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Printed out at Cer – June 3, 2014
Exit from the Crisis?
The following authors have contributed to this report: Stefan Collignon, Piero Esposito,
Stefano Fantacone, Petya Garalova, Carlo Milani.
R A P P O R T O C E R
5 5
Summary 7
Exiting the crisis 13
ECONOMIC GROWTH AND EUROPE’S GROWTH POTENTIAL 13
UNEMPLOYMENT AND NAWRU 16
INVESTMENT IN THE CRISIS 18
PUBLIC FINANCES AND DEBT 22
FISCAL POLICY 22
Box 1. The production function 28
Box 2. EC’s estimations of potential output 28
Box 3. Net lending linkages among corporations, government and households 28
Box 4. The Crowding out vs Keynesian effects of public expenditure on the cor-
porate sector: a Granger causality test 28
Cost competitiveness and institutional setting 13
CAPITAL AND EFFICIENCY AND THE CER COMPETITIVENESS INDEX 13
UNIT LABOUR COSTS AND LABOUR MARKET ADJUSTMENTS 16
SECTORAL DYNAMICS 18
ULC, CAPITAL EFFICIENCY AND DELOCALIZATION 22
SECTORAL REALLOCATION AND EFFICIENCY GAINS 22
WITHIN SECTORS CHANGES 22
SECTORAL REALLOCATION AND CHANGES IN THE SPECIALIZATION PATTERNS 22
Box 5. The decomposition of ULC growth 28
Box 6. Direction and intensity of sectoral reallocation 28
External trade, imbalances and the exchange rate
13
EXCHANGE RATE POLICY AND COMPETITIVENESSET 13
Box 7. What drives the exchange rate appreciation? Evidence from a VAR
based analysis
24
N. 1 - 2 0 1 4
6
European Banking Union: state of the art and critical aspects
13
FRAGMENTATION IN THE EURO AREA BANKING MARKET 13
SINGLE SUPERVISORY MECHANISM 16
CRITICAL ASPECTS ON THE SSM 18
SINGLE RESOLUTION MECHANISM 22
CRITICAL ASPECTS ON THE SRM 24
SINGLE DEPOSIT GUARANTEE SCHEME 22
CRITICAL ASPECTS ON THE SDGS 24
CONCLUSIONS 24
R A P P O R T O C E R
7 7
Summary
1
The worst of the Euro-crisis is over. So it seems. But for how long? Is economic growth
returning and creating jobs and taking the pressure off public finances? No certain
answer can be given. Europe’s track record with crisis management has not been
impressive. The economic crisis after the Lehman bankruptcy in September 2008 was
the deepest recession since the 1920s, but governments all over the world responded
by very large stimulus packages and as a consequence, the world was already com-
ing out of recession in 2010. No sooner than that, Europe implemented exit policies
from economic stimulus and started tightening fiscal and monetary policy. A year
later the Euro Area was back in crisis and unemployment exploded. This time, it was
different: Europe had a home-made crisis. The question is now whether it can find its
way out of this crisis without repeating the same mistake of early exit again.
2
In this Rapporto Europa, we review the most important developments which have
taken place in Europe during the last year with the aim of understanding the failures
of the current policy framework and we provide indications for future improvements.
Chapter 1 starts with an overview of growth, employment, private and public spend-
ing and the recent debate about calculating potential output. As many observers
have recognized, the recession in the Euro Area has worsened because of the aus-
terity measures imposed to reduce public debt to sustainable levels after the tempo-
rary suspension of the SGP in 2009. The lack of domestic demand and investment
was the channel though which the recession spread also to countries in better
shape.
3
Part of the debate on the effect of austerity has become focused on problems of es-
timating potential output and structural unemployment. The calculation of potential
output is affected by theoretical and empirical problems: from a theoretical point of
view, the mainstream theory underlying the calculation of potential output rules out
the possibility that short and medium term demand constraints can have a detri-
mental effect on potential GDP since the latter should be affected only by long run
determinants. However, empirically this hypothesis is falsified: we have already pro-
vided evidence in the last Report on Europe (2013) that a prolonged recession af-
fects potential GDP by reducing the pace of capital accumulation. More recent da-
ta on the components of potential GDP indicate that southern Europe and Ireland in
general have seen a continuous deterioration of the investment dynamics, compro-
mising the long run growth perspective. With this evidence we argue that reducing
N. 1 - 2 0 1 4
8
the risk factors for investors, lowering the cost of capital and labour, and stimulating
aggregate demand are fundamental policies to bring Europe back to a sustainable
growth path.
4
By looking at flow of funds statistics, we find that during the crisis the corporate sector
has almost everywhere become a net lender and households, especially in the South
have been lending less and less, which can explain the overall drop in investments.
We test empirically whether the reduction in investment is due to a crowding out ef-
fect from government borrowing but instead, we find that the Euro Area as a whole
follows a Keynesian pattern, with governments stepping in order to compensate for
the lack of demand in the private sector.
5
The important implication of the above result is that in order to stabilize the Euro Area,
macroeconomic policy, including fiscal policy, should be conducted at the Euro Ar-
ea level. There is, hence, a strong argument in favour of the coordination of fiscal
policies among Member States.
6
While aggregate demand is one important factor for ending the crisis, the regional
distribution of demand matters. In chapter 2 we analyse the dynamics of cost com-
petitiveness and the underlying components in order to assess the contribution of
cyclical factors and the role of labour market reforms and automatic stabilizers for
the resumption of growth. As it is now traditional for Rapporto Europa, we start by
showing the evolution of the Cer Competitiveness Index (CCI), which links the cost of
labour to the capital efficiency and the profit rate.
7
We show recent developments of ULCs and capital efficiency and reveal to what
extend institutional causes, such as labour market structures and their reforms, as well
as wage bargaining processes, have contributed to this pattern. We also investigate
the sectoral dimension of such processes by comparing the dynamics in manufactur-
ing, construction and in the services sector.
8
The aggregate path of wages, productivity and ULCs in Europe is the result of im-
portant intersectoral reallocation, which explains the German case and its difference
with the rest of Europe particularly well. We then look at sectoral dynamics in order to
understand where competitive gains and losses originate and how they are related
to sectoral reallocation through the Euro Area.
R A P P O R T O C E R
9 9
9
The main findings are the following: first, the Euro Area is losing competitiveness rela-
tive to the other main advanced economies and the strong currency is one of the
reasons, but not the most important one. Domestic cost developments are more im-
portant. In recent years, a partial rebalancing of the competitive positions of south-
ern European countries has been due to a process of wage compression caused by
the recession, while productivity improvements have been absent almost every-
where. The productivity adjustments in countries like Italy and France have been
hampered by employment protection mechanisms like the "wage fund guarantee",
while in Spain the timid productivity recovery is due to massive unemployment. In all
cases, we conclude that competitive positions will start to diverge again with the re-
covery.
