concern the ECB.

Increasing the equity capital requirements, no matter The crisis mechanism described above will become

how high, remains ineffective as long as evading these irrelevant if it is undermined by the ECB. By deciding

requirements induces policymakers to grant aid mea- independently to acquire government bonds, the ECB

sures in order to prevent a shut-down of the banks made its owners liable to rescue states. Acquiring the

(regulation paradox). In order to make sure that the government bonds was not a monetary policy mea-

equity capital of a bank can truly be liable without the sure in the true sense, for – as emphasised by the ECB

need to shut down the bank, it is imperative that loss- time and again – it sterilises the effects on the money

es, which push the equity capital below the legal limit, supply by liquidity-absorbing actions. As the ECB

are met by new outside capital. A bank rescue system even rescinded its earlier announced credit-standing

that rescues the banks but not their stockholders criteria for repurchase agreements, it in fact is now

would protect the banking system better against sov- pursuing a policy that potentially violates Article 125

ereign insolvencies and would thus deflate the argu- TFEU, according to which one country is not liable

ment that was put forth in the crisis of May 2010 in for the debts of another country.

favour of the government rescue systems. 92

EEAG Report 2011 Chapter 2

Treaty the last sentence of the cited paragraph should

If the EU countries agree on a crisis mechanism that

aims at the participation of private creditors in the be supplemented with this proviso:

payment crisis of a member state, the responsibili-

ties of the ECB must also be detailed. In the course “The indirect purchase of government bonds is limit-

of negotiations about redesigning the EU Treaties, a ed to securities of high creditworthiness and exclu-

change in the distribution of voting rights in accor- sively permitted for purposes of monetary policy.”

dance with the size of capital shares could be envis-

aged so as to protect the big European guarantor In light of our proposal, there is already a lender of

countries against excessive liability. If policymakers last resort providing liquidity help to states; relieving

are not willing to go that far, it is at least necessary the ECB from responsibilities that are not appropriate

to supplement Article 123 (1) TFEU in such a way for monetary authorities to bear is advisable.

that the ECB may only acquire government bonds

in the secondary market for purposes of monetary An important issue is whether the ECB should

policy. nonetheless play a role in maintaining financial stabil-

ity for the euro system as a whole. Technically, it

In this context it is advisable to look closely at the for- makes sense for a central bank to provide liquidity

mulation of the relevant Treaty articles: support to financial intermediaries, according to

sound principles, as discussed in a previous EEAG

“Overdraft facilities or any other type of credit facili- report (EEAG 2009, Chapter 2). Yet, in view of the

ty with the European Central Bank or with the central fiscal implications of financial crises, discretion in the

banks of the Member States (hereinafter referred to provision of liquidity help may be subject to undue

as ‘national central banks’) in favour of Union insti- political influence, creating a hidden channel of fiscal

tutions, bodies, offices or agencies, central govern- transfers in contradiction to the goals of the new

ments, regional, local or other public authorities, European fiscal governance system. As the German

other bodies governed by public law, or public under- experience of the early 1920s has shown, direct or

takings of Member States shall be prohibited, as shall indirect access of governments to central bank money

the purchase directly from them by the European would also risk financing government budget deficits

Central Bank or national central banks of debt with newly issued money, which could result in hyper-


25 inflation. Thus we consider it essential to limit such

central bank policy strictly to the exceptional purpose

The formulation clearly states that the ECB may not of fighting a deflationary risk.

grant direct loans to the states and may not directly

acquire government securities. To the layman it

sounds like a general clause that precludes misuse in 2.7 Concluding remarks

the form of funding a government deficit by printing

money. Purchases on the secondary market are not There were good reasons for the founders of the

precluded, however. The fact that Greece sold its gov- European Monetary Union to include a no-bailout

ernment bonds to its central bank using the detour via clause in the Treaty. It basically means that the mem-

its commercial banks was permitted because it was ber countries must deal with their fiscal problems

not prohibited. themselves and must not expect the help of neigh-

bouring countries and their taxpayers. Knowing this,

To be sure, such purchases may be necessary in given investors would require a higher risk premium of

situations to fight a general deflation in the euro area, weaker debtors than for economically stable coun-

which is more than merely a remote possibility, as the tries, which would then prevent excessive borrowing,

Japanese example shows. This applies especially if the mispricing and bubbles in the euro area. So the idea.

interest floor of 0 percent has been reached and there

is still a direct risk of deflation, measured by the Past events have shown, however, that the no-bailout

Harmonised Consumer Price Index for the entire euro clause was not sufficiently credible, and that mispric-

area. But the ECB should not forget its credit-stand- ing and bubbles occurred nevertheless. This was due

ing criteria, nor should it try to protect government to the fact that systemically important banks could

budgets. Therefore, for a future amendment of the expect to be rescued by their states, and the states in

turn by the community of member states, to avoid

25 Consolidated Version of the Treaty on the Functioning of the panic reactions and domino effects. Obviously there

European Union (TFEU), Article 123, Section 1. 93 EEAG Report 2011

Chapter 2 was speculation that in case of crisis enough pressure countries in the periphery experienced a housing

would be built up to induce the EU countries to pro- boom with unprecedented GDP growth rates.

vide help, even though they were violating the EU

Treaty in doing so. As a result of the slump, Germany’s imports grew

only little and its product prices stagnated, improving

The problematic moral hazard effects that were creat- the competitiveness of German exports. Similarly, in

ed by the lack of credibility of the no-bailout clause the booming countries imports grew quickly, while

was enhanced by the Basel system’s deficiency of not exports were constrained by rapid price increases that

requiring banks to hold any regulatory equity capital undermined these countries’ competitiveness. Via

against government bonds. This deficiency is a major these mechanisms, trade imbalances developed that

explanation of why French, and to some extent also were large enough to match the capital flows induced

German, banks were so heavily exposed to govern- by the euro from Germany to the countries in the

ment bonds in this crisis and why they exerted suffi- periphery. As Christine Lagarde pointed out so right-

cient pressure on their governments to agree on the ly, EU countries were dancing the tango, but the

rescue measures of May 2010. music was coming from the capital rather than the

goods markets.

The situation was exacerbated further in that the

Stability and Growth Pact was never taken seriously. The capital flows and the resulting trade flows even-

New borrowing by the European countries has tually became excessive and unsustainable, triggering

exceeded the 3 percent ceiling of the Stability and a bursting of real estate bubbles and the sovereign

Growth Pact 97 times. Only in 29 cases could the high debt crisis Europe is now suffering.

deficits be justified by the exemptions provided in the

Pact. In 68 cases, sanctions should have been Debt discipline only came into effect when, well into

imposed, but in fact, they never were. The rules devel- the global crisis, financial markets started to charge

oped by the European Union to harness government sizeable interest rates according to the different credit

debt proved to be utterly ineffective. standing of each country. Only then did financial

markets activate the debt brake that had been lacking

For these reasons, in the initial period under the in Europe for private and public debtors. Too late, one

European Monetary Union, Europe was charac- may argue.

terised by what Hungarian economist Janós Kornai

once called “soft budget constraints” in making his For this reason alone, no crisis mechanism should be

famous prediction that Communism was doomed to demanded for Europe that eliminates interest spreads

fail. Soft budget constraints always lead to disaster. again (as happened in the first years of the euro). In

Although in the present crisis it was not the fall of the particular, the euro area should under no circum-

entire system, it was a crisis severe enough to threaten stances adopt eurobonds or similarly constructed

confidence in the future of the European Union. community loans, as have been advocated by some

European politicians. We can only warn that taking

In economic terms the soft budget constraints operat- the direction of issuing such bonds will exacerbate the

ed via a rapid interest rate convergence relative to pre- problems we see at the root of the crisis. Eurobonds

euro times. Before the introduction of the euro there will do nothing but strengthen incentives for oppor-

were huge interest spreads, much bigger than today, to tunistic behaviour on the part of debtors and credi-

compensate for a perceived depreciation risk. With the tors, given that they prevent the emergence of funda-

launch of the euro, the implicit bailout expectations mental risk premia by acting as full-coverage insur-

eliminated these spreads, inducing huge and unprece- ance against insolvency. Appropriate pricing of sover-

dented capital flows in Europe. The capital basically eign risk is an essential feature of well-functioning

flowed out of Germany, which became the world’s sec- financial markets and this excludes joint liability

ond largest capital exporter after China, and into the mechanisms. It induces debtors and creditors not to

countries of Europe’s south and western periphery, exaggerate the capital flows and to exercise caution in

creating an overheated boom in the periphery and a lending. This is the essential prerequisite of removing

severe slump in Germany. While in Germany the net the European trade imbalances in the future. Those

investment share in output was pushed to the lowest who want to force artificially a convergence of nomi-

level in the OECD, real estate prices declined and nal interest rates across government bonds by political

growth fell to the second lowest level in Europe, the measures, in spite of different probabilities of


EEAG Report 2011 Chapter 2

redemption, de facto argue in favour of cross-subsi- ernments, for a maximum of two years in a row. This

dising the flow of capital into relatively unsafe coun- time period should be long enough for the country to

tries. They advocate a policy that would again expose raise its taxes or cut its expenditures so as to convince

the euro area to periods of relative overheating of the private creditors to resume lending.

countries with more fragile fiscal and financial foun-

dations, and relative stagnation in the countries with Second, if the payment difficulties persist after the

better discipline, which would perpetuate the trade two-year period, an impending insolvency is to be

imbalances. assumed. The ESM now provides help in terms of

partially guaranteeing the replacement bonds that the

We do not want to be misunderstood, however. We country can offer the creditors whose claims become

argue neither against the provision of emergency due, but only under the condition of a haircut for the

liquidity to address panics, nor against rescue mea- respective loan maturities. The haircut will see to it

sures to help countries in pursuing their restructur- that the banks and other owners of government

ing needs. In our proposal, the mandatory inclusion bonds bear part of the risk of their investments. As

of collective action clauses (CAC) in all bonds sold the haircut will, within limits, be sized on the basis of

by euro-area governments together with the provi- the discounts already priced in by investors, it will

sion of replacement bonds, guaranteed to 80 per- clearly help stabilising markets. Providing financial

cent by the Community states and available in case resources from the community of euro states to

of emergency, will grant considerable protection. investors, without ensuring a haircut as a precondi-

The availability of these bonds will allow GIPS tion, in the amount of the actual discounts priced by

countries (or any country facing a looming crisis) to markets, would be tantamount to shoving profits onto

service existing bonds sequentially, as they come due the speculators.

at maturity, by the sale of bonds with CAC and in

all likelihood to avoid insolvency. We warn against Third, should the country be unable to service the

establishing a full-coverage insurance against insol- replacement bonds and need to draw on the guaran-

vency, however, as some EU politicians are appar- tees from the ESM, full insolvency must be declared

ently contemplating. for the entire outstanding government debt.

The CAC bonds, backed by partially guaranteed The key prerequisite for maintaining the market disci-

replacement bonds, provide a possibility for troubled pline ensured by correct interest spreads (and for

European countries to address their financing needs allowing capital markets to allocate aggregate savings

immediately. As these bonds define and limit the risk efficiently) is the sequencing and relative size of the

to investors, they provide a key instrument for coun- haircut and government aid in the case of impending

tries to raise money from the market without having insolvency. Before financial aid in the form of guar-

to resort to the funds of the ESM. For instance, issu- anteed replacement bonds may be granted, the credi-

ing these bonds can make it possible for these coun- tors must initially offer a partial waiver of their

tries to repurchase debt at today’s discounted market claims. Only this order of events (with defined maxi-

values, with the goal of significantly reducing their mum losses for the investors) can guarantee that the

debt-to-GDP ratios. creditors apply caution when granting loans and

demand interest mark-ups.

For countries that nevertheless face difficulties, we

propose a three-stage crisis mechanism that distin- There are reasons to hope that future crises of the

guishes between illiquidity, impending insolvency and euro area will not be as severe as the current one,

(full) insolvency. We place most emphasis on the sec- given that some of the initially huge differences

ond of these concepts, because it is a breakwater pro- between the European economies have been reduced

cedure that seeks to avoid full insolvency. in the first decade of the euro. Despite their excesses,

the recent capital flows within the euro area have

First, if a country cannot service its debt, a mere liq- indeed fostered the catching-up process in lagging

uidity crisis will be assumed, i.e. a temporary difficul- countries. Because of the reduced distance, and the

ty due to a surge of mistrust in markets that will soon emergence of country risk in financial markets, the

be overcome. The European Stability Mechanism catching-up process within the euro area can be

(ESM) helps overcome a liquidity crisis by providing expected to be much slower in the future. At the same

short-term loans, senior to private loans given to gov- time, the crisis will necessarily cause real exchange

95 EEAG Report 2011

Chapter 2 rate realignment, leading to a sustained rebalancing

of trade and capital flows.

Nevertheless, the crisis has revealed severe deficiencies

in the Maastricht Treaty and has now paved the way

for a new economic governance system, ensuring the

long-run stability of the euro area. The new system

must address the core issue of complementarity

between surveillance, supervision and regulation, on

the one hand, and market discipline, on the other. The

main mistake of the past, undermining the second pil-

lar, should not be repeated.


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EEAG (2011), "Greece", CESifo, Munich 2011, pp. 97–125.

The EEAG Report on the European Economy,

G vided further support through its decision to buy


REECE euro-area bonds in the secondary markets.

3.1 Introduction This chapter discusses whether the bailout package

will prove sufficient to place the Greek economy on

As most European countries were coming out of a sustainable path, i.e. whether after the end of the

recession at the end of 2009, Greece was entering a programme in June 2013 Greece will be able (or the

tumultuous period. The announcement of the market will perceive it as able and willing) to con-

newly elected Greek government in October 2009 tinue making the large interest payments and roll

that the projected budget deficit for 2009 would be over its debt without the need for further official


12.7 percent of GDP (rather than the 5.1 percent assistance.

projection that appeared in the 2009 Spring

Commission forecast), was initially met with shock Any attempt at understanding how Greece reached

and opprobrium in Brussels and other euro-area the brink of default, and whether the current

capitals. The initial reaction of policymakers bailout package and attendant policy measures and

across the European Union was that the risk of reforms will succeed in solving Greece’s perceived

contagion was minimal, and that the right way to solvency problems, requires that some salient (and

deal with the situation was to let Greece “swing in unique among the EU countries) features of the

the wind”. Greek economy are brought to attention. We review

these features in Section 3.3, immediately after

However, by April 2010 the manifestations of the describing the evolution of key macroeconomic

Greek crisis were perceived as threatening the finan- aggregates (Section 3.2). We then discuss in Section

cial stability of the euro area. In early May 2010 the 3.4 the details of the bailout package and the poli-

contagion from the Greek crisis was indeed spread- cies and reforms (including pension reform) under-

ing across Europe. Moreover, the Irish, Portuguese, taken so far. In Section 3.5 we evaluate whether the

and Spanish repo bond markets were becoming less policies detailed by the Memorandum of Under-

liquid, and market participants started paying clos- standing (the official agreement between the Greek

er attention to the exposure of different banks to government and the European Union, IMF and

Greek, Portuguese or Spanish sovereign debt (BIS ECB) will be enough to return Greece’s public and

2010). By this time policymakers had recognised the external debt to a sustainable path. This section dis-

gravity of the situation, and in addition to the cusses also whether it will prove politically feasible

110 billion euros bailout package offered to Greece to implement the policies detailed in the

by the European Union, the European Central Memorandum. Section 3.6 discusses how Greece

Bank (ECB) and the International Monetary Fund will deal with the day after the official financing

(IMF) – commonly known as the “troika” – they runs out in the second quarter of 2013. Section 3.7

decided on May 10 to set up a rescue package, offers some concluding comments.

totalling up to 750 billion euros in an effort to pre-

vent a euro-area confidence crisis. 3 The ECB pro- 3.2 Macroeconomic developments

1 This chapter has been prepared with the partial input of Thomas In this section we give a brief overview of the main

Moutos. He also kindly allowed the EEAG to use material he has

published elsewhere and has assured the EEAG that the editors have macroeconomic developments in Greece during the

given their promission. See Katsimi and Moutos (2010) and Moutos

and Tsitsikas (2010). last five decades, but the emphasis will be on the evo-

2 The 2009 budget deficit turned out to be significantly higher than

that. After a revision by Eurostat in April 2010, which placed it at lution of the Greek economy during the last 15 years.

13.6 percent of GDP, the latest figure (November 2010) announced We also focus more on issues of economic structure

by Eurostat is 15.4 percent of GDP.

3 The total of 750 billion euros will consist of up to 500 billion euros that differentiate the Greek economy from the rest of

provided by euro-area member states, with the IMF providing at

least half as much. the euro area.

97 EEAG Report 2011

Chapter 3 3.2.1 Growth performance Figure 3.1

Greek GDP per capita relative to EU-15 and the peripheral-4

Following the end of the three-year %

civil war in 1949, Greece started its 120 Average of

reconstruction period in the 1950s. Ireland, Italy, Portugal and Spain

According to Maddison (1995), 100

Greece had in 1950 the lowest per-

capita income among the group of 80

countries that later became the EU-15. EU-15

Consistent with convergence theories, 60

Greece was the fastest growing econo-

my among this group of countries 40

from 1950 to 1973 and by 1973 its per 72 76 78 8 98 06

66 70 74 80 2 84 86 90 92 94 6 00 02 4 08

0 62 64 68 8

8 9 0

6 19 19 19 19 19 20

19 19 19 19 19 19 19 19 19 19 19 20 20 20 20

19 19 19 19

capita GDP had risen above Ireland’s Source: Ameco: Domestic Product, Gross Domestic Product per Head of Population, at Constant Prices

and Portugal’s. During the rest of the (RVGDP),, data extracted on 11 January 2011;

own calculations.

1970s Greece’s growth rate decelerat-

ed, but it was still the highest among ployment rate increased gradually to 11.7 percent in

the (later to become the) EU-15, and the second 1999, despite the fact that the 1990s were a higher-

highest growth rate among the OECD countries growth decade than the 1980s. The fast growth dur-

behind only Japan. This development is portrayed ing the last decade brought the unemployment rate

in Figure 3.1. down to 7.7 percent in 2008, but by 2009 it had

climbed to 9.5 percent, reaching even 13.5 percent in

The long period of fast growth came to an abrupt end October 2010.

in the 1980s. During this decade, per capita GDP in

Greece grew not only at a slower rate than the peri- The fluctuations in the unemployment rate were not

pheral-4 (Ireland, Italy, Portugal and Spain), but also matched by fluctuations in the total employment rate

in comparison with the (unweighted) average for the which, following a small decline in the early 1990s,

(later to become the) EU-15 and the OECD (2 percent increased steadily, from 55 percent in 1983 to 61 per-

and 2.1 percent, respectively). cent in 2008. Unlike other euro-area (EA) countries,

the increases in the employment rate in Greece were

The anaemic performance of the economy continued not accompanied by substantial decreases in hours

until 1993 (the 1990 to 1993 growth in per capita worked per employed person (Figure 3.3). The aver-

GDP was minus 0.5 percent per annum), but age annual hours worked per employed person remain

improved for the rest of the 1990s and accelerated in far above the EA-12 average (Greece: 2,160, EA-12:

the first decade of the new millennium. However, as 1,578, in 2009) and are higher than in any other coun-

discussed below, the relatively fast growth of the last try in the EU-27.

decade did not have solid foundations, but was based

on an unsustainable public and private

spending spree. Figure 3.2 Unemployment rates


3.2.2 Labour market 21


The changes in the average growth 15

rates from decade to decade were Spain

reflected in changes in the unemploy- 12 Greece

ment rate (Figure 3.2). Until 1981, due 9

to fast output growth and emigration,

the unemployment rate was kept below 6 Portugal

4 percent. By 1984, the unemployment 3

rate had climbed above 7 percent, and 0

it declined slightly up to the end of the 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

decade. During the 1990s the unem- Source: Ameco: Population and Employment, Unemployment, Percentage of Civilian Labour Force (ZUTN),, data extracted on 11 January 2011.


EEAG Report 2011 Chapter 3

women), and jobs clashing with

Figure 3.3 their responsibilities as home-

Annual hours worked per employed person makers will be less attractive. The

hours efficient course of action for a

2300 family in these circumstances is

Greece often for the male member to

2100 work long hours in market-based

activities and the female member

to specialize in home production

1900 Portugal (or to participate in the shadow


1700 EA-12 Given the expected contraction

in aggregate demand for hours

1500 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 of work in the Greek economy

Source: Ameco: Domestic Product, Gross Domestic Product per Hours Worked, Average annual hours worked due to the consolidation mea-

per person employed (NLHA),, data extracted

on 11 January 2011. sures of the bailout package, it

is important that policy mea-

An explanation for the high number of hours worked sures are taken that soften the impact on the mea-

is the importance of self-employment in the Greek sured unemployment rate and the incidence of un-

economy. The share of self-employment in total employment by inducing some work-sharing (e.g.,

employment is the highest among OECD countries (it through facilitating the creation of part-time em-

is about 16 percentage points higher than the EA-12 ployment opportunities or temporary reductions in


average). Self-employed people tend to work and individual work hours).

report longer hours than dependent employees; for

example, it is common for small store owners – and

there are many of them in Greece – to work more than 3.2.3 Public sector

70 hours per week. The Greek government is highly centralized. The

A complementary explanation reflects the interaction central government collected almost 67 percent of

between the Greek socio-economic structure, an revenues and accounted for about 55 percent of

underdeveloped welfare state and employment protec- expenditures in 2007; the relevant figures for the

tion legislation (EPL). Greece had (until the reforms OECD as a whole are 58 percent and 43 percent,

of July 2010) one of the strictest EPL measures respectively (OECD 2009). Local governments repre-

among OECD countries (OECD 2004). A high level sent a very small portion of total revenues and expen-

of EPL implies that employers will try to sort out ditures (Greece: 2.6 percent and 5.6 percent, OECD:

among job applicants of similar productivity those 17.6 percent and 32.2 percent, respectively) and

ones who are more likely to stay with the firm for a receive most of their revenues as grants from the cen-

long period of time, and offer them a wage-employ- tral government (more than 90 percent of their fund-

ment package that involves long work hours. Given ing). Social security funds account for over 30 percent

the Greek family and social welfare structure, these of revenues and almost 40 percent of expenditures

applicants will most likely be prime-aged men. The (OECD: 21.4 percent and 24.6 percent, respectively).

absence of a well-developed welfare state implies that

females face serious constraints in their labour market

activity. Both the willingness of employers to hire Government spending and its components

them will be lower (as employers may wish to avoid Up until 1980, government spending in Greece was

future quits induced by childbearing or other family- significantly smaller than the average for the coun-

related care activities that are usually performed by tries which became the initial 12 countries of the

euro area (EA-12). In 1970, government spending as

4 This is only partly explained by the larger share of agricultural a proportion of GDP was 23 percent in Greece and

employment in Greece, and it may well be induced by a privately effi-

cient response to the limits on the size of the firm caused by the high 34 percent in the (later to become the) EA-12,

employment protection legislation. This arises because firm owners whereas in 1980 the corresponding figures were

prefer to rely on “flexible” family members to staff the company. The

implications are reflected in the very small average size of Greek 30 percent for Greece and 43 percent in the (later to

firms. 99 EEAG Report 2011

Chapter 3 5

become the) EA-12. After a Figure 3.4

huge expansion of the pub- Government spendings

lic sector in Greece in the % of GDP

1980s, government spending 55

as a proportion of GDP

had, by 1990, gone above 50

that of the states that EU-15

became the EA-12, the rele-

vant figures being 49 per- 45 Greece

cent for Greece and 48 per-

cent for the EA-12 (OECD 40

2009). Since the increase in Average of

Ireland, Italy, Portugal and Spain

spending was not accompa-

nied by corresponding in- 35

creases in government rev- 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Ameco: General Government (S13), Expenditure (ESA95), Total expenditure (TE) (UUTG),

enue, the explosion in public, data extracted on 11 January 2011; own

debt as well as the prospect calculations.

of European Monetary percentage of GDP) in Greece had surpassed the

Union (EMU) participation forced successive Greek corresponding figures for the average of Ireland,

governments in the 1990s to put the brakes on accel- Italy, Portugal and Spain, whereas by 2008 it had

erating government spending. By 1999, government matched the EU-15 average.

spending was down to 44 percent of GDP in Greece

compared with 48 percent in the EA-12 states. It The growth in government spending in Greece is

appears that after gaining entry in the euro area, largely accounted for by the growth in social transfers,

Greek policymakers stopped being as vigilant in which rose from 8 percent of GDP in 1970 to 21 per-

their efforts to further curb government spending, cent of GDP in 2009, and in the compensation of

and by 2008 (before the global crisis hit Greece), public employees (from 8 percent in 1976 to 12.7 per-

government spending stood at 48 percent, climbing cent of GDP in 2009). 6 Of particular interest is the

to 52 percent of GDP in 2009. Of particular interest fact that during this period government spending on

is the comparison in the evolution of government gross fixed capital formation (excluding capital trans-

spending among the peripheral EU countries. Figure fers received) remained practically unchanged, hover-

3.4 shows that by 1997, government spending (as a ing at around 3 percent of GDP.

5 The low share of government spending until 1980 is noteworthy The most important category among income transfers

given Greece’s large military spending, which has been on average

50 percent larger than what the government spends on education. in Greece is pension benefits. This is the fastest grow-

The implications of this allocation of public spending for Greece’s ing category of social spending, and the biggest risk

long-run growth potential are beyond dispute.

6 For the earlier data see Ministry of National Economy (1998), regarding the sustainability of public finances in

whereas the recent data are from the Ameco database.

Table 3.1 Demography-related government expenditure

Greece EU-27 Euro area Change





Change 2007–


2007– Level


2007– Level


Level 2060


2060 2007


2060 2007



(% of (percentage (% of (percentage (% of (percentage

GDP) points) GDP) points) GDP) points)

Pensions 11.7 7.7 12.4 10.2 1.7 2.4 11.1 2.1 2.8

Health care 5.0 0.9 1.4 6.7 1.0 1.5 6.7 1.0 1.4

Long-term care 1.4 0.8 2.2 1.2 0.6 1.1 1.3 0.7 1.4


benefits 0.3 –0.1 –0.1 0.8 –0.2 –0.2 1.0 –0.2 –0.2

Education 3.7 –0.3 0.0 4.3 –0.3 –0.2 4.2 –0.3 –0.2

Total 22.1 9.1 15.9 23.1 2.7 4.7 24.3 3.2 5.2

Source: European Commission (2009), p. 26. 100

EEAG Report 2011 Chapter 3

Greece. Government spending on Figure 3.5

pension payments was expected Wages by sector and nominal GDP in Greece

to rise in Greece from 11.7 per- Index 1995=100

cent of GDP in 2007 to 19.4 per- 330

cent in 2035 (for the EU-27 the Publicly-owned enterprises

rise is expected to be only 1.7 per- 270

centage points, taking it to Nominal GDP

11.9 percent of GDP in 2035). 210

Table 3.1 provides long-term pro-

jections for pension spending as Public sector

well as for different categories of 150

demography-related expendi- Private sector (excl. banks)

tures. The sum of all other age- 90

related government expenditures 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

is expected to rise by only 1.4 per- Source: Bank of Greece, Annual Reports (2002, 2005 and 2010); own calculations.

centage points until 2035 (in con-

trast to the 7.7 percentage points

for pensions alone); the policy wage bill increased by 33 percent. The growth in pub-

reforms of the pension system adopted in July 2010 as lic sector compensation costs continued in the 1990s

part of the bailout package may go some way towards under different guises. Nominal compensation per

ensuring that the pension system will not be the cause employee in public enterprises grew significantly

of recurring fiscal crises like the one the country expe- faster than wages in other sectors. We can see from

rienced in 2010. Figure 3.5 that the cumulative increase over the peri-

od from 1995 to 2009 in (gross) nominal private sec-

The large growth in general government spending on tor compensation per employee (excluding the bank-

public employee compensation (from 8.3 percent of ing sector) was 116 percent, whereas the cumulative

GDP in 1976, to 12.7 percent in 2009)

7 is the result of increase in the public sector was 159 percent, and in

considerable increases in both the number of (gener- publicly owned enterprises 221 percent. 9 The cumula-

al) government employees and in their real wages, tive increase in nominal GDP during the same period

especially during the 1980s. While up to 2000, the was equal to 160 percent, the same as the increase in

Greek government was spending less (as a percentage public sector compensation per employee. We note

of GDP) than the EA-12 average on wages and that the increase in the economy-wide real compensa-

salaries, the inexorable rise in government spending tion per employee was equal to 39 percent during the

on employee compensation has pushed it now higher same period, whereas the increase in GDP per

than the EA-12 average. Between 1976 and the second employed person was equal to 35 percent. The

quarter of 2010, the number of government employ- increase in the labour share was thus due to profliga-

ees almost tripled (from about 282 thousand to 10

cy in the wider public sector, a result of the loose


768 thousand ), while private sector employment dur- budget constraints that had come with the euro in

ing the same period increased by about 24 percent some of Europe’s peripheral countries.

(from 2.95 million to 3.66 million); thus, general gov-

ernment employment increased from 8.7 percent of The above-described developments in public sector

total employment in 1976 to 17.3 percent in the sec- pay and employment reflect the fact that public sector

ond quarter of 2010. employment has remained a major channel through

which political parties in Greece dispense favours to

Real wages of civil servants received a very large boost partisan voters, as well a “redistributive” tool in peri-

in the 1980s. In 1982 alone, the central government’s ods of high unemployment (see Demekas and

Kontolemis 2000). The relatively large size of employ-

ment in the public sector, and the desire of the two

7 These numbers are calculated using data from the Ministry of

National Economy (1998). contending political parties in Greece to use appoint-

8 The use of the word “about” is intentional. The Ministry of

Finance, until June 2010, had no precise idea of the total number of

general government employees. This reflects mainly the unwilling- 9

ness of various ministries to reveal the number of civil servants See Fotoniata and Moutos (2010).


employed in their core operations and in the public enterprises under From 1995 to 2009, the rise in real private sector wages was small-

their control. A census of civil servants undertaken in July 2010 er than the rise in business sector productivity (Fotoniata and

revealed that their number is 768,009. Moutos 2010).

101 EEAG Report 2011

Chapter 3 ments in the public sector to gain Figure 3.7

votes, was one of the factors Structure of total revenue of Greek general government

responsible for why the increases % of total revenue

in public sector wages were con- 50

sistently above those awarded in Indirect taxes

the private sector. The conse- 40

quence was not only a surge in

government spending but also

increasing reservation wages for 30

private sector employment, Social security contributions

which undermined the competi-

tiveness of the Greek economy. 20 Direct taxes

Economists call this phenome-

non the Dutch disease after the 10

difficulties the Dutch economy 1970 1975 1980 1985 1990 1995 2000 2005

Source: Ameco: General Government (S13), Revenue (ESA95),

once faced when the natural gas serie/SelectSerie.cfm, data extracted on 11 January 2011; own calculations.

industry absorbed substantial

fractions of the workforce from

industry by outbidding wages. Greece (at 37 percent of GDP) had again fallen way

below the EU-15 (which stood at 44.3 percent) and

even the peripheral-4 average (which stood at

39.2 percent) – see Figure 3.6. Sources of government funding

The rise in government revenue only hesitantly fol- Direct taxes (including social security taxes) con-

lowed the rise in government spending. While govern- tributed the most to the rise in government revenue;

ment spending relative to GDP rose by 18 percentage whereas in 1976 they were 13 percent of GDP and

points in the 1980s, government revenue rose by only 47 percent of total government revenue, by 2009 they

5 percentage points (from 27 percent in 1980 to had risen to 23 percent of GDP and 59 percent of

32 percent in 1990). More adjustment in government government revenue. As a result, the significance of

revenue occurred in the 1990s, when its GDP share indirect taxes declined from 46 percent of government

rose by 11 percentage points (from 32 percent of GDP revenue in 1976 to 30 percent in 2009. This reduction

in 1990 to 43 percent in 2000). This brought Greece’s in the importance of indirect taxes was a result of two

general government revenue 3 percentage points forces: first, the harmonisation of indirect taxation in

below the EU-15 average (and above the average for Greece with those of the (then) EEC in 1980 (the year

the peripheral-4), but by 2009 government receipts in prior to Greece’s accession to the EEC) when many

indirect taxes were cut or abol-

ished; 11 second, the creation of

the Single Market in 1992, when

Figure 3.6 more indirect taxes were abol-

Total revenue of general governments ished. Figure 3.7 depicts the evo-

% of GDP lution of different sources of tax

48 revenue in total (tax and non-tax)

46 revenue.


44 Social security contributions,

Greece which provided 26 percent of

42 government revenue in 1976, rose

40 Average of

Ireland, Italy, 11 Following Greece’s entry in the EEC in

38 Portugal and Spain 1981, there was a large decrease of tariff

revenue; whereas in 1974 tariff revenue

36 contributed 7.5 percent to total tax rev-

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 enue, by 1982 the share of tariff revenue in

total tax revenue had declined to 1.8 per-

Source: Ameco: General Government (S13), Revenue (ESA95), Total revenue (TR) (URTG), cent, and by 1990 had declined to below, data extracted on 11 January 2011; own 0.1 percent.

calculations. 102

EEAG Report 2011 Chapter 3

to form 31 percent of revenue in 1985, and climbed to the estimated size of the shadow economy in the two



38 percent in 2009. This rise in the importance of

social security contributions in government revenue The distributional implications of tax evasion in

came about through large rises in statutory tax rates. Greece have been found to largely offset some of the

In 1981, the rate for employer social security contri- progressive elements of the tax system. Matsaganis

butions stood at 18.75 percent, whereas the employee and Flevotomou (2010) have compared the tax

rate was 10.25 percent. By 2008, these rates had risen reported incomes of a large sample of income tax

to 28 percent for employers and 16 percent for returns in 2004/05 with those observed in the house-

employees. The relevant figures for the EU-15 average hold budget survey of that year. They found that tax

in 2008 were 24 percent and 11.4 percent, respectively evasion causes the poverty rate and the poverty gap to

(OECD 2008). rise above what would have been the case under full

tax compliance, in spite of the fact that in their calcu-

The outline of the Greek tax system shows that lations the poverty line was allowed to rise to reflect

Greece has significantly lower tax revenue (including higher disposable incomes with tax evasion.

social security contributions) than the other EU-15

countries and even lower ones than the other coun- In the past, Greek governments have tried to deal with

tries in the periphery (with the exception of Ireland). tax evasion by inferring an individual’s income on the

In comparison to the EU-15, the lack of total govern- basis of “objective criteria” (i.e. presumptive taxa-

ment revenue, and of tax revenue, relative to GDP has tion). This method presumes that a minimum level of

been in the range of 6 to 7 percent of GDP in recent income is required for an individual to own assets or

years. consumer durables of various sizes or value (e.g.

houses, swimming pools, passenger cars, motor boats)

In addition, the Greek tax system is replete with seri- and to pay for household services (e.g. maids, garden-

ous drawbacks. (Some of the above-mentioned short- ers, drivers, tutors). An individual’s tax obligations

comings of the tax system have been ameliorated by would then be calculated on the higher of their

the 2010 tax reform, which we discuss in Section 3.4). reported or “objectively calculated” income. Various

These have arisen as the tax system has been changing other methods have also been tried in the past in order

frequently in ad-hoc fashion to comply with EU reg- to infer the income of self-employed individuals (e.g.

ulations, to generate additional revenue and to reverse in the case of dentists an algorithm based on the years

(or sometimes foster) real or perceived inequities of of practice, the geographical location of the surgery,

the tax system. the use of dental assistants, etc.).

Both the issues of equity and efficiency are adversely Despite the shortcomings of these methods, it is

affected by the main issue bedevilling Greek public worth noting that they resulted in higher tax obliga-

finances, namely tax evasion. This issue is particular- tions for many of the professional classes (e.g. medical

ly pertinent among those owning small businesses and doctors, dentists, lawyers, architects), which on aver-

the self-employed (from plumbers and electricians to age reported incomes below those earned by manu-

medical doctors and lawyers), and it is exacerbated by facturing workers. These methods were abandoned a

the fact that the share of self-employed in total few years ago in the expectation that the reduction in

employment is so high in Greece. That the self- statutory tax rates would increase taxpayer compli-

employed are more likely to tax-evade than those on ance. However, the response of the professional class-

dependent employment is well established in the liter- es was not as expected since they continued to declare

ature. For example, using US tax audit data, Slemrod ridiculously low incomes.

13 As a result, the current

and Yitzhaki (2002) calculated that the rate of under- Greek government, forced also by the threat of

reporting of income from dependent employment was default, is bringing forward legislation that reinstates

less than 1 percent, whereas the rate at which the self-

employed under-reported their income was close to 12 Schneider and Enste (2000) and Schneider (2006) estimate the size

of the shadow economy in Greece to be the largest (as a proportion

58 percent. Assuming that the behaviour of the self- of GDP) among 21 OECD countries. Their estimates hover between

employed in Greece regarding tax evasion is similar to 25 and 30 percent of GDP.

13 For example, according to data released from the Ministry of

that in the United States, the difference in the shares National Economy (reported in the Greek newspaper Ta Nea,

31 March,

of self-employment in the two countries (Greece: 2010), among the 151 medical doctors practicing in the most lucrative

(for medical professionals) area of Athens, more than 40 percent of

30 percent, United States: 7 percent) would explain them reported annual, before-tax, incomes of less than 20,000 euros

most of the difference (about 20 percentage points) in in 2008, which is less than the average income for wage earners.

103 EEAG Report 2011

Chapter 3 (and in some cases reinforces) the Figure 3.8

old “objective criteria” for the Greek gross debt and government budget deficit

calculation of minimum taxable % of GDP

% of GDP

income. 140 18



In addition to the large rates of Gross debt (left axis) 14



income tax evasion, Greece faces (right axis) 12

very high rates of payroll tax eva- 80 10

Debt Maastricht Limit

sion. As is to be expected in such (60%, left axis) 8


cases, the estimates vary widely. 6

Studies conducted by the Social 40 4

Insurance Foundation (IKA) 20 Deficit Maastricht Limit 2

estimate that payroll tax evasion (3%, right axis)

0 0

has increased through the years; 74 82 84 86 88 92 94 96 98 00 02 08

76 78 80 90 04 06

19 19 19 19 19 19 19 19 19 20 20 20

19 19 19 19 20 20

the early 1990s’ estimates were

around 13 percent of revenues, Source: Ameco: General Government (S13), Expenditure (ESA95),

serie/SelectSerie.cfm, data extracted on 11 January 2011; own calculations.

whereas more recent estimates

raise this figure from about behaviour is provided by the existence of deadlines

16 percent in 2003 to 20 percent in 2005 (POPOKP that permit taxpayers to be absolved of their tax

2005). IKA estimated that employers in 10 percent of obligations if the state has not managed to collect the

all firms inspected in 2008 failed to pay social contri- owed taxes in time. In 2007 alone, around 3.5 billion

butions, while 27 percent of all workers remained euros (about 1.5 percent of GDP) in taxes were writ-

unregistered (Matsaganis et al. 2010). A weak connec- ten off, mainly due to lapses in time for the collection

tion between individual contributions and benefits of the owed tax revenue (State Audit Council 2008).

has created incentives for collusion between employer

and employee in order to minimise their social securi- The failures in collecting taxes and in reigning in

ty contributions. government spending were reflected in the fast accu-

mulation of public debt. The accumulation of pub-

On the face of it, successive Greek governments have lic debt through successive budget deficits is depict-

tried to implement reforms aimed at increasing the ed in Figure 3.8 for the period from 1974 to 2009. 14

efficiency of tax collection, mainly through efforts to

curb tax evasion. For example, from 2004 to 2007 new We note the large deficits of the 1980s and early

measures were instituted with the aim of reducing tax 1990s which took the debt-to-GDP ratio from

evasion. The most important of these measures were: 20 percent in 1975 to 100 percent in 1994. The gov-

(i) the imposition of VAT on new buildings (aimed at ernment’s focus on the goal of EMU participation

reducing the incidence of informal activity in con- led to the fiscal consolidation of 1994 to 2000, but

struction activities), and (ii) the upgrading of the this was reversed after being admitted to the euro

information technology used for the cross-checking of area. The onset of the global financial crisis put an

tax data and the restructuring of audit services. In end to the perception (held by both politicians and

addition, cuts in personal income taxes and measures financial markets) that Greek public finances were

to broaden the tax base (through the imposition of a sustainable, and by the end of 2009 the public debt-

10 percent tax on dividends and capital gains) and to to-GDP ratio had risen to 127 percent, and the bud-

simplify the tax system (through a unique property get deficit for the year is estimated at 15.4 percent of

holding tax) were introduced. Yet, these measures GDP.

have not had much effect on tax evasion. A reason for

this is that the measures are mostly piecemeal and do Given the fast growth in nominal (and real) GDP that

not take into account all other pieces of existing leg- the Greek economy registered from the mid-1990s

islation. Another reason is that recurring tax until 2008 and the rather moderate (by Greek stan-

amnesties have eroded the credibility of the system by dards) deficits recorded during the period, how can

providing incentives to taxpayers to delay and eventu- 14 From 1953 to 1973 Greek governments were very prudent and, in

ally evade the payment of taxes. The current Greek most years, modest annual budget surpluses were recorded. This fis-

government announced another such “settlement” in cal stance was partly a result of the fact that the country could not

borrow internationally prior to 1966, when the settlement of the

October 2010. A further incentive for tax-evading 1930s default was finally completed.


EEAG Report 2011 Chapter 3

spending and revenues are equal – the rate compo-

one account for the fact that there was not a decline in nent; (iv) various activities undertaken by the govern-

the debt-to-GDP ratio? ment that affect the accumulation of debt but are not


reported as deficit – the

To answer this question we decompose the well- The

stock-flow adjustment.


known identity details of this decomposition are explained in Box 3.1.

describing the accumulation of pub-

lic debt in order to disentangle the relative importance

of the following four factors to debt accumulation: Figure 3.9 presents the annual decomposition of the

(i) over-generous programme spending and lax tax debt accumulation, whereas Figure 3.10 presents the

policy (and administration) leading to a primary compound effect of the different components.

deficit even if the economy is operating at potential Starting from 1990, when government debt was

output – we call this the 72 percent of GDP, the debt-to-GDP ratio reached

(ii) pri-

structural component;

mary deficits arising as a result of output being below 15 Blanchard (1990), Buiter, Corsetti and Roubini (1993), and Fortin

potential – the (iii) the (real) inter-

cyclical component; (1996) present various ways of decomposing the public debt accu-

mulation identity.

est rate exceeding the GDP growth rate, so that the 16 The data used in this section relate to debt and deficits as report-

debt-to-GDP ratio would rise even if programme ed by Ameco before the November 2010 revision by Eurostat.

Box 3.1 Public debt decomposition t, B

The government budget constraint implies that the stock of public debt at the end of period results from


inherited debt at the end of period t-1, B , plus the budget deficit during period t, D :

t–1 t

B = D + B .

t t t


Interest payments can be separated from other expenditures, and the accumulation identity can then be rewritten

as: B = (1 + r ) B + PD , (1)

t t t



is the primary deficit in period t. To account for the effects of growth on the government’s ability to

where PD t

borrow, after some simple manipulations we can approximate the evolution of government debt in terms of ratios

to GDP (denoted by lowercase letters):

= ( ) +

b b r g b pd , (2)



t t t t t t

is the growth rate of real GDP.

where g t

An implication of equation (2) is that in order for the debt ratio to be stabilised, the left hand side of (2) must be

zero, implying that the primary balance should satisfy

= ( ) . (3)

pd r g b

t t t t

This implies that when the real interest rate is higher than the growth of real GDP and the debt is positive, the

< 0

government must run a primary surplus ( ).


Using equation (2), we can rewrite the debt (-to-GDP ratio) accumulation identity as

* *

= + ( ) + ( ) , (4)

b b pd pd pd r g b

1 1

t t t t t t t t


where stands for the primary deficit-to-GDP ratio when GDP is at its potential level. In equation (4) we

pd t

now have the debt accumulation consisting of three components. The first component is the structural component

and measures the contribution of the primary deficit to debt accumulation if the economy is operating at full

capacity. The second component is the cyclical component (this is the second term on the right hand side) and

measures the contribution that the primary deficit makes to debt accumulation as a result of the economy

operating below capacity. Finally, the third component, which has been called the rate component, measures the

influence of the difference between the (real) interest rate and growth of GDP on the debt-to-GDP ratio.

In order to apply equation (4) in the Greek context, we need to take into account various activities undertaken by

the government that affect the accumulation of debt but are not reported as deficit. These activities are subsumed

under the term stock-flow adjustment (European Commision 2004). Taking into account the stock-flow

adjustment term (sf ), the modified equation (4) reads:

t * *

= + ( ) + ( ) + . (5)

b b pd pd pd r g b sf

1 1

t t t t t t t t t

The Ameco database provides estimates for two measures of potential output as well as estimates of the

cyclically adjusted deficit for both of these measures. Since the results of using either measure of potential output

do not affect, to any significant degree, the contribution of each factor to the evolution of debt, we will present

results based on the sustainable GDP measure. 105 EEAG Report 2011

Chapter 3 stock-flow adjustments to the rise

Figure 3.9 in the debt-to-GDP ratio? The

Decomposition of Greek debt growth Greek government had accumu-

% of GDP lated (especially during the


25 Rate component 1980s) large implicit liabilities in

Stock-flow adjustment 20

20 the form of loan guarantees to

Structural component “restructured enterprises”, which


15 Cyclical component became quasi-public entities.

Debt growth 10

10 From 1990 to 1993 the govern-

ment took over the long-standing


5 liabilities of these entities to the


0 banking system – up to that point

these liabilities were not recorded


-5 in government debt. 17 These lia-

bilities (known as “consolidation


-10 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 loans”) amounted to 1.8 trillion

Source: Moutos and Tsitsikas (2010), p. 181. drachmas (about 5.3 billion

euros), and had by 1992 added

113 percent at the end of 2009. Figure 3.10 makes 10 percentage points to the debt-to-GDP ratio.

clear that the rise in the debt-to-GDP ratio by 41 per-

centage points from 1990 to 2009 can be wholly attrib- Large stock-flow adjustments were also recorded dur-

uted to the stock-flow effect, which, in the absence of ing the 1994 to 2000 period since the second phase of

other forces, would have contributed 62 percentage EMU required a consolidation of government

points to the debt-to-GDP ratio. (We note that this accounts, especially with the central bank. The gov-

conclusion would most likely remain intact had we ernment had three accounts with the central bank,

used the latest debt and deficit data as revised by which were overdrawn to the sum of 3.04 trillion

Eurostat in November 2010.) The joint, cumulative drachmas (about 9 billion euros), all of which had to

force of the other three components would have sub- be transformed into formal debt by the end of 1993 so

tracted from the debt-to-GDP ratio 21 percentage that Greece could enter the second phase of EMU

points, of which the structural component con- (see Manessiotis and Reischauer 2001 for more

tributed 12 points, the rate component 8 points and details). This action alone added another 16 percent-

the cyclical component just 1 percentage point. age points to the debt-to-GDP ratio. In addition to

these very large, debt-increasing, stock-flow adjust-

What government actions (both before and after ments, it is worth mentioning that during the consoli-

1991) were responsible for this huge contribution of dation period some (far smaller) debt-reducing

adjustments were made. These

involved the transfer of Social

Figure 3.10 Security Fund’s deposits from the

central bank (where they were

Decomposition of Greek debt growth - compound effect held in its own name) to the gov-

% of GDP

80 ernment’s accounts, as well as the

Rate component privatization revenue that was

Stock-flow adjustment

60 Structural component used to retire public debt. It is

Cyclical component evident that the effort at budget

Debt growth

40 consolidation that started in 2010

will not be successful if it does

20 not manage to reign in the cre-

ation of the off-budget liabilities,


-20 17 Large stock-flow adjustments took

place in 1982 and in 1985 as well. These

resulted from previous loans that the

-40 Bank of Greece extended to the govern-

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 ment in order for the latter to make off-

Source: Moutos and Tsitsikas (2010), p. 182. budget transfers to farmers.


EEAG Report 2011 Chapter 3

which are still accumulating in Figure 3.11

some publicly-owned enterprises. Net national saving rates of the EU periphery

% of GDP

From Figure 3.9 we observe that 30

from 1994 to 2000, the structural 25 Greece

component contributed on aver- 20

age about 4 percentage points per Ireland


annum to debt reduction. This Spain


process was reversed gradually 5

from 2001 to 2009; during this Portugal Italy


period the structural component -5

added on average about 2 per-

centage points per annum to the -10

increase in the debt-to-GDP -15 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2009

ratio. One may be justified in Source: Ameco: Capital Formation and Saving, Total Economy and Sectors, Net-Saving, National (USNN),

thinking that the efforts of Greek, data extracted on 11 January 2011; own


governments to reign in the accu-

mulation of debt were relaxed associated with significant increases in both the net

after the country gained entry into the euro area, and gross saving rate until 1974. For the 35 years since

given that Greek interest rates fell dramatically (see 1974, however, there has been a steady decline in the

Chapter 2, Figure 2.1). A more benign interpretation saving rate, with the net saving rate dropping by about

would take into account the steep rise in spending on 32 percentage points, from 20 percent to minus 12 per-

infrastructure necessitated by the 2004 Athens cent. 19 This huge drop in the national saving rate has

Olympics and the recent global financial crisis. (since 1988) not been associated with a rise in govern-

Nevertheless, the very large debt-to-GDP ratio left the ment borrowing, but it is wholly attributable to the

country vulnerable to perturbations in the difference decline in the private sector’s gross saving rate (from

between GDP growth and real interest rates. We note 27 percent in 1988 to 11 percent in 2008; see Moutos

that due to the low interest rate environment in which and Tsitsikas 2010).

Greece was operating after entering the EMU and

until the onset of the global financial crisis, as well as The decline in the Greek national saving rate is larger

the fast growth rates it experienced after 1994, the rate than in any other EU-15 country. Figure 3.11 shows

component did not contribute to debt accumulation the net national saving rates for Greece, Ireland, Italy,

(in fact, it subtracted 8 points 18 ). Portugal and Spain, whereas Figure 3.12 displays the

same variable for the EU-15, Germany, Japan, the

3.2.4 External imbalances

Bringing the government’s Figure 3.12

finances in a sustainable position Net national saving rates

is a key priority for Greece. Un- % of GDP

fortunately, this may not be the 20

main problem; the very high, and

rising, net foreign indebtedness 15 Japan

may be the bigger problem. The Germany

fast growth experienced by the 10 EU-15

Greek economy after 1950 (iden-

tified with the initial stages of its 5

catch-up phase with the ad- United Kingdom

vanced OECD economies), was 0 United States


18 See Moutos and Tsitsikas (2010) for 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

more details. Source: Ameco: Capital Formation and Saving, Total Economy and Sectors, Net-Saving, National (USNN),

19 See Figure 3.11. The difference between, data extracted on 11 January 2011; own

gross and net saving is the depreciation of calculations.

capital (i.e., capital consumption). 107 EEAG Report 2011

Chapter 3 United Kingdom and the United Figure 3.14

States. Greece and Portugal are Share of services in total exports and total imports

the only countries in the euro %

area for which the net national 65

saving rate turned negative under 55

the euro, long before the onset of Greece (exports)

the global financial crisis in 2008, 45

another aspect of the soft budget


constraints that prevailed. 35 EA-12 (imports)

EA-12 (exports)

The upshot of the large decline in 25

national saving for Greece has 15

been a gradual widening of the Greece (imports)

current account deficit and the 5

accumulation of foreign debt 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Ameco: Exports and Imports of Goods and Services, National Accounts,

(Figure 3.13). During its period finance/ameco/user/serie/SelectSerie.cfm, data extracted on 11 January 2011; own calculations.

of fast growth from 1950 to 1973

(about 7 percent per annum), alisation of trade took effect), but there was an

Greece ran small current account deficits, which were improvement in the transfers balance (mainly trans-

on average about 2 percent of GDP. These small cur- fers from the European Union), which, as long as it

rent account deficits were made up of large deficits in lasted, prevented a large deterioration of the current

the trade balance on goods and services (about 7 per- account. The current account deteriorated sharply

cent on average) and significant surpluses (about around the year 2000 shortly before Greece was

5 percent on average) on the income and transfers admitted to the euro area. According to Bank of

accounts, mainly reflecting remittances from Greek Greece figures, the country’s negative net internation-

seamen and emigrants. al investment position stood at about 98 percent of

GDP by the third quarter of 2010 – a result of the

Following the first oil crisis and up to Greece’s acces- huge current account deficits that were incurred dur-

sion to the EEC in 1981, there was a reduction in the ing the last 10 years.


growth rate (to still respectable 4 percent per annum),

and a marked improvement in the trade balance, We conclude this section by drawing attention to the

which produced a string of current account surpluses. overwhelming influence of the service sector in total

From 1981 onwards, both the income and trade Greek exports (Figure 3.14). The share of services in

accounts started deteriorating (as emigrants started total exports increased during the 1990s from an

returning to the home country, and the gradual liber- already high level and has, during

the last decade, been more than

twice as large as the correspond-

Figure 3.13 ing measure for the EA-12.

Greek current account and trade balance Before the crisis, in 2008, trans-

% of GDP portation services (mainly sea

4 Current account balance transport) contributed 56 percent

to the total exports of services,


-4 20 Among the likely causes of the decline

in the saving rate in Greece is the continu-

Trade balance ous decline of the share of agricultural

-8 employment (since farmers face greater

income uncertainty than wage earners –

especially government employees), and

-12 the gradual extension of unfunded pen-

sion benefits to a larger part of the popu-


-16 21 See Bank of Greece, Statistics, External

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2009 Sector, International Investment Position

Source: Ameco: Balances with the Rest of the World, National Accounts, Balances with the Rest of the World,

National Accounts, Balance on current transactions with the rest of the world (UBCA), International_Investment_Position-, data extracted on 11 January 2011; own data extracted on 23 January


calculations. 2011, own calculations.


EEAG Report 2011 Chapter 3

to 86 percent by the end of 2009 (IMF 2010b). The

while travel services (mainly tourism) contributed rise by 83 percentage points in net foreign indebted-


another 34 percent. ness dwarfs the 25 point rise in the public debt-to-

GDP ratio during the same period (from 102 percent

During the recent global crisis, the share of services in in 1997 to 127 percent in 2009).

total exports decreased in Greece by about 4 percent-

age points from 2008 to 2009, whereas it increased by Consistent with these facts, the net borrowing require-

about 2.5 percentage points in the EA-12. These dif- ments of the Greek economy as a proportion of GDP

ferential movements reflect the fact that Greece was from 2000 until 2008 were on average 10.6 percent per

earning from transportation services in 2008 as much annum. During the same period, the average budget

as from its total exports of goods (including ships and deficit was 5.9 percent per annum. (according to the

oil). The considerable slowdown in world trade in data revised by Eurostat in November 2010), implying

2009 reduced Greek receipts of transportation ser- that the private sector not only was unable to finance

vices by about 30 percent in 2009 relative to 2008. the government’s budget deficit, but was also an

equally significant net contributor to the rise in the

country’s net foreign indebtedness (Katsimi and

3.3 The crisis Moutos 2010).

The slowdown in global economic activity in 2008, In addition to the very large trade deficits, the rise in

and the recession in OECD countries in 2009 were the foreign indebtedness was also fuelled by (i) the grad-

prelude, but not the cause, of the Greek crisis. With ual decrease in the current and capital transfers, which

hindsight we know that Greece had been on an unsus- Greece was receiving (mainly) from the European

tainable path for many years. In fact, it may have been Union, and (ii) the sharp deterioration in the income

unfortunate for Greece that the global crisis did not account (Figure 3.15). In 1995, the balance on current

come earlier – for, in this case, both the public debt-to- and capital transfers was equal to 3.6 percent of GDP

GDP ratio and the net foreign indebtedness-to-GDP (2.9 on current transfers, and 0.7 on capital transfers).

ratio would have been smaller, thus making the In 2009, the magnitude for the sum of these transfers

adjustment less painful, and the probability of default had dropped to just 0.3 percent of GDP. The deterio-

or debt restructuring smaller. ration in net income receipts was even larger; in 1995

there was a surplus of 2.8 percent of GDP, which by

Greece’s inability to access private financial markets is 2009 had turned to a deficit of 2.9 percent.

related to the fact that a constantly increasing share of

its public debt is externally held, which compromises When a large proportion of public debt is held exter-

the perceived ability (and willingness) of the country nally and debt interest payments to foreigners are a

to keep honouring its debt obligations to foreigners. large proportion of the country’s GDP, foreign

The projected level of net external debt for 2010 is

99 percent of GDP. At the end of

2009 the average net external Figure 3.15

debt-to-GDP ratio of the GIPS

countries (Greece, Ireland, Por- Greek external balances

tugal and Spain) stood at about % of GDP

82 percent (Cabral 2010). 4 Capital transfers balance


The current account deficits 0

incurred after 1997 have been -2

responsible for increasing the -4 Income balance

Current transfers

country’s net foreign debt posi- balance


tion as a proportion of GDP -8

from 3 percent of GDP in 1997 Net lending (+)/

-10 borrowing(-)


22 See Bank of Greece, Statistics, External -14

Sector, Balance of Payments, Basic Items, 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Ameco: Balances with the Rest of the World, National Accounts, Balances with the Rest of the World,

sic_data_of_Balance_of_PaymentsAnnual National Accounts, Balance on current transactions with the rest of the world (UBCA),

data extracted on 23 January

_data.xls, economy_finance/ameco/user/serie/SelectSerie.cfm, data extracted on 11 January 2011; own calculations.

2011, own calculations. 109 EEAG Report 2011

Chapter 3 more than three years, the charge rises to 400 basis

investors may start to question the ability (and/or points. To cover operational costs, a one-off service

willingness) of the government to generate the fee of 50 basis points is also charged for each drawing.

resources required for debt service to foreigners. In the The euro-area loans are envisaged to carry the same

case of Greece, the interest payments made to for- maturities as IMF lending, i.e., a three-year grace

eigners were 3.8 percent of GDP in 2009. In the first period and subsequent repayment of principal in

months of 2010, market estimates for this figure had eight equal quarterly tranches. The interest rate for

it rising to at least 5 percent of GDP in the near the IMF loan (30 billion euros) is around 3.3 percent.

future, under the assumption that interest rates would


not rise – not a small figure by historical standards. The European Council Decision of 10 May 2010

requires Greece to adopt a number of measures

before the deadlines of end-June 2010, end-September

3.4 The bailout 2010, end-December 2010 and end-March 2011.

According to the Memorandum of Understanding

In October 2009, the newly elected Greek government (see European Commission 2010a, Attachment II,

announced that the projected budget deficit for 2009 pp. 59–84) between the Greek government, the

was 12.7 percent of GDP rather than the 2 percent European Commission, the ECB and the IMF, the

displayed in the Greek 2009 budget (approved by adjustment will be frontloaded and will be based

Parliament in December 2008). From this moment more on permanent expenditure cuts than tax increas-

until the formal request for assistance on 23 April es. In total, the fiscal consolidation measures 24

2010, the Greek government attempted to “educate” will

the public about the severity of the brewing crisis and amount to about 20 percent of one year’s GDP over

persuade itself that nothing less than the standard the 2010 to 2014 period. The total adjustment of

IMF bailout package was the only available option. 20 percentage points is planned to be spread over the

As becomes apparent from the events detailed in years, as in Table 3.3. Note that none of these consol-

Box 3.2, domestic political and economic considera- idation measures force the Greek government to save

tions, including the need to persuade the traditional and actually reduce its debt. The measures are merely

voters of the governing party as to the necessity of the designed so as to reduce the net increase in debt.

conditionality-based bailout package, were instru-

mental in delaying the official recognition of the lim- The adjustment programme, in addition to cuts in the

ited choices available to the country. public sector wage bill and increases in indirect taxa-

tion, includes a wide-ranging reform of the pension

The total value of the loans to be disbursed to Greece system and structural reform initiatives aimed to

amounts to 110 billion euros, of which 80 billion are boost the capacity to export and reduce the very large

intergovernmental loans pledged by the euro-area trade deficit. As noted in Section 3.2, reform of the

countries, and 30 billion offered by the IMF. The pro- pension system is the most important budget item for

jected disbursement of these loans is targeted to meet fiscal sustainability (see Table 3.1). Projections from

Greece’s financing needs up to the first half of 2013. the European Commission (2010a) about the growth

Table 3.2 provides these details as well as the predict- of the public debt with an unreformed pension system

ed evolution of government and external debt. (but with all other consolidation measures in place)

raise the debt-to-GDP ratio to more than 250 percent

The euro-area loans carry a variable interest rate, cal- by 2050.


culated as the three-month Euribor rate plus a charge

of 300 basis points. For amounts outstanding for The pension reform adopted by the Greek Parliament

on 8 and 15 July 2010 (for the private and public sec-

tor, respectively) simplifies the current highly frag-

23 For example, the interest payments that the Latin American coun- mented pension system, enhances transparency and

tries had to make to foreigners were on average about 6 percent of

GDP during the debt crisis of the 1980s (Agénor and Montiel 1996). fairness, postpones the retirement age and decreases

The annual reparations that Germany had to make after the initial

period of heavy reparations following the end of World War I the generosity of benefits, while preserving an ade-

(1924–1931) were less than 3 percent of GDP (Webb 1988). (This fig-

ure does not include the most voluminous reparations, though.

Amongst others, most of Germany’s trading fleet and all patent

rights were transferred, German foreign property was nationalized 24

and substantial territories (e.g., Alsace) were lost, see Webb 1988). The consolidation measures include the, as yet, unidentified ones

On the other hand, even 15 years after unification west German as well as those announced by the Greek government before 10 May

transfers to eastern Germany were about 5 percent of west German 2010.


GDP (Sinn 2007, p. 149). IMF (2010a) estimates that for a few years Projections which do not take into account either the consolida-

Greece will have to transfer as much as 5 percent of its GDP as (net) tion measures or the pension reform of 2010 raise the debt-to-GDP

debt interest payments abroad. ratio to over 400 percent by 2040 (see Cecchetti et al. 2010).


EEAG Report 2011 Chapter 3

Box 3.2 Timeline of the Greek sovereign debt crisis

21 October 2009: The newly elected government notifies Eurostat that the projected government budget

deficit for 2009 is 12.5 percent of GDP, instead of the 3.7 percent updated projection

reported in April 2009.

22 October 2009: 10-year bond spread (over the German bond) remains unchanged at 134 basis points.

5 November 2009: Update of government budget reveals an estimated deficit of 12.7 percent of GDP for

2009, more than six times the initial budget (December 2008) estimate.

6 November 2009: 10-year bond spread remains at 139 basis points.

8 November 2009: Budget draft aims to cut deficit to 8.7 percent of GDP for 2010, and projects public debt to

rise to 121 percent of GDP in 2010 from 113.4 percent in 2009.

8 December 2009: Fitch Ratings cuts Greece's rating to BBB+ from A-, with a negative outlook.

9 December 2009: 10-year bond spread reaches 247 basis points.

16 December 2009: Standard & Poor’s cuts Greece’s rating to BBB+ from A-.

22 December 2009: Moody’s cuts Greece's rating to A2 from A1.

23 December 2009: Parliament adopts the 2010 budget setting a general government deficit target of

9.1 percent of GDP.

1 February 2010: 10-year bond spread reaches 270 basis points.

2 February 2010: The European Commission adopts (i) a proposal for a Council Decision, in view of the

excessive deficit correction in Greece by 2012, (ii) a Draft Council Recommendation with

a view to ending the inconsistency with the broad guidelines of the economic policies, and

(iii) a Draft Council Opinion on Greece’s Stability Programme.

3 February 2010: Greece announces a set of measures in addition to those announced in the Stability

Programme (freezing wages and raising excise taxes with the aim of reducing the

government deficit).

11 February 2010: European Council invites the Economic and Financial Affairs Council (ECOFIN) to adopt

these documents, and calls on the European Commission to monitor implementation of the

Council decision and recommendation, in liaison with the ECB and drawing on the

expertise of the IMF. The euro-area member states declare their readiness to take

determined and coordinated action, if needed, to safeguard the financial stability in the euro

area as a whole.

16 February 2010: European Council adopts the above-mentioned documents, after discussion in the


3 March 2010: Greece announces new deficit-reducing measures of over 2 percent of GDP, including an

increase in the VAT rates and other indirect taxes and a cut in the wage bill (through the

reduction in allowances, and partial cancellation of the Easter, summer and Christmas

bonuses, of civil servants).

8 March 2010: Greece submits a report on progress with implementation of the Stability Programme and

additional measures.

15 March 2010: The Eurogroup welcomes the report by Greece, and embraces the European Commission’s

assessment that the additional measures appear sufficient to safeguard the 2010 budgetary

targets, if fully implemented.

25 March 2010: 10-year bond spread drops to 250 basis points.

25 March 2010: Heads of state and governments of the euro-area countries reaffirm that they fully support

the efforts of the Greek government and welcome the additional measures announced on

3 March, which appear sufficient to safeguard the 2010 budgetary targets.

8 April 2010: 10-year bond spread reaches 430 basis points.

11 April 2010: The Eurogroup reaffirms the readiness by euro-area member states to take determined and

coordinated action if needed. It highlights that the objective is not to provide financing at

average euro-area interest rates but to safeguard financial stability in the euro area as a


15 April 2010: Greece requests “discussions with the European Commission, the ECB and the IMF on a

multi-year programme of economic policies … that could be supported with financial

assistance …, if the Greek authorities were to decide to request such assistance”.

22 April 2010: Eurostat revises its estimate for the 2009 Greek budget deficit to 13.6 percent.

22 April 2010: 10-year bond spread rises to 586 basis points.

23 April 2010: Greece requests financial assistance from the euro-area member states and the IMF.

27 April 2010: Standard & Poor’s downgrades Greece’s debt ratings below investment grade to junk bond


27 April 2010: 10-year bond spreads reach 755 basis points.

111 EEAG Report 2011




11.91 MB




+1 anno fa


Dispensa al corso di Economia dell'integrazione europea della Prof.ssa Lilia Cavallari. Trattasi del rapporto dell'EEAG 2011, parte del programma d'esame per i capitoli 1-4. Al suo interno sono affrontati i seguenti temi: conseguenze della crisi economica mondiale, politiche fiscali e monetarie in Europa e nei paesi sviluppati, il nuovo sistema di governance per l'area Euro e la crisi dei debiti, la situazione economico-finanziaria della Grecia e della Spagna.

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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