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Turning the page? Eu fiscal consolidation

Dispensa al corso di Economia dell'integrazione europea della Prof.ssa Lilia Cavallari. Trattasi del rapporto di Paul van den Noord, economic adviser della Commissione Europea. Al suo interno sono analizzate le conseguenze della crisi economica sulla finanza e sulla crescita economica degli stati, sono fornite stime ed auspicate riforme.

Esame di Economia aziendale docente Prof. L. Cavallari

Anteprima

ESTRATTO DOCUMENTO

Against this backdrop, the next section of this paper takes stock of the fiscal situation in the

EU in the wake of the crisis. This is followed by a discussion of the medium- to long-term

fiscal consolidation requirement as estimated in the Commission's Sustainability Report

released in the autumn of 2009 (European Commission 2009a). Subsequently, the two are put

together to gauge the size of the fiscal consolidation task at hand and compares this to the

fiscal consolidation efforts enshrined in the ongoing Excessive Deficit Procedures agreed by

the European Council for a major subset of EU Member States. The before-last section

discusses some ongoing developments in the EU fiscal surveillance and coordination

framework and the final section concludes.

2. The fiscal cost of the crisis

The financial crisis led to large increases in public debt and contingent liabilities related to

financial rescues, which represents the direct fiscal cost of the crisis. Moreover, the

improvement of fiscal positions prior to the crisis proved largely ephemeral, being associated

with growth of tax rich activity in housing, construction markets and financial markets. The

unwinding of these windfalls, along with the fiscal stimulus adopted by EU governments as

part of the EU strategy for coordinated action, is the indirect fiscal cost of the crisis. This

section provides estimates of both the direct and indirect fiscal costs.

2.1. The direct fiscal cost

After the demise of Lehman in September 2008 many EU countries scrambled to rescue their

systemically important financial institutions. This had potentially large cross-border spillover

effects, quickly revealing the need for a coordinated EU strategy. This prompted Member

State governments, together with the Commission, to spell out the principles and objectives of

financial rescues. Rescue packages for national banking sectors were rapidly set up in line

with the guidance provided by the Commission on the design and implementation of State aid

in favour of banks. The rationale of this guidance was to ensure that the rescue measures

attained the objectives of financial stability and maintenance of credit flows, while

minimising competition distortions and negative cross-border spillovers of public

interventions.

By late 2009 the Commission had approved a total of over 3½ trillion (31.4% of GDP) of

State aid measures to financial institutions. EUR 1½ trillion (12.7% of GDP) were effectively

used under the four main headings of debt guarantees, recapitalisation, liquidity support, and

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treatment of impaired assets (see Table 1). State guarantees on bank liabilities represent the

largest budgetary commitment among the aid instruments, with EUR 2.9 trillion (24.7% of

EU GDP) of approved measures, out of which EUR 1 trillion (7.9% of GDP) have been

effectively granted. EUR 300 billion of state recapitalisations were approved (2.7 % of EU

GDP), out of which EUR 170 billion (1.7 % of EU GDP) was effective. Provided either as

part of a national scheme or through recapitalisation of individual banks on an ad-hoc basis,

state capital took the form typically of ordinary or of preferential shares. In case of

recapitalisation by preferential shares, the State aid rules determined the level of pricing,

including step ups in order to incentivise the banks to redeem State capital when market

conditions permit.

As Table 1 indicates there are considerable differences in terms of the size of the financial

support programmes among Member States. At almost double its GDP, Ireland has committed

by far the most resources to bank rescues. There is a second league of countries which

includes the United Kingdom, Belgium and the Netherlands with effective support so far in

the range of 20 to 30% of GDP, and a third group with effective support of around 10% of

GDP (Austria, Germany and Sweden). These differences reflect the relative size of their

banking sectors (United Kingdom, Ireland), the exposure to impaired assets originating in the

United States (United Kingdom, Germany), the exposure to a collapse of local real estate

markets (United Kingdom, Ireland, Spain, Denmark) and the exposure to emerging economies

in Central and Eastern Europe (Sweden, Finland, Austria, Greece, Belgium, Netherlands).

(Table 1)

The overall figures of the committed funds can be used to gauge a range estimate for the total

direct fiscal costs of the crisis. In a favourable scenario, a large part of the fiscal commitments

may either be recovered or may not materialise (in the case of guarantees) (Table 2). In a

more adverse scenario, however, these costs could easily add up to about 13 % of GDP. This

estimated upper bound for the costs of the current crisis is derived by assuming that capital

injections would double from the currently approved 2.7% GDP, while applying to other

public bank interventions (including guarantees) the lower end of the range of recovery rates

in past crises. This estimate of 13% is well in line with the average of past financial crisis and

looks therefore realistic (see Table 3 for an overview of net and gross direct outlays of past

financial crises). But in individual Member States the direct fiscal costs may of course be

much higher than this average. (Table 2)

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(Table 3)

2.2. The indirect fiscal cost

Aside from this direct fiscal cost of the crisis, there is an indirect cost. This comprises the

deterioration in the fiscal position induced by the decline in economic activity and increasing

debt service cost, along with the impact of discretionary fiscal action in support of the real

economy.

It is possible to track the current developments in budget deficits in the EU against previous

banking and financial crisis episodes. According to Figure 1, the deterioration of fiscal

positions in the EU is comparable to earlier financial crisis episodes, with the fiscal deficit on

average estimated to have increased from less than -0.8% (0.6% in the euro area) of GDP in

2007 to 6.8 % (6.3% in the euro area)of GDP in 2009 and 7.2 % (6.6% in the euro area) of

GDP by 2010. Indeed, the deterioration in the fiscal deficit as a share of GDP averaged about

7 percentage points for the major financial crises in the early-1990s in Finland, Norway,

Sweden, Spain and Japan. (Figure 1)

The distribution of the increases in fiscal deficits, however, is rather uneven, even though

fiscal positions have deteriorated virtually everywhere in the EU (Figure 2). By far the

sharpest (projected) deficit increases – rising to two-digit levels as a percent of GDP –

occurred in Greece, Latvia, the United Kingdom, Ireland and Spain. It is no coincidence that

these countries' fiscal positions have been disproportionally hit, given that some of the

mechanisms that shaped the crisis were particularly prevalent there. The United Kingdom and

Ireland are important financial centres and all five countries have seen major housing and

consumption booms. Credit growth and soaring asset prices, in particular of housing, have

tended to buoy government revenues during the boom with large shortfalls in the subsequent

slump. Figures 3 and 4 illustrate the link between fiscal shortfalls and housing and suggest

that countries which had comparatively large construction sectors and/or elevated real house

2

prices in 2007 also registered the most rapid deterioration in their fiscal positions.

2 The mnemonics used in these and subsequent figures are: BE = Belgium, BG = Bulgaria,

CZ = Czech Republic, DK = Denmark, DE = Germany, IE = Ireland, EE = Estonia, EL =

Greece, ES = Spain, FR = France, IT = Italy, CY = Cyprus, LV = Latvia, LT = Lithuania,

LU = Luxembourg, HU = Hungary, MT = Malta, , NL = Netherlands, AT = Austria, PL =

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(Figures 2, 3 and 4)

A more formal analysis of the relationship between asset price and associated developments

and fiscal outcomes is reported in European Commission (2009b). It distinguishes between a

direct channel (transaction taxes and tax revenues stemming from construction activity) and

an indirect channel that runs through the wealth and collateral effects on consumption and

investment. It suggests that tax revenues grew strongly in response to the asset boom,

although its impact on the fiscal position was muted since expenditure adjusted upward as

well. In the downturn, revenues responded equally heftily, in the opposite direction, but this

was not offset by adjustments in expenditure, which explains the sharp deterioration in fiscal

positions. Regression analysis in the report shows that the main determinants of the revenue

windfalls (or shortfalls) reside in growth surprises (i.e. errors in growth projections). But after

controlling for growth surprises, house price developments explain a significant share of the

temporary windfalls in Ireland, Spain and the United Kingdom. Deteriorating trade balances

associated with rapid growth in imports and weak exports in the run up to the crisis were also

found to have yielded temporary tax windfalls in several countries, reflecting that imports are

part of the VAT tax base whereas exports are not. Both internal and external imbalances thus

3

exacerbated the cyclical swings in the fiscal balance.

It would be wrong to attribute the entire increase in fiscal deficits since the onset of the crisis

to the shrinking demand for housing, higher cost of unemployment insurance or other

'automatic stabilisers'. Some of the run up in fiscal deficits has been the result of discretionary

action. Specifically, governments adopted fiscal stimulus measures under the aegis of the

European Economic Recovery Plan (EERP). The coordinated fiscal stimulus was motivated

by the need to stabilise the economy. Monetary policy had been eased substantially, with

official interest rates near the zero-rate bound. With the room for interest rate cuts thus

practically exhausted, fiscal stimulus can be very effective as it will help prevent deflation and

thus lower the real rate of interest. Fiscal policy is thus most effective when it is most needed,

although the fiscal multipliers tend to be lower if the fiscal expansion is not perceived as

temporary as private agents will respond adversely an expected increase in public debt (see

Roeger and In 't Veld 2009).

Poland, PT = Portugal, RO = Romania, Sl = Slovenia, SK = Slovak Republic, FI = Finland,

SE = Sweden and UK = United Kingdom.

3 In fact, here is evidence that real estate bubbles and trade deficits are to some extent two

sides of one coin, with the former absorbing labour and capital resources that would

otherwise be available for export activities, see e.g. Balázs and Kierzenkowski (2010).

6

The fiscal stimulus under the EERP was initially estimated to amount to some 2% of GDP on

average in the EU for the period 2009-2010, including EUR 20 billion (0.3 % of EU GDP)

through loans funded by the European Investment Bank. More recent estimates point to an

even stronger impulse. The packages rely both on revenue and expenditure measures (each

contributing roughly half), including spending on public investment (about one quarter of the

total stimulus), and were mostly temporary and targeted on the sectors most affected by the

crisis (car scrapping schemes being a prominent example). The stimulus measures were

estimated to contribute about ¾ of a percentage point to real GDP growth in 2009 and to

contribute about of a percentage point in 2010. The dispersion of package sizes has been

considerable though (Figure 5). For 2009 by far the largest fiscal stimulus package (in

comparison to its GDP) was adopted by Spain, followed by Austria and the United Kingdom.

For 2010 Germany and Poland stand out by their comparatively large fiscal stimulus

packages. (Figures 5, 6 and 7)

It is important that the distribution of package sizes is appropriately mapped onto the

distribution of countries' needs and their 'fiscal space' (i.e. their ability to temporarily run

fiscal deficits without jeopardising the sustainability of their public finances or their external

positions). The analysis in Figure 6 suggests that, in most cases, Member States whose

negative output gap (i.e. their degree of economic slack) was perceived to be largest, were

also those that pursued the strongest fiscal stimulus – and vice versa. Figure 7 suggests that

overall the amount of stimulus is also positively correlated with the fiscal space of Member

4

States, although there are again exceptions. The exceptions include several emerging

economies in Eastern Europe, some of which have seen their fiscal room for manoeuvre

restrained due to EU balance of payments assistance provided together with the IMF and the

World Bank (see below). This finding is important because it would be appropriate for

Member States with a large 'fiscal space' to bear a larger share of the burden of fiscal stimulus

4 The fiscal space indicator used in Figure 7 comprises five elements: the initial public debt,

the contingent liabilities vis-à-vis the financial sector, the expected revenue shortfalls

stemming from the unwinding of the real estate and construction boom, the current

account position and the share of discretionary (as opposed to entitlement) expenditure in

the government budget (see for further explanation European Commission 2009b and

2009c). It should be underscored that the indicator is an imperfect gauge of fiscal space

and for illustrative purposes only. 7

under the EERP and, conversely for countries with a more limited fiscal space to provide less

fiscal stimulus.

2.3. Developments in public indebtedness

An issue of major concern is that public indebtedness is on an upward slope. This is the case

not only because governments have implemented capital injections in distressed banks and

granted guarantees that are debt financed (the latter only if and once guarantees are exercised)

-- and yet do not show up in the budget balance since they do not entail public expenditure on

goods and services in a national accounting sense -- but also because fiscal deficits are rapidly

increasing. As indicated in Figure 8, the expected increase in public debt – about 20% of GDP

from end 2007 to end 2010 – is typical for a financial crisis episode by historical standards.

However, the jumping-off point is considerably higher (by up to 30 percentage points) this

time than in previous financial crises. Moreover, the ongoing debt run-up coincides with the

onset of the ageing bulge in public (health, pension) expenditure.

As depicted in Figure 9, the largest increases in public debt are indeed projected for those

Member States which also record the sharpest increases in fiscal deficits, i.e. the United

Kingdom, Spain, Ireland and Latvia. However, owing to their more favourable starting points,

these are not the Member States that are projected to post the highest rate of public

indebtedness, which remain the 'usual suspects' Italy, Belgium and Greece. Tentative

projections point to a further increase of government indebtedness to a level of around 125%

of GDP by 2020 on average in the EU under an unchanged-policy assumption. A sharp

deterioration of the sustainability of public finances can thus be expected even before the

budgetary cost of ageing is taken into account. These prospects thus call for a substantial

adjustment in the years ahead. (Figures 8 and 9)

3. Sustainability concerns

Financial market assessments of sovereign risk have been changing rapidly recently, which is

partly a reflection of the concerns that exist over the sustainability of the public finances in

the longer run alongside short-run liquidity concerns in some cases (Greece in particular). The

most recent issue of the Commission's periodical Sustainability Report (European

Commission 2009a) disentangles the various determinants of sustainability, in particular: (i)

the impact of the starting position of public debt and deficits on the debt snowball; and (ii)

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additional effects of ageing and the associated increase in age-related public expenditure and

slower potential growth. This section will review its findings, preceded by a short discussion

of the methodology.

3.1 Methodological issues

The European Commission (2006) has developed a fiscal indicator that has been used to

assess the sustainability of public finances in the European Union, most recently in the 2009

Sustainability Report (European Commission 2009a). The maths is relatively straightforward,

but inspecting it more closely is helpful for a deeper understanding of the indicator.

The methodology builds on the government's intertemporal budget constraint, which can be

represented in a stylised form as follows:

PB i D D

(1) − + = ∆

t t t t

−1

t PB

where is the time index, is the primary balance (fiscal balance excluding debt-interest

D i

payments), is public debt, is the nominal interest rate and is the difference operator. This

can be reformulated in terms of ratios to GDP:

pb r d d

(2) − + = ∆

t t t t

−1 r

where lower-case characters denote ratios to GDP while is the real interest rate relative to

the real growth rate of the economy (g) defined as:

i

1 + t

r

1 + =

(3) t ( )( )

g π

1 + 1 +

t t

where is the inflation rate. Solving the difference equation (2), under the simplifying

π

t r

assumption that is constant, yields a relationship between the initial debt ratio and the debt

ratio at infinity, conditional on the future development of the primary balance and the interest-

5

growth rate differential :

j j

+

1 +

1

   

∞ 1 1

d pb d

= + lim

(4)    

t t j t j

1 + +

r r

   

1 + 1 +

j → ∞

j = 0

5 r

Assuming a time-variant does not change the results fundamentally, but maker the maths

a lot more unpleasant. The actual indicator used by the European Commission (2006,

r

2009a) does assume a time-variant to reflect variations in the growth rate of the economy

g, i

whereas the interest rate is held constant.

9 i.e.

Sustainability requires that the present value of future debt approaches zero at infinity,

debt cannot grow at a rate faster than the rate of interest – if it did debt would be explosive

and no investors would be willing to buy government bonds at the going interest rate. This is

the transversality condition to rule out a Ponzi game, and to satisfy it, the last term of equation

(4) must be zero. This yields:

j 1

+

 

∞ 1

∑ ∗+

d pb

=

(5)  

t t j

1

− r

 

1 +

j 0

=

pb* sustainable projected

where is the primary balance, which can differ from the primary

pb. S

balance under unchanged policies We define the sustainability gap as the difference

between the two:

∗+

pb pb S

= +

(6) t j t j t

+ S

Substituting this identity in equation (5) and solving for the sustainability gap yields the

following expression: j +

1

 

∞ 1

∑ ( )

S rd pb r pb pb

(7) = − − −

 

t t t t j t

− − + −

1 1 1

1

42

43 r

1 +

j = 0

1

4

4

4

4

4

2

4

4

4

4

4

3

IBP LTC

S

This shows that the sustainability gap can be thought of as consisting of two components.

IBP

The first component, labelled (initial budgetary position), corresponds to the necessary

once-and-for-all increase in the structural primary balance to offset the debt build-up that

would result if the initial structural primary balance was maintained in the future. The smaller,

or the more negative, this initial structural primary position (or the higher the initial debt

LTC

ratio), the larger will be the sustainability gap. The second component, labelled (long-

term change) corresponds to the necessary once-and-for-all increase in the structural primary

balance to offset any debt build-up associated with a fall in the structural primary balance due

to a future increase in age-related expenditure. The stronger this increase in age-related

expenditure, the larger will be the sustainability gap. Putting the two together, one obtains the

required increase in the structural primary balance on the account of, both, the initial

budgetary position and its future deterioration due to ageing. The Commission's methodology

also uses an additional measure, in which debt is constrained to be at most 60% of GDP at

S

some pre-set point in time in line with the Maastricht criteria. This is called the indicator,

1

S indicator on which we focus here. The transversality condition on which

as opposed to the 2

S S

the indicator is based is objective whereas the debt criterion on which the indicator is

2 1

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based is normative. Numerically the differences between the two indicators can be significant,

but they generally point in the same direction.

3.2 Measuring the sustainability gap

Figure 10 shows the initial structural balance as a per cent of potential GDP (in 2009) as

reported in European Commission (2009a) along with the projected change in ageing-related

expenditure between 2010 and 2060. Importantly, the structural balance positions shown in

this table have been revised since the Sustainability Report was published and the possible

implications of this are discussed in the next section. For now we stick to the 2009

Sustainability Report. The Report defines ageing-related expenditure to include public

spending on pensions, healthcare and long-term care, netted against projected declines in

education expenditure and unemployment benefit payments. The computations are based on

the assumption that the old age dependency ratio will increase from 25% in 2007 to 54% in

2060 in the EU as a whole (with considerable variation across Member States). In addition,

potential growth is projected, due to ageing, to fall from 2.4% in 2007-2020 to 1.3% over

2041-2060, with again considerable variation across Member States. Finally, the real interest

rate is assumed to be fixed at 3%. (Figures 10 and 11)

S

The indicator reported in Figure 11 shows a sustainability gap of 6.5% of GDP for the EU

2

as a whole (5.8% for the euro area), meaning that for public finances to be sustainable, the

structural primary surplus would need to be increased from its estimated 2009 level by an

amount of 6.5% (5.8%) of GDP once and for all. This would be a consolidation which is not

without historical precedent for some individual countries, but it clearly would be for the EU

as a whole. The largest sustainability gaps, of more than 8% of GDP, are found for Ireland,

Greece, Luxembourg, the United Kingdom, Slovenia, Spain, Latvia, Romania and Cyprus. An

adjustment in the range of 4 to 8 percentage points would be required in Slovakia, Czech

Republic, Malta, Lithuania, Netherlands, Portugal, France, Belgium, Austria, Germany and

Finland. Smaller adjustments or no adjustment at all would be required in Poland, Sweden,

Italy, Estonia, Bulgaria, Hungary and Denmark. S

According to Figure 11, the composition of the indicator, in terms of the respective

2

contributions of the initial budgetary position (IBP) and the impact of the long term change in

ageing-related expenditure (LTC), appears to be rather diverse. Figure 12 looks more directly

11

at the distribution of this composition across countries. In the countries above the dashed

diagonal line the sustainability gap is dominated by the projected increase in ageing-related

expenditure whereas the initial budgetary position is the more predominant cause in countries

below the dashed line. It turns out that the large sustainability gaps of Slovenia, Greece and

Luxembourg are mostly due to the strong impact of growth in ageing-related expenditure. By

contrast, the very large sustainability gaps of Ireland, the UK, Latvia and Spain are more

dominated by their relatively poor initial budgetary positions. This reflects to some extent that

these countries in 2009 were ahead of other countries in terms of the severe fiscal implications

of the crisis. (Figure 11)

A number of final observations are in order. First, as discussed in the previous section, many

Member States have taken on contingent liabilities in the course of the financial crisis which

are not incorporated in the above estimates. For countries with comparatively large financial

rescue programmes, the sustainability gap may thus turn out larger than estimated here.

Second, in some countries (Greece in particular), the initial budgetary position has been

substantially revised since the 2009 Sustainability Report was published, and this affects

countries' relative positions, as will be discussed in section 4. Third, the assumed potential

growth rates may prove too optimistic, as discussed in more detail below.

3.3 The impact of lower potential growth and higher interest rates

It is difficult to imagine that the crisis would not have a long-lasting impact on the potential

growth rate over and above the impact of ageing. Recent studies of past episodes of financial

distress suggest sizeable output losses which are generally not recovered (Cerra and Saxena,

2008), especially if the crisis results in sharp increases in public indebtedness (Reinhart and

Rogoff, 2010). Based on a country-panel regression analysis, Furceri and Mourougane (2009),

estimate the impact on potential output to be in the range of 1.3 to 3.8%, with the upper

estimate corresponding to deep and severe financial crisis. This estimate is in the ball park of

estimates resulting from econometric work by the European Commission and simulations

with its QUEST model, both putting the potential output loss roughly in the 2 to 4% range

(European Commission 2009c,d). This estimated loss reflects a projected increase in

structural unemployment and slower growth in the capital stock as investment is severely hit

by the crisis. The loss in potential output may be even larger if total factor productivity were

to fall to a lower trajectory as well, although the net impact is ambiguous. Innovation may

12

falter as R&D expenditure has been hit by the crisis, but, on the other hand, the least efficient

suppliers are likely to disappear and this could have a favourable impact on productivity.

European Commission (2009a) reports the impact on the sustainability gap of a scenario in

which the level of potential output is assumed to be persistently lower due to the financial

6

crisis in line with these estimates, labelled as the "Lost decade" scenario. It suggests an

increase in the sustainability gap by about 1.2 percentage point on average in the EU and the

euro area. The dispersion of this impact across Member States is very wide, with particularly

large increases in Ireland and Spain along with Malta (Figure 13). On the basis of this

scenario exercise and the estimated contingent liabilities, European Commission (2009a)

classifies Member States in three risk categories (high, medium and low). Member States in

the high risk class in the euro area are Slovenia, Spain, Ireland, the Netherlands, Malta,

Slovakia and Greece (the latter mostly because of its high initial debt level), and outside the

euro area the United Kingdom, Romania, Latvia, Lithuania and the Czech Republic. Low risk

Member States outside the euro area would be Denmark, Estonia, Sweden, Bulgaria and in the

euro area Finland. All other Member States would be in the middle risk category.

(Figure 13)

As becomes clear from inspecting equation (7), an increase in the real interest rate has a

(numerically) equivalent effect on fiscal sustainability as a fall in the growth rate of the

economy. Such an increase in real interest rates may well materialise in certain cases if

investors consider the risk of default of a government to have increased, e.g. because they fear

that the political system of a particular country may not be able to produce the required

increase in the primary structural balance to close the sustainability gap. For now, with a few

notable exceptions, real interest rates are generally very low owing to the easy stance of

monetary policy, the still weak economy and strong demand for sovereign bonds by banks (to

reduce the risk profile of their portfolios and to benefit from the upward sloping yield curve).

But his may well change as the economy and banks' balance sheets recover and monetary

policy exits from its accommodative stance, thus further heightening the need for fiscal

consolidation.

6 In fact, the report presents estimates for three scenarios labelled the "Rebound scenario" in

which the loss in potential output would be fully recovered after ten years, the "Lost

decade" scenario in which potential output would return to its pre-crisis growth rate after

ten years (but not the level of potential output), and the "Permanent shock" scenario in

which also the growth rate of potential output is permanently lower.

13

Some observers have pursued the idea that the adoption of higher inflation targets by central

banks could help to reduce the differential between real interest and growth rates (see

equation 3). However, such a strategy would be self-defeating. Since Fisher parity will

normally hold, the increase in inflation expectations would simply push up nominal bond

yields. The sovereign risk premium would simply be replaced with an inflation risk premium,

without much affecting the real interest-growth rate differential. Worse still, potential output

growth could falter further as the greater inflation uncertainty typically associated higher

inflation would blurs price signals and jeopardise the efficient allocation of resources.

4. The fiscal consolidation challenge

The timing of the exit from fiscal stimulus and subsequent fiscal consolidation to address the

ageing issue should balance sustainability and stabilisation concerns. Even so, aside from the

exact timing, the need for a decisive exit is pertinent. This backdrop this section first discusses

the EU's exit strategy. This is followed by estimates of the size of the required consolidation

effort and a tentative and stylised assessment of its likely economic impact based on the

existing literature. Coordination issues are left for the final section of the paper.

4.1 The EU's fiscal exit strategy

In the acute stages of the crisis the focus was on fiscal stimulus and other crisis mitigation and

control measures. However, that an exit from fiscal stimulus and subsequent fiscal

consolidation would be inevitable was clear from the outset. As it became gradually clear that

the recessionary tailspin had been arrested around the summer of 2009, more decisive steps

towards the exit were taken. On 17 September 2009 EU leaders first agreed to formulate exit

strategies to phase out stimulus measures, coupled with a call on Member States to implement

them only when economic recovery was secured. This was echoed at the 24-25 September

2009 G-20 Summit, which pledged to sustain policy stimulus until durable recovery and

renewed job creation were secured, while continuing to develop cooperative and coordinated

exit strategies with policy measures to be implemented depending on varied national needs.

On 19 - 20 October 2009 the ECOFIN Council adopted conclusions on a coordinated fiscal

exit strategy across countries dependent on further economic recovery forecasts, although

2011 would be the latest start date for fiscal consolidation requiring efforts, above 0.5% of

GDP per annum for most countries. On 1 - 2 December 2009 the ECOFIN Council agreed on

principles for the coordinated exit strategy of public support schemes. Specifically,

coordination among Member States should avoid negative spill-over effects and would

14

account for national specificities. The timing of the exit should take into account a broad

range of elements, including macroeconomic and financial sector stability, the functioning of

credit channels, systemic risk assessment and the pace of natural phasing out by banks.

Meanwhile the Council has opened a large number of Excessive Deficit Procedures (EDPs)

7

under the Stability and Growth Pact (Table 4). While formally distinct from the exit strategy

-- the EDPs would have been launched anyway under the corrective arm of the Stability and

Growth Pact (see the final section) -- they are now effectively used to enforce the fiscal exit.

The first country to enter an EDP since the onset of the crisis was the United Kingdom (July

2008), although at that point Hungary was also in EDP (since July 2004). In April 2009 EDPs

were launched for Ireland, Greece and Spain, and in July 2009 for Poland, Romania,

Lithuania, Malta and Latvia. This was followed in December 2009 with another batch of

EDP's concerning Latvia, Austria, Belgium, the Czech Republic, Germany, France, Italy, the

Netherlands, Portugal, Slovenia and Slovakia. All in all, a record 20 countries are now subject

to an EDP, with only seven countries so far not involved in an EDP (Bulgaria, Denmark,

8

Cyprus, Estonia, Finland, Luxembourg and Sweden). In some cases, the Council has issued

revised recommendations for countries which either were found to backtrack on their

correction commitments or that were hit by further bad surprises in their budgets.

(Table 4)

Since the start of 2010 the Greek fiscal crisis has been overshadowing the fiscal exit strategy

for the EU as a whole. On 18 - 19 January 2010 the ECOFIN Council adopted conclusions on

government deficit and debt statistics in Greece and urged the Greek government to tackle

outstanding problems. On 15 - 16 February 2010 the ECOFIN Council accepted Greece's

7 The EDP sets out criteria, schedules and deadlines for the Council to reach a decision on

the existence of an "excessive deficit" (meaning a deficit above the 3% of GDP threshold

or that is inconsistent with convergence of public debt to the 60% of GDP threshold). No

EDP procedure will be launched if the excess of the government deficit over the 3%

threshold is considered temporary and exceptional and the deficit remains close to the

threshold. When the Council decides that a deficit is excessive, it makes recommendations

to the Member State concerned and establishes deadlines for effective corrective action to

be taken. The Council monitors implementation of its recommendations and abrogates the

EDP decision when the excessive deficit is corrected. If the Member State fails to comply,

the Council can decide to move to the next step of the EDP, the ultimate possibility being

to impose financial sanctions.

8 Moreover, on 12 May 2010 the Commission has launched EDPs for Bulgaria, Cyprus,

Denmark, Finland and Luxembourg, but these were still to be confirmed by the Council a

the time of writing. 15

updated Stability Programme which sets 2012 as the date for reducing the deficit below 3%.

The Council also called on Greece to ensure a budgetary adjustment of at least 4% GDP in

2010. It set numerical limits to Greece's government deficits and to annual changes in its

consolidated gross debt in 2010, 2011 and 2012. On 25 - 26 March 2010 the Spring European

Council fully supported the efforts of the Greek government. And finally in the weekend of 1

-2 May 2010 a rescue package involving substantial International Monetary Fund and euro

area Member States loans was finally agreed. However, the strong focus on the Greek

predicament, while understandable, should not be allowed to eclipse the fiscal exit challenge

affecting other EU Member States.

The 2009 Sustainability Report provides estimates of the required primary structural balance

S

in the period 2011-2015 (based on the indicator and a projection of the structural primary

2

balance for that period under unchanged policies). This required structural primary balance

can be set against the currently estimated development of the structural primary balance to get

an impression of the size of the correction required to achieve sustainability. This is done in

Table 5. It shows that, relative to the 2009 estimates, by far the largest correction in the

structural primary balance is indeed required in Greece, of the order of 20% of GDP, which is

obviously not surprising in view of the size of its debt and deficit in 2009. However, sizeable

corrections -- in the range of 10 to 20% of GDP -- would also be required in Ireland, Spain,

Cyprus, Romania, the United Kingdom, Luxembourg, Slovenia and Lithuania. For the

European Union as a whole the required correction now stands at 7% of GDP (6.7% for the

euro area), an increase by ½ a percentage point (1 percentage point for the euro area) relative

to the estimate in the Sustainability Report.

(Table 5)

It is interesting to check if this sustainability requirement is reflected in the agreed "fiscal

effort" (the required correction in the structural balance) as agreed by the Council for

countries in EDP (see Table 4). As Figure 14 shows, this is indeed broadly the case: countries

whose sustainability gap is highest are also those that have seen the largest correction

9

requirements in their EDPs and vice versa. This is reassuring. The relationship between the

two requirements is not one-to-one, but this should reflect the fact that the required fiscal

efforts under the EDPs are, in most cases, lower limits: countries are expected to do more,

9 In Figure 14 Greece is not shown because its EDP has been overtaken by the programme

for deficit reduction agreed by the euro area Member States, the European Commission,

the ECB and the IMF, with the deficit required to reach 3% of GDP by 2014.

16

depending also on the pace of the economic recovery. The corollary is that respecting the

fiscal effort countries have committed to under their EDPs is consistent with the need to

secure fiscal sustainability. (Figure 14)

4.3 The economic impact of fiscal consolidation

While fiscal consolidation is unavoidable, it obviously has repercussions for demand. How

strong this effect will be, and perhaps even its sign, is uncertain. There is vast literature on the

subject, so it is impossible to review it exhaustively here, and just a few highlights will be

presented. Giavazzi and Pagano (1990) were among the first to argue that fiscal

consolidations can in fact be expansionary, based on a number of case studies. In their

seminal paper Alesina and Perotti (1995) found that economic growth fared better during

large fiscal consolidations that relied on cuts in (current) government spending rather than

higher taxes. Cuts in expenditure would: (i) reduce expectations of more disruptive tax

increases in the future (Blanchard 1990); (ii) contribute to easing financial conditions such as

real interest rates or a depreciation of the exchange rate (Alesina et al. 2002, Lane and Perotti

2003); and (iii) crowd in labour and improve competitiveness (Alesina and Ardegna 1998,

Lane and Perotti 2003). By contrast, tax-driven consolidations reduce labour supply (Barro

1981) and crowd out investment (Baxter and King 1993).

According to Perotti (1999) the odds of an expansionary effect of fiscal consolidation increase

with the extent of the initial fiscal predicament, possibly because the private sector realises

that the situation is unsustainable. This is particularly true for expenditure-based

consolidations because they are more difficult and therefore signal the government's resolve

in tackling the problem, and they are also less damaging for potential growth than (distorting)

tax increases. Reinhart and Rogoff (2010) argue that when government debt rises above 90%

of GDP, median growth falls by 1 percentage point. Consequently, cutting debt below that

threshold would boost economic growth. The implications of these findings do not necessarily

conflict with standard 'Keynesianism': the fiscal multiplier is likely to be positive in normal

times, and certainly at times of financial crisis when households and business are credit

constrained, but turns negative in the face of severe fiscal imbalances. Moreover, there is

broad consensus that the odds of the multiplier becoming negative (i.e. of the adjustment

being expansionary) increases when the fiscal consolidation is combined with structural

reform to enhance potential output and the ability of the economy to absorb shocks smoothly.

17

Another important issue is the timing of fiscal exits. The timing of the exit from fiscal

stimulus and subsequent fiscal consolidation should balance sustainability and stabilisation

concerns. A too early and abrupt exit hampers the recovery process, increases unemployment

10

and social hardship and may entail an unnecessary destruction of viable productive capacity.

Too late exit leads to an unfavourable policy mix (monetary tightening kicks in when fiscal

policy is still supportive, makes fiscal consolidation more difficult), delays essential

restructuring of the economy, distorts competition, and threatens budgetary sustainability. In

relative

the strongly integrated EU economy there is also an issue of timing of Member States

among each other. A Member State that starts fiscal exit too early could exploit a first mover

advantage in terms of better competitiveness and a lower risk premium, while the contraction

effect spills over to other countries via the trade channel. Conversely, a country that

consolidates too late may render its public finances unsustainable, which may spill over other

Member States via bond markets and the confidence channel.

The political economy of fiscal consolidations has been studied extensively. Alesina, Perotti

and Tavares (1998) and Brender and Drazen (2008) find that, contrary to the conventional

wisdom, governments which reduce budget deficits drastically and systematically do not face

a loss in popularity in established democracies. Buti et al. (2009) confirm these results and

11

also show that fear of electoral backlashes in the wake of structural reform is unfounded.

These findings seem at odds with the reluctance of governments to adopt severe adjustment

policies (except under the worst circumstances), but this can be explained by the tendency of

vocal interest groups to abuse 'Keynesian' views to protect their own interests. In fact,

et al.

according to Buti (2009) structural reform can even be electorally beneficial, provided

10 The 1937/38 recession in the United States is often quoted as a warning against premature

exits from fiscal stimulus. However, the cutback in fiscal stimulus at the time was not an

early but rather a late exit, in the wake of an unduly late and timid entry in the Great

Depression in the first half of the early-1930s (Van den Noord 2010). Moreover, while the

1937/38 recession can be attributed to cut backs in fiscal stimulus to some extent, were

predominant. Notably, geopolitical tensions played a major role, along with adverse

business confidence effects of Roosevelt's New Deal policies. Concerning the latter, the

strengthening of wage bargaining power amid mass unemployment and heightened

uncertainty over property rights were prominent.

11 Buti et al. (2010) suggest, moreover, the electoral impact of reform to be strongly

dependent on which types of policies are considered. In particular, reform measures that

are more likely to hit large groups of 'insiders', such as reform of employment protection

legislation or pension reform, seem electorally damaging. In contrast, reform measures

targeted at large groups of 'outsiders', such as the unemployed, would be electorally

beneficial, while lowering taxes on labour would also find a positive reception with the

electorate. 18

that financial markets work well, as they bring future yields of structural reform forward in

time. This is important in this context, given that structural reform is inevitable in order to

boost potential output and thereby facilitate the fiscal challenge (not least in the face of aging

populations).

Are there really no downsides to fiscal consolidation? In fact there are some. First, with

interest rates (at least at the short end) close to the zero-rate bound, the crowding-in effects of

fiscal consolidation via lower interest rates may be small. This is why it is important that the

pre-commitment of governments to fiscal consolidation is strong: it will keep bond yields low

and facilitate the exit from monetary ease. But, second, to the extent sovereign bond yields

fall, the associated flattening of the yield curve may in fact slow down the process of balance

sheet restoration in the banking industry, as this owes much to the possibility to invest cheap

base money in higher yielding bonds (unless capital gains on bonds offset this effect). Third,

it is also not obvious that exchange rate depreciation could play its amplifying role of

expansionary fiscal contraction. This is certainly the case inside the euro area, but even for the

area as whole this is not obvious since other economies (including the United States) also face

the need to consolidate there budgets. It is even less obvious that currencies of the developed

economies will be able to depreciate against emerging Asian economies, unless emerging

Asia changes its exchange rate policies. Finally, it is also not obvious that fiscal consolidation

can rely solely on expenditure cuts. Tax increases may have to be accepted, especially on

wealth and capital income.

In sum, the historical experience provides evidence of public debt thresholds above which

economic growth is persistently lowered, suggesting that fiscal consolidation is essential for

sustaining growth. The guiding principles for successful fiscal consolidations – also rooted in

the historical experience – are that they should be based primarily on expenditure cuts

complemented by structural reforms to increase work incentives and public sector efficiency.

Tax based consolidation can probably not be avoided though, but tends to work better if

gradual and starting from a lower initial tax burden. Improvements in the fiscal institutions

can be important complements to consolidation. Difficult macroeconomic and public finance

starting points appear to be catalysts for successful consolidations, which augurs well in the

current situation, even if the transition to sustainable public finances will be very painful, yet

unavoidable, in some cases. 19


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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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