10 By looking at sectoral dynamics, we found that the German performance is the result
of the increased profitability of the manufacturing sector, while the service sector has
absorbed the additional labour supply introduced by labour market reforms. To dif-
ferent degrees, the other countries behaved in the opposite way, experiencing
competitive deteriorations and reductions of their returns to capital. German wage
and salary earners have benefitted from a redistribution of GDP at the expense of
capital owners.
11 The sectoral dynamics is also important with respect to the reallocation of resources
and internal efficiency gains. By mean of a decomposition analysis we find that both
effects have been important in explaining the dynamics of labour costs and produc-
tivity up to 2007. The German success is a striking case: while overall efficiency gains
in productivity and wage moderation were important, a substantial part of the ULC
changes are explained by the expansion of low wage sectors, which have experi-
enced low or negative ULC growth. Structural effects were also important in mitigat-
ing the efficiency losses in southern European countries and, in the case of Spain, we
observe substantial gains from structural change in the following years. For Italy, in-
stead, the degree of sectoral reallocation after the crisis has been rather modest and
can partly explain the disappointing aggregate performance.
12
In chapter 3 we assess the current state of trade and current account imbalances as
well as the role of the exchange rate, both as a vehicle to boost the competitiveness
of the Euro Area as a whole and to rebalance the European economy internally
and externally.
13
We find, on the one hand, that trade and current account imbalances have sub-
N. 1 - 2 0 1 4
10
stantially shrunk in the last two years, mainly thanks to the contraction of imports, alt-
hough the recovery of demand from outside the EU gave a boost to the Euro Area
exports; with the slowdown in emerging markets, the latter effect seems now to be
fading out. We conclude that the unwinding of imbalances is likely to be only a tem-
porary phenomenon. The imbalance problem is expected to return with the recov-
ery over the next years.
14
Among politicians in European southern states, the recent appreciation of the euro
with respect to the USD has been blamed for the slow exit from the crisis. A new de-
bate about the desirability of devaluing the currency via direct interventions by the
ECB is gaining momentum. We analyse the possible causes of the recent apprecia-
tion and argue that it is mainly due to the high trade and current account surplus of
the Euro Area that is caused by the boom of extra EU export in Germany and by the
import contraction in crises countries, above all in Italy. These current account devel-
opments are not compensated by capital outflows from the Euro Area. We show
that a reduction in the surplus is a much more effective tool for bringing down the
euro-dollar exchange rate to a level around 1.25, than an intervention by the ECB.
Foreign exchange interventions would also reduce the potential for Quantitative Eas-
ing policies which the ECB is already implementing.
15 Finally, in the last chapter we discuss the different aspects related to the creation of
the banking union. Financial stability is necessary for the exit from the crisis and the
Banking Union could help to rebuild a correctly functioning interbank market, there-
by sustaining the economic recovery. We review the three pillars of the EBU, namely
the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and
the Single Deposit Guarantee Scheme (SDGS), and discuss the shortcomings of the cur-
rent structure.
16 We argue that the actual decisions in the structure of the EBU seem more connected
with the narrow national interest of Northern European creditors, and in particular to
the objective of not exposing taxpayers to the risk of having to pay for the mistakes
of other MS. Nevertheless, they disregard the risks a major financial crisis could have
for Europeans in North and South. These national egoisms are a hurdle for creating a
stable and durable economic and financial union. Financial crises observed in the
US, such as the S&L and subprime crises, show that federal actions may become in-
dispensable in order to prevent more disruptive shocks.
R A P P O R T O C E R
11 11
Exiting the Crisis
ECONOMIC GROWTH AND EUROPE’S GROWTH POTENTIAL
1
Europe’s double-dip recession needs an explanation. No doubt the incompetent
handling of the Greek sovereign debt crisis in 2010, which quickly spilled over to other
southern Member States, including Ireland, was an important factor in this develop-
ment. Financial markets lost trust in Europe’s byzantine governance and the lack of
commitment to a full bailout had caused fire sales of risky sovereign debt so that re-
gional interest rate spreads diverged dramatically (figure1).Yields only came down
after the European Central Bank (ECB) stepped in as a lender of last resort who
would buy up the excessive oversupply of government securities. The leadership
shown by Mario Draghi and the ECB has saved the euro. However, for some Member
States the spreads are still considerable, and they prevent a rapid return to econom-
ic growth, especially although not only in the south.
Figure 1. 10-year Government Bond Yields
0
5
10
15
20
25
30
35
40
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Franc e Germany Greece IrelandIta ly Portugal Spain Union bond
Gre
ece
jo
ins e
uro
Le
hm
an
Gre
ek d
eb
t cri
sis
OM
T a
nn
ou
nce
d
Source: EUROSTAT.
2
In 2010, the Greek drama occurred against a background of renewed macroeco-
nomic tightening which neutralised or even counterbalanced previous stimulus
measures. Especially fiscal policy tightened too soon, because of the dogmatic ap-
plication of the Stability and Growth Pact (SGP). The Pact had been suspended in
N. 1 - 2 0 1 4
12
late 2008 in accordance with its rules which stipulated that in the case of very deep
recessions the 3% target would no longer apply. However, once rates of growth had
turned positive again in 2010, the 3% objective was automatically re-instated and
Member States had to reduce their deficits again below the 3% mark. Germany and
the European Commission became the driver of new austerity.
3
Early exit from stimulus measures in 2010 and the imposition of excessive austerity
measures have caused the second recession in the Euro Area. The difference to the
United States is flagrant. While in Europe economic growth started to slow down and
ultimately became negative, in the USA the recovery was sustained after 2010 be-
cause expansive fiscal and monetary policies were tightened only gradually. Japan,
on the other hand, also fell into a double dip because various governments pursued
austerity measures; the country only recovered when the new Abe government
started to stimulate the economy again at the begin of 2013 (figure 2).
Figure 2. GDP in the main advanced economies (y/y growth)
-10
-8
-6
-4
-2
0
2
4
6
2007 2008 2009 2010 2011 2012 2013
Euro Area (17 countries) EU (28 countries) Japan United States
Source: OECD Stats.
4
Since 2013, Europe’s recovery has been slow but steady, although many countries
are still experiencing zero or negative growth; the non-EA members performed slight-
ly better, mainly due to the transformation economies in Central and Eastern Europe
and the negative impact from southern Member States (table 1). Due to accommo-
dating fiscal policies and enormous monetization of public debt, the UK is expected
to grow faster than any other major European economy in 2014 according to the
updated IMF projections (1). Interestingly, this success is driven by investment spend-
(1) IMF, World Economic Outlook, April 2014.
R A P P O R T O C E R
13 13
ing which has grown by 8.8 per cent over the past year.
5
The global impulses for economic growth came primarily from the dynamic emerg-
ing economies, which quickly recovered in 2010, but since the end of 2011 even
these countries have started to suffer, due to the low demand for imports from ad-
vanced economies that has caused a slowdown in their own export growth. This pat-
tern can be seen from developments in the BRICs as shown in figure 3: y/y growth fell
below 8% in China and it is approaching the zero level in Russia, while only being
slightly above 1% in Brazil. The Ukrainian adventure and the imposition of sanctions is
likely to push Russia into recession.
Table 1. GDP growth in the European Union
http://www.imf.org/external/pubs/ft/weo/2014/01/pdf/text.pdf
N. 1 - 2 0 1 4
14
2012 2013 2014 2015
European Union (28 countries) -0,4 0,0 1,4 1,9
Euro Area (18 countries) -0,7 -0,4 1,1 1,7
Austria 0,9 0,4 1,6 1,8
Belgium -0,1 0,1 1,1 1,4
Cyprus -2,4 -8,7 -3,9 1,1
Estonia 3,9 1,3 3,0 3,9
Finland -0,8 -0,6 0,6 1,6
France 0,0 0,2 0,9 1,7
Germany 0,7 0,5 1,7 1,9
Greece -6,4 -4,0 0,6 2,9
Ireland 0,2 0,3 1,7 2,5
Italy -2,5 -1,8 0,7 1,2
Latvia 5,0 4,0 4,1 4,2
Luxembourg -0,2 1,9 1,8 1,1
Malta 0,8 1,8 1,9 2,0
Netherlands -1,2 -1,0 0,2 1,2
Portugal -3,2 -1,8 0,8 1,5
Slovakia 1,8 0,9 2,1 2,9
Slovenia -2,5 -2,7 -1,0 0,7
Spain -1,6 -1,3 0,5 1,7
Denmark -0,4 0,3 1,7 1,8
Sweden 1,0 1,1 2,8 3,5
United Kingdom 0,1 1,3 2,2 2,4
Bulgaria 0,8 0,5 1,5 1,8
Croatia -2,0 -0,7 0,5 1,2
Czech Republic -1,0 -1,0 1,8 2,2
Hungary -1,7 0,7 1,8 2,1
Lithuania 3,7 3,4 3,6 3,9
Poland 1,9 1,3 2,5 2,9
Romania 0,7 2,2 2,1 2,4
Japan 2,0 2,1 2,0 1,3
United States 2,8 1,6 2,6 3,1
Source: AMECO.
R A P P O R T O C E R
15 15
Figure 3. GDP in the main emerging economies (y/y growth)
-12
-8
-4
0
4
8
12
16
2007 2008 2009 2010 2011 2012 2013
Brazil China India Russia
Source: OECD Stats.
6
Because of the increasing integration of the world economy, the slowdown in
emerging markets has also reduced the exports opportunities for advanced econo-
mies, especially in Europe; only Germany has been able to preserve its market share
in the world economy. No doubt, Germany’s export performance has been support-
ed by wage restraint and other supply side reforms; nevertheless, an important role
has also been the long-term strategic implantation of German firms in dynamic
emerging economies, which has secured them access to booming markets when
Europe went into bust, while at the same time, some components of German exports
were outsourced to cheaper location in the European market. For this reason, the
lacklustre exports performance by some euro Member States to dynamic emerging
markets is less disturbing than it might first appear. Germany is Europe’s industrial hub,
which pulls in output from other regions of the internal market and the exports from
Germany to the rest of the world generate the foreign exchange which net importers
in other countries use to make international payments. This logic is entirely in accord-
ance with a monetary union. In principle there is nothing wrong with other countries
shifting their export orientation from the rest of the world towards Germany. However,
the problem is that German firms may appropriate a share of the profit, which other-
wise would accrue to the periphery. More importantly, Germany is sourcing less from
Western Europe and more from CEECs, so that Europe’s south does not fully benefit
from the German boom. Hence, the issue of competitiveness becomes central in a
monetary union for the regional balance of economic growth. We discuss these is-
sues further in chapter 2.
7
The return to economic growth in Europe depends simultaneously on supply and
demand factors. Economists usually assume that the supply factors are structural and
take a long time to change, while demand depends on spending money and has
N. 1 - 2 0 1 4
16
Figure 4. Potential and real output and output gaps
200
220
240
260
280
300
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Austr ia
2,000
2,200
2,400
2,600
-6
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Germany
7,000
7,500
8,000
8,500
9,000
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Euro Area (12 countries)
700
800
900
1,000 -6
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Spain
120
140
160
180
-8
-4
0
4
8
00 02 04 06 08 10 12 14
Finland
1,500
1,600
1,700
1,800
1,900
2,000
-4
-2
0
2
4
00 02 04 06 08 10 12 14
France
140
160
180
200
220
-15
-10
-5
0
5
00 02 04 06 08 10 12 14
Greece
100
120
140
160
180
200
-8
-4
0
4
8
00 02 04 06 08 10 12 14
Ireland
1,300
1,350
1,400
1,450
1,500
-6
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Italy
460,000
480,000
500,000
520,000
540,000
560,000
00 02 04 06 08 10 12 14
Japan
440
480
520
560
600
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Netherlands
600
800
1,000
1,200
1,400
1,600
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Poland
130
140
150
160
170
-6
-4
-2
0
2
4
00 02 04 06 08 10 12 14
Portugal
1,000
1,100
1,200
1,300
1,400
-6
-4
-2
0
2
4
00 02 04 06 08 10 12 14
United King dom
10,000
12,000
14,000
16,000
-4
-2
0
2
4
00 02 04 06 08 10 12 14
GDP (constant 2005 prices) Output gap (right axis) Potential GDP (constant 2005 prices)
United States
Source: AMECO.
therefore more immediate effects. Traditionally, this is expressed by calculating a
production function for potential output and then comparing it with actual GDP. i.e.
with spending. The difference between the two is the output gap. When the output
gap is negative, demand is insufficient for absorbing the potential output; when it is
positive, demand is excessive and may cause inflation. Macroeconomic policy
should therefore aim at minimizing the output gap in order to ensure sustained high
R A P P O R T O C E R
17 17
levels of employment, essentially by adjusting monetary policy (interest rates) and by
using fiscal policy only as an automatic stabilizer.
8
Figure 4 shows for some collected countries how GDP, potential GDP and the output
gaps have developed during the crisis. Nearly all countries have had negative out-
put gaps since the global financial crisis hit in 2008. The sudden drop in actual output
has been dramatic in all countries, except in Poland, and the output gaps have
stayed negative everywhere, except in Germany. However, in the southern crisis
countries potential output has also started to shrink, which is different from what
standard economic theory claims. We must conclude that the story of demand and
supply is not as simple as standard models assume.
Figure 4 shows that, with the exception of Germany and possibly the USA, most coun-
tries have experienced a slowdown of potential growth, i.e. of Europe’s supply-side
capacity to generate income. What are the factors and causes behind this devel-
opment? If we consider the typical production function approach, productive ca-
pacity is made up of three variables that drive potential output: labour, capital and
technological capacities which are measured by total factor productivity (TFP) (see
Box 1 “The production function”).
9
Figure 5 presents the evolution of these factors and the countries’ overall rate of po-
tential output. With the exception of Greece and Spain, all European economies
shown here had a tendency for lower potential growth since the mid-1990s or early
2000s. This trend was dominated by a fall in total factor productivity. While the growth
rates for TFP have often more than halved, they have suffered most in countries with
bubbles in the real estate sector such as Spain, Ireland, Italy and the UK. Nevertheless,
the performance of countries like Italy and Spain, where total factor productivity has
stagnated for many years despite worldwide technological change driven by the IT-
sector, indicates serious malfunctioning of national societies, which are not capable of
absorbing innovation and change. In Spain, this is most probably due to the real estate
boom of the pre-crisis years that absorbed investment without technological change.
10
However, while the technology argument may be appropriate for “normal” times, it
seems no longer valid in the severe depression of recent years. It may be more ap-
propriate to distinguish between a technology-component of TFP and a shock-
component. However, there are no estimates for such separation. The European
N. 1 - 2 0 1 4
18
Figure 5. Factor contribution to potential output growth
-1
0
1
2
3
4
1985 1990 1995 2000 2005 2010 2015
Austria
-1
0
1
2
3
4
1985 1990 1995 2000 2005 2010 2015
Germany
-4
-2
0
2
4
6
1985 1990 1995 2000 2005 2010 2015
Greece
-4
-2
0
2
4
1985 1990 1995 2000 2005 2010 2015
Spain
-1
0
1
2
3
1985 1990 1995 2000 2005 2010 2015
France
-4
0
4
8
12
1985 1990 1995 2000 2005 2010 2015
Ireland
-1
0
1
2
3
1985 1990 1995 2000 2005 2010 2015
Italy
-2
0
2
4
6
1985 1990 1995 2000 2005 2010 2015
Portugal
-1
0
1
2
3
4
1985 1990 1995 2000 2005 2010 2015
Capital Labour TFP Potential GDP
United Kingdom
Source: European Commission Forecasts.
Commission estimates for TFP show a dramatic deterioration after the financial crisis.
There is no good explanation for this. TFP is a variable which accounts for effects in
total output not caused by traditionally measured inputs of labor and capital (See
Box 1) It is usually assumed that if all inputs are accounted for, then total factor
productivity may be interpreted as a measure of the economy’s long-term techno-
logical change or technological dynamism. But why should one believe that after
the Lehman collapse in 2008 technological progress suddenly stopped or even be-
came negative? Hence, there are some serious problems with the concept and cal-
culation of potential output. In Box 2 “EC’s estimations of potential output “we show
the main methodological problems in the way the Commission calculates potential
variables. One explanation is simply that potential output is demand constrained, so
that the recession has reduced output growth below the combined effect from cap-
ital and labour reductions, because the adjustments of the capital and labour stocks
take longer time.
R A P P O R T O C E R
19 19
11
How does the supply-side adjust? Labour is the most flexible part of the production
function insofar as workers can be hired and fired rapidly, while capital depends on
investment, and technology depends on the deep tissue of society such as educa-
tion, social infrastructure, research and development, etc. If the capital stock does
not grow at the rate sufficient to accommodate the growing labour force plus tech-
nological progress, structural unemployment will increase and potential output will
slow down or even shrink. This means, the reduction in potential output can be ex-
plained either by the change in equilibrium unemployment or by insufficient invest-
ment, although in fine long run changes in the natural rate of (un)employment may
always be explained by investment. We will first look at the labour market argument.
UNEMPLOYMENT AND NAWRU
12
Figure 5 shows that developments in the labour market have been negative for po-
tential output. Yet, while this makes intuitively sense, given the high levels of unem-
ployment in Europe, the way the European Commission calculates it is not without
problems. In line with neoclassical economic theory, the labour variable that matters
for potential output is equilibrium employment, because if there is excess demand for
labour, one would expect accelerating inflation and this cannot be an indicator for
long run potential output. For this reason, the Commission calculates an equilibrium
rate of unemployment, called NAWRU, which is supposed to indicate the level of un-
employment at which wage inflation does not accelerate. The problem is that these
estimates have nearly doubled since the beginning of the crisis and this demands an
explanation which is hard to find.
13
Due to the mix of negative supply and demand factors, unemployment has shot up
during the crisis in most countries – but not in all. As one sees in figure 6, in Germany
unemployment has fallen ever since 2005, with a brief temporary increase in 2010. In
Finland, unemployment seems to be stable around 8 percent. In many countries, the
stickiness of high unemployment is of greatest concern. Unemployment does not
seem to come down quickly, even when economic grow returns. As a consequence
of enduring unemployment, equilibrium or structural unemployment measured by
the NAWRU has increased in most Member States, except in Germany, Poland and
Finland. In the southern Euro Area Member States, the increase is dramatic, often
doubling during the crisis. In recent year, however, the increase has slowed down
and actual unemployment has started to come down, except in France, but this re-
versal is modest in Europe compared to the USA or Japan.
N. 1 - 2 0 1 4
20
14
Economic theory has two models for explaining equilibrium unemployment. The
“natural rate” model, developed by Milton Friedman from the inflation-expectation
augmented Phillips curve, assumes that long run employment levels reflect structural
factors in the labour market, so that high structural” or “natural” unemployment can
only be reduced by structural reforms, which make the labour market more flexible.
This logic implies that if structural unemployment has increased recently, it must be
that the labour market has become more rigid. This is odd. Europe has worked on
structural reforms for years and there is no evidence that the economic crisis has
shifted policy objectives in this respect or that policy responses to the crisis have
made the labour market “more rigid”. Thus, Europe’s slow growth and rising unem-
ployment cannot be explained by structural factors in the labour market. This does
not imply that there are no problems in labour market, but that they do not explain
why unemployment rose, or why it does not come down. Structural problems, such
as high youth unemployment or precarious contracts are a problem in itself, which
need to be dealt with, but they do not explain mass unemployment.
15
The alternative model is the Non-accelerating inflation rate of unemployment
(NAIRU) which derives long run equilibrium unemployment from wage and price set-
ting. In this model, disequilibria in the labour market result from the power of wage
setter and market power of firms. When the claims on total output by labour and
capital are incompatible, inflation is the mechanism to balance the claims in real
terms, but when the central bank does not accommodate this inflation, the adjust-
ment is unemployment. Thus, structural reforms need to reduce the distorting power
of trade unions and firms, so that a competitive equilibrium is more rapidly achieved.
De facto, the emphasis is on wage bargaining, so that the NAIRU is correctly trans-
formed by the European Commission into the Non-accelerating wage rate of unem-
ployment (NAWRU). Empirically, this is also problematic, for Olivier Blanchard (2) has
observed that the creation of the single market in Europe should have brought down
this equilibrium rate of unemployment and it is hard to understand why these struc-
tural factors have changed so dramatically after 2008. If structural unemployment
has increased during the crisis, it would imply that the wage bargaining power of
trade unions or the price setting power of firms has suddenly increased, and this is
certainly not how workers and employers are experiencing the world today.
16
As we show in Box 2, there are serious flaws in the way the Commission calculates
(2) Blanchard, Olivier J., 2004. Explaining European Unemployment, NBER Reporter, Summer 2004.
R A P P O R T O C E R
21 21
structural unemployment. In addition, as pointed out by several authors (3), the
mainstream theory underlying the calculation of potential output rules out the possi-
bility that prolonged stagnation of demand can affect potential GDP because such
low demand would result in decelerating inflation. But after the global financial crisis,
unemployment has increased substantially, while both prices and wages have not
fallen, so that the only possible explanation within this framework is that structural un-
employment increased.
Figure 6. Actual and structural unemployment rate
(3) See for example Klär, E. "Potential Economic Variables and Actual Economic Policies in Europe",
Intereconomics 2013/1.
N. 1 - 2 0 1 4
22
3.5
4.0
4.5
5.0
5.5
00 02 04 06 08 10 12 14
Austria
4
6
8
10
12
00 02 04 06 08 10 12 14
Germany
7
8
9
10
11
12
13
00 02 04 06 08 10 12 14
Euro Area (12 countries )
8
12
16
20
24
28
00 02 04 06 08 10 12 14
Spain
6
7
8
9
10
11
12
00 02 04 06 08 10 12 14
Finland
7
8
9
10
11
12
00 02 04 06 08 10 12 14
France
5
10
15
20
25
30
00 02 04 06 08 10 12 14
Greece
2
4
6
8
10
12
14
16
00 02 04 06 08 10 12 14
I reland
6
8
10
12
14
00 02 04 06 08 10 12 14
Italy
3.6
4.0
4.4
4.8
5.2
5.6
00 02 04 06 08 10 12 14
Japan
2
4
6
8
10
00 02 04 06 08 10 12 14
N etherlands
4
8
12
16
20
24
00 02 04 06 08 10 12 14
Poland
4
8
12
16
20
00 02 04 06 08 10 12 14
Portugal
4
5
6
7
8
9
00 02 04 06 08 10 12 14
U nited Kingdom
2
4
6
8
10
00 02 04 06 08 10 12 14
NAWRU Unemployment rate
U nited States
Source: AMECO.
17
This argument cannot be justified in light of the current events. Some authors (4) have
(4) Stockhammer, E. and Klär, E., 2011, Capital accumulation, labour market institutions, and unem-
ployment in the medium run. Cambridge Journal of Economics, 35(2), pp: 437-457 and the literature
therein.
R A P P O R T O C E R
23 23
argued against the traditional assumptions that cyclical events do not have an im-
pact on the long run evolution of macroeconomic variables. In this framework, the
drop in investments during the crises results in a lower number of hours worked, with
the final effect on the number of employed persons depending on the level of inter-
nal flexibility (i.e. reductions in the average hours worked per employee). We will look
in the next chapter at the impact of internal flexibility on unemployment and labour
costs. However, in Rapporto Europa 2013 we have shown that prolonged periods of
negative output gaps affect potential GDP negatively, mainly by reducing invest-
ment. Hence, in order to find explanations for the current high levels of unemploy-
ment in Europe, we should look at the drivers of the investment dynamics. When cap-
ital accumulation is slowing down and the growth rate of investment becomes nega-
tive, the falling capital stock will increase structural unemployment. Hence, the cru-
cial variable for getting higher employment is investment. The disastrous effects of the
Euro crisis are due to the high uncertainty in the financial and political environment of
the European economy. Higher risks required higher returns on capital to compen-
sate potential failures, so that in order to increase employment, it is necessary to in-
crease profit margins and to reduce risk and uncertainty or to speed up to process of
balance sheet restructuring of both firms and MFI. We will now discuss the investment
performance in the European economy.
INVESTMENT IN THE CRISIS
18
Net investment is the change in the capital stock of an economy. Figure 7 shows the
dramatic reduction in capital accumulation after the Lehman bankruptcy in 2008.
While the capital stock grew between 2 and 2.5% before the crisis, its growth rate fell
below 1% thereafter. In Greece, Italy, Portugal, and also in Japan, the capital stock
shrank. Quite obviously, this enduring reduction of capital inputs into production must
have slowed down the capacities of producing (potential) output.
19
It is well known that the factors determining investment are complex. In macroeco-
nomic terms, investment is output not used for consumption in this period. In a closed
economy, this coincides with savings, but in an open economy a net export surplus is
equivalent to shipping savings abroad. However, when less money is spent on do-
mestic consumption, investment and the surplus cannot be sold abroad, actual out-
put remains below potential and firms will reconsider if they will employ the same
amount of capital and labour in the next period. Output and growth are therefore
driven by investment decisions rather than by savings.
Figure 7. The rate of capital accumulation
N. 1 - 2 0 1 4
24
0.5
1.0
1.5
2.0
2.5
3.0
96 98 00 02 04 06 08 10 12 14
Austria
0.4
0.8
1.2
1.6
2.0
2.4
96 98 00 02 04 06 08 10 12 14
Belgium
0.4
0.8
1.2
1.6
2.0
2.4
96 98 00 02 04 06 08 10 12 14
Germany
0.5
1.0
1.5
2.0
2.5
3.0
96 98 00 02 04 06 08 10 12 14
Euro area (18)
0
1
2
3
4
5
96 98 00 02 04 06 08 10 12 14
Spain
0.5
1.0
1.5
2.0
2.5
96 98 00 02 04 06 08 10 12 14
Finland
0.8
1.2
1.6
2.0
2.4
2.8
96 98 00 02 04 06 08 10 12 14
France
-4
-2
0
2
4
6
96 98 00 02 04 06 08 10 12 14
Greece
0
2
4
6
8
96 98 00 02 04 06 08 10 12 14
Ireland
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
96 98 00 02 04 06 08 10 12 14
I taly
-1
0
1
2
3
4
96 98 00 02 04 06 08 10 12 14
Japan
0
2
4
6
8
96 98 00 02 04 06 08 10 12 14
Luxembourg
0.0
0.5
1.0
1.5
2.0
2.5
3.0
96 98 00 02 04 06 08 10 12 14
Netherlands
-2
0
2
4
6
96 98 00 02 04 06 08 10 12 14
Portugal
0
1
2
3
4
96 98 00 02 04 06 08 10 12 14
United States
Source: own elaboration on AMECO.
20
Investment, i.e. the increase in the capital stock, will depend on the expected return
on capital, which means, on the one hand, on the costs of labour and capital and
the relative prices of factors of production and of products, and on the other hand
on expectations. In an economic crisis, expectations are pessimistic and that lowers
investment. If they are excessively pessimistic, policies that try to lower costs to regain
a decent return may be helpless. Furthermore, if cost cutting by firms or the govern-
R A P P O R T O C E R
25 25
ment reduces total spending in the economy, the lack of demand for output pro-
duced will lower prices and this is also a disincentive for investment. Hence, there are
many variables that need to pull into the same direction in order to generate growth
and create jobs. There is no simple policy answer. But a good cocktail of measures
consist in:
Reducing risk factors for investors and political uncertainty
Improving supply-side conditions by reducing costs for capital and labour (interest
rates and wages) and increasing productivity of capital and labour
Improving demand-side conditions by increasing spending on consumption and
investment goods and by compensating the lack of private demand by public de-
mand.
21
One explanation for the drop in investment is that during the crisis, the risk premium
for investment has increased, so that in equilibrium the capital stock requires a higher
return on investment. Uncertainties about Europe and financial risks are still a major
obstacle for investment in the Euro Area, although the European Central Bank has
greatly contributed to reducing the uncertainty by setting up the program for Out-
right Monetary Transactions (OMT), and as a result the prohibitive interest spreads
have narrowed (see again figure 1). This should improve the propensity to invest and
the exit from the crisis.
Supply-side conditions will be discussed in the next chapter. We will now look at the
private spending and then at the public sector.
22
The private sector consists of households and firms. Usually, the spending patterns of
households are fairly stable, while investment is much more volatile. Nevertheless, fig-
ure 8 shows some interesting differences in spending patterns. In most of the later cri-
sis countries in Europe’s south, private consumption did increase at significantly high-
er rates than in the north, especially after the mid-2000s. In Germany and the Nether-
lands, but also in Italy in the early euro years, household consumption stagnated; in
the booming economies Spain, Ireland and Greece, household spending rose. With
the Lehman crisis, this came to an abrupt halt: private spending was cut everywhere.
No wonder, economic growth also turned negative. The stimulus measures in the cri-
sis-fighting mood seem to have turned the inclination for households to spend. But
while the United States returned to a previous stable spending pattern, in the Euro
Area the rebounce was of short duration and turned negative again in 2011-2012. No
doubt the Euro-crisis made households reluctant to spend money and the austerity
measures in the southern countries reduced available purchasing power.
Figure 8. GDP, Consumption and Investment at constant prices: growth rates
N. 1 - 2 0 1 4
26
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Austria
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Belgium
-.20
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Germany
-.20
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Euro area (12 countries)
-.3
-.2
-.1
.0
.1
.2
00 02 04 06 08 10 12 14
Spain
-.2
-.1
.0
.1
.2
00 02 04 06 08 10 12 14
Finland
-.16
-.12
-.08
-.04
.00
.04
.08
00 02 04 06 08 10 12 14
France
-.3
-.2
-.1
.0
.1
.2
.3
00 02 04 06 08 10 12 14
Greece
-.4
-.3
-.2
-.1
.0
.1
.2
00 02 04 06 08 10 12 14
Ireland
-.20
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Italy
-.20
-.15
-.10
-.05
.00
.05
00 02 04 06 08 10 12 14
Japan
-.3
-.2
-.1
.0
.1
.2
00 02 04 06 08 10 12 14
Luxembourg
-.20
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Netherlands
-.20
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Portugal
-.20
-.15
-.10
-.05
.00
.05
.10
00 02 04 06 08 10 12 14
Real Gross Domestic product Real Private Consumption Real Private Investment
United States
Source: AMECO.
23
Some economists believe that a consumption boom is unsustainable unless it is sup-
R A P P O R T O C E R
27 27
ported by investment (5). However, before the crisis, Spain, Ireland, and France, all
had investment booms – just like the United States. Yet, this investment was primarily
in real estate and induced by an asset price bubble which was not sustainable. On
the other hand, in Italy and Portugal real investment was generally weak. The same is
true for Germany, which had, however, two short-lived investment peaks before and
after the crisis. A similar pattern is also found in the Netherlands and Japan. By con-
trast, in the USA investment has continuously grown under the Obama administration.
24
It is an important factor of the continuing crisis that in countries of the southern Euro
Area, namely in Spain, Greece and Portugal, private investment has been falling
every year since 2008. Except for a small temporary peak in 2010, the same is true for
Italy. Only in Ireland did investment started to grow again in 2012. Thus, the overall
picture is that the capital stock has grown rapidly in Europe’s south before the crisis,
and that it has shrank since then.
25
Investment is done by firms. The interaction between different functional sectors in an
economy is shown by the flow of funds. In a simple textbook world, households are
assumed to save part of their income, which they lend to other sectors. The corpo-
rate sector is to borrow these funds and invest, while the government and the rest of
the world are supposed to be in equilibrium, i.e. neither to lend not to borrow. This
flow of funds is intermediated by banks and financial markets. However, in the Euro-
pean reality this stylized model does not fit realities. Figure 9 shows the net lend-
ing/borrowing by institutional sectors in the Euro Area. Some fascinating feature ap-
pear: households have always lent their savings to the other sectors, as standard
theory claims, although the amount of lending fell from 13 to 8 percent during the
pre-crisis boom and then quickly rose to 17% of GDP. Banks and financial institutions
have also been net lenders with a steadily growing share. On the other hand, the
corporate sector borrowed 15% of GDP during the dot.com boom in the early days
of monetary union and then decelerated borrowing until the next boom took off on
2004. By the time the Lehman crisis hit, the corporate sector borrowed 12 percent of
GDP from other sectors, and then it sharply stopped doing so. By the second quarter
of 2011, the corporate sector started to actually pay back its debt rather than bor-
rowing and this lasted for over a year. At the end of 2011, firms shortly borrowed
again, but in the climate of renewed recession, they soon returned to lending and
repaying debt. Governments have borrowed from households and banks during the
slow-growth period after the dot-com collapse and again massively during the glob-
(5) On this point see in particular Giavazzi, F. and Spaventa, L. (2010) "Why the current account may
matter in a monetary union: Lessons from the financial crisis in the Euro area," CEPR Discussion Papers
8008, C.E.P.R. Discussion Papers.
N. 1 - 2 0 1 4
28
al recession. They have reduced their borrowing by 10 percentage points of GDP
during the pre-crisis boom, but stimulated the economy by 26 percentage points in
2010. However, soon thereafter, fiscal consolidation set in. With households, banks
and non-financial corporation all lending and government borrowing less, the excess
funds were lent to the rest of the world, which generated a large current account
surplus.
Figure 9. Net lending/borrowing by institutional sectors in the Euro Area
-30
-20
-10
0
10
20
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Governement Households and NPISH
Monetary and Financial Institutions Non Financial Corporations
Rest of the W orld
Le
hm
an
Source: ECB.
26
Flow of funds statistics can also be decomposed to see the impact of certain coun-
tries or regions. Figure 10 shows the decomposition for 9 Euro Area Member States.
Very divergent pattern emerge: in Germany, France, Italy and Portugal, households
have been lending as the standard paradigm assumes, but not so in Spain and Ire-
land during the property bubble, and not at all in Greece and Finland. The corporate
sector has borrowed only in France, Italy, Spain and Portugal before the crisis, but has
either reduced net borrowing or turned it into lending and repayment of debt after
the crisis erupted. By contrast, Germany, Greece, the Netherlands and Finland all
have had net lending corporate sectors. Hence, in these countries firms have not
borrowed to invest, but they have saved and lent their profits either to households at
home (Greece) or abroad (Germany, Netherlands, Finland). Thus, the success of
northern countries was largely due to consumption booms from the south.
R A P P O R T O C E R
29 29
Figure 10. Sectoral net borrowing/lending in selected Member States as % of
GDP
-6
-4
-2
0
2
4
6
00 02 04 06 08 10 12 14
Aus tria
-8
-4
0
4
8
00 02 04 06 08 10 12 14
Germany
-15
-10
-5
0
5
10
00 02 04 06 08 10 12 14
Spain
-8
-4
0
4
8
00 02 04 06 08 10 12 14
France
-20
-10
0
10
20
30
00 02 04 06 08 10 12 14
Greece
-40
-20
0
20
40
00 02 04 06 08 10 12 14
Ireland
-6
-4
-2
0
2
4
6
00 02 04 06 08 10 12 14
Ita ly
-10
-5
0
5
10
15
00 02 04 06 08 10 12 14
N etherlands
-12
-8
-4
0
4
8
12
00 02 04 06 08 10 12 14
Corporations Government Households Rest of the World
Portugal
Source: EUROSTAT.
27
In Box 3 “Net lending linkages among corporations, government and households” we
estimate the relation between the net position of the three domestic institutional sec-
tors. According to the results, corporate borrowing is negatively affected by govern-
ment borrowing (coefficient -0.65), while household lending seems to have no im-
pact on the corporate sector. This is interesting, as the absence of a link between
household lending and corporate borrowing might indicate that the Horioka-
Feldstein paradox is no longer valid in monetary union (6). On the other hand, the
(6) According to standard economic theory, in the absence of regulation in international financial
markets, the savings of any country should flow to the most productive investment opportunities.
Therefore, domestic saving rates would be uncorrelated with domestic investment rates, and in-
creased saving rates within one country need not result in increased investment. Feldstein and Horioka
N. 1 - 2 0 1 4
30
negative and significant coefficient for the corporate-government relations can be
due to either Keynesian effects in macroeconomic policy or to a crowding out of
public borrowing at the expense of private sector borrowing. As we show in Box 4
”The Crowding out vs Keynesian effects of public expenditure on the corporate sec-
tor: a Granger causality test” in the Euro Area as a whole the evidence is in favour
of Keynesian effects, although country-by country the behavior of individual coun-
tries is mixed, with such Keynesian effects showing up only in the case of France
and Austria.
28
The important implication of the above result is that the Euro Area as a whole follows
a Keynesian pattern and in order to spread the benefits of such behavior to all coun-
tries, macroeconomic policy, including fiscal policy, should be conducted at the Eu-
ro Area level. There is, hence, a strong argument in favour of the coordination of fis-
cal policy among Member States.
PUBLIC FINANCES AND DEBT
29
If private consumption became insufficient during the crisis and investment slowed
down, spending was reduced. In this situation public spending by diverse govern-
ment bodies ought to compensate for the shortfall of demand. However, in Europe
this claim is complicated by the already high debt levels of several Member States,
most notably Italy.
Table 2 shows the debt to GDP levels of the European Union Member States and the
USA and Japan. Most of the increase in public debt is concentrated in the period
2007-2010 as result of the global financial crisis and the temporary amendment of the
Stability and Growth Pact. Currently, the aggregate debt ratio for the Euro Area is
close to 100 %, but seven countries are well above this average (Greece, Italy, Por-
tugal, Cyprus, Ireland, Belgium and Spain). Only Luxemburg and the new Member
States Estonia, Latvia and Slovakia fulfil the 60 percent criterion of the monetary un-
ion. In general, Central and Eastern Europe and Scandinavia have the lowest debt
levels. The public debt ratio is marginally higher in the USA than in Europe, but in Ja-
pan it has stabilised around 240%.
Table 2. Gross public debt in percentage of GDP
argued that if the assumption is true and there is perfect capital mobility, we should observe low cor-
relation between domestic investment and savings, but they found that this was empirically not true.
Our estimates here show that it is true within monetary union. See: Feldstein, Martin and Horioka,
Charles (1980), "Domestic Saving and International Capital Flows", Economic Journal 90 (358): 314–329.
R A P P O R T O C E R
31 31
Difference Difference
2007 2010 2007-2010 2011 2012 2013 2014 2010-2014
European Union (28 countries) 58,9 80,0 21,1 82,9 86,6 89,8 90,2 10,2
Euro Area (18 countries) 66,2 85,6 19,3 87,9 92,6 95,5 95,9 10,3
Austria 60,2 72,3 12,0 72,8 74,0 74,8 74,5 2,2
Belgium 84,0 95,7 11,7 98,0 99,8 100,4 101,3 5,7
Cyprus 58,8 61,3 2,5 71,5 86,6 116,0 124,4 63,0
Estonia 3,7 6,7 3,0 6,1 9,8 10,0 9,7 3,0
Finland 35,2 48,7 13,5 49,2 53,6 58,4 61,0 12,4
France 64,2 82,4 18,1 85,8 90,2 93,5 95,3 12,9
Germany 65,2 82,5 17,2 80,0 81,0 79,6 77,1 -5,4
Greece 107,3 148,3 41,0 170,3 156,9 176,2 175,9 27,6
Ireland 24,9 91,2 66,3 104,1 117,4 124,4 120,8 29,6
Italy 103,3 119,3 16,0 120,7 127,0 133,0 134,0 14,7
Latvia 9,0 44,4 35,4 41,9 40,6 42,5 39,3 -5,1
Luxembourg 6,7 19,5 12,8 18,7 21,7 24,5 25,7 6,2
Malta 60,7 66,8 6,1 69,5 71,3 72,6 73,3 6,6
Netherlands 45,3 63,4 18,1 65,7 71,3 74,8 76,4 13,0
Portugal 68,4 94,0 25,6 108,2 124,1 127,8 126,7 32,7
Slovakia 29,6 41,0 11,4 43,4 52,4 54,3 57,2 16,3
Slovenia 23,1 38,7 15,7 47,1 54,4 63,2 70,1 31,4
Spain 36,3 61,7 25,4 70,5 86,0 94,8 99,9 38,2
Denmark 27,1 42,7 15,6 46,4 45,4 44,3 43,7 1,0
Sweden 40,2 39,4 -0,8 38,6 38,2 41,3 41,9 2,5
United Kingdom 43,7 78,4 34,7 84,3 88,7 94,3 96,9 18,5
Bulgaria 17,2 16,2 -1,0 16,3 18,5 19,4 22,6 6,4
Croatia 34,0 44,9 10,9 51,6 55,5 59,6 64,7 19,9
Czech Republic 27,9 38,4 10,4 41,4 46,2 49,0 50,6 12,3
Hungary 67,0 82,2 15,1 82,1 79,8 80,7 79,9 -2,3
Lithuania 16,8 37,8 20,9 38,3 40,5 39,9 40,2 2,4
Poland 45,0 54,9 9,9 56,2 55,6 58,2 51,0 -3,9
Romania 12,8 30,5 17,7 34,7 37,9 38,5 39,1 8,6
United States 64,4 95,2 30,8 99,4 102,7 104,7 105,2 10,0
Japan 183,0 216,0 32,9 230,3 238,0 243,4 242,0 26,1
Source: AMECO.
30
Between 2010 and 2014, debt levels have risen in the Euro Area by 10 percentage
points. Only in Germany and Latvia are they coming down. But outside the Euro Ar-
N. 1 - 2 0 1 4
32
ea, developments are not necessarily any better. In the United Kingdom, debt is
approaching 100% of GDP, with an increase that is nearly double of the Euro Area,
but Denmark is keeping debt stable. In Hungary and Poland, debt is also coming
down. The increases in public debt, measured in percentage points of GDP, are
nearly twice as high in Europe than in the USA. These unfavourable debt dynamics re-
flect partly the negative growth of GDP in the Euro Area, for if GDP falls, the debt/GDP
ratio will obviously rise. The evolution of these debt levels is therefore not an indicator
for government spending and the stabilising impact of public spending. To evaluate
this, we need to look at the budget positions. However, it is important to keep in mind
that high debt levels are a constraint on governments’ capacity to borrow.
FISCAL POLICY
31
Fiscal policy in the Euro Area is governed by the Stability and Growth Pact (SGP),
which has recently been reinforced by the Fiscal Compact, which reflects a com-
mitment by Member States to give the rules of the SGP quasi-constitutional status. It
also says that within 20 years all Member States should have reduced their debt to
below 60% of GDP. The rules of this Pact are guided by two commitments. On the
one hand, the overall purpose is to avoid excessive deficits by individual Member
States which could cause harm on other members by either destabilising the finan-
cial system or by pushing interest rates up for everyone. For this reason, the rule says
that no member state’s deficit ought to exceed 3% of GDP, otherwise a procedure is
set into motion that can ultimately lead to the imposition of penalties. On the other
hand, the SGP is driven by the philosophy that active fiscal policies are to be avoid-
ed, but that automatic stabilisers are necessary to avoid excessive cyclical variations.
For this reason, the Pact says that the cyclically adjusted deficit (also called structural
deficit) ought to be in balance or surplus, except for some structural factors which
are assessed separately by the European Commission. Nevertheless, the calculation
of structural balances, being derived from potential output estimates, suffers from the
same flaws explained in Box 2 and it is in most of the cases severely downward bi-
ased.
32
Leaving aside calculation problems, with low or even negative growth, these rules
are likely to constrain the return to higher output growth and full employment. In or-
der to stimulate the economy’s demand side, a large negative output gap may re-
quire more stimulating expenditure than the 3% rule permits. In fact, the premature
exit from stimulus policies in 2010 was one of the reasons why the Euro Area fell into a
double-dip recession. But balancing the structural deficit puts additional pressure on
fiscal policy, because if long lasting output gaps reduce potential output, the gap
might close, but government revenue will fall as well. Hence, in order to balance the
R A P P O R T O C E R
33 33
cyclically adjusted deficit, public authorities have to cut and restructure their ex-
penditure and/or increase revenue by raising taxes. Both effects are likely to hamper
private investment and economic growth.
33
The difficulties are further acerbated by the fact, that governments must generate a
primary surplus in order to service their debt. The primary surplus is the net govern-
ment budget balance after deducting the payments for interest and debt repay-
ments. If this debt service is high, there is little room for other public spending such as
infrastructure and salaries. In fact, taxpayers will have to pay more and receive less.
The balance goes to bond holders, which are wealthy individuals or institutional in-
vestors. This system is a perfect redistribution of income from the bottom to the top of
the social hierarchy.
34
In order for the debt ratio to fall, it is necessary that the primary surplus is larger than
the growth-adjusted interest rate (the difference between interest and growth rates)
multiplied by the debt ratio. Hence, the rise in debt, observed in table 1, has nar-
rowed the margins for public spending on public goods. In addition, the increase in
risk premia on government debt in crisis countries together with negative or reduced
growth rates has seriously limited the capacity of Member States to finance the tradi-
tional functions of the public sector. Fiscal policy must increase primary surpluses in
order to keep public debt sustainable, but this reduces the absorption of potential
output at a time when the private sector is hesitant to invest and consume. This is the
policy dilemma in most Member States of the Euro Area.
35
Figure 11 shows the evolution of budget indicators since the beginning of the Euro
crisis in 2010. The first remarkable feature is that only some northern Member States –
namely Germany, Austria, Finland and Luxembourg - have remained safely within
the 3 percent margin. Belgium recorded a deficit below 3% only in 2013, the Nether-
lands is slightly outside the threshold while France is in the worst situation, with a deficit
above 4%. The Euro Area as a whole has attained the 3 percent threshold in 2013;
with the exception of Italy, whose deficit is stable at 3% since 2012, the southern crisis
countries all remain far from the Stability and Growth Pact requirements. However it is
interesting to note that the same is true for the United Kingdom and even for Poland
which has been one of the most successful EU economies in recent years.
36
With respect to the second rule of the Stability and Growth Pact, only Germany and
Luxembourg have achieved a balanced cyclically adjusted budget position.
Among the other countries, only Italy in 2013 is close to this threshold as result of the
N. 1 - 2 0 1 4
34
consolidation efforts started at the end of 2011. The European Commission forecasts
that Greece will achieve that target in 2014 and the Netherlands in 2015. Poland will
temporarily have a positive structural budget position in 2014. Hence the fiscal rules
of the Stability and Growth Pact are violated in nearly all Member States at the pre-
sent time. While this might be appropriate in the present crisis environment, it does
create a serious imbalance between the institutional commitments and actual per-
formances of their budget policies. Such a discrepancy undermines the trust in the
governance of the Euro Area.
Figure 11. Total and primary budget balances: actual and cyclically adjusted
values
R A P P O R T O C E R
35 35
-5
-4
-3
-2
-1
0
1
2010 2011 2012 2013
Aus tria
-6
-4
-2
0
2
2010 2011 2012 2013
Belgium
-6
-4
-2
0
2
4
2010 2011 2012 2013
Germany
-8
-6
-4
-2
0
2
2010 2011 2012 2013
Euro area (18)
-12
-10
-8
-6
-4
-2
0
2010 2011 2012 2013
Spain
-4
-3
-2
-1
0
1
2010 2011 2012 2013
Finland
-8
-6
-4
-2
0
2010 2011 2012 2013
France
-16
-12
-8
-4
0
4
2010 2011 2012 2013
Greece
-40
-30
-20
-10
0
2010 2011 2012 2013
I reland
-6
-4
-2
0
2
4
6
2010 2011 2012 2013
I taly
-4
-3
-2
-1
0
1
2
2010 2011 2012 2013
Luxembourg
-6
-4
-2
0
2
2010 2011 2012 2013
Netherlands
-10
-8
-6
-4
-2
0
2010 2011 2012 2013
Poland
-10
-8
-6
-4
-2
0
2
2010 2011 2012 2013
Portugal
-12
-10
-8
-6
-4
-2
0
2010 2011 2012 2013
Primary balance Primary balance, cyclically adjusted Balance Balance, cyclically adjusted
United Kingdom
Source: AMECO.
37
The problems are reinforced by the adverse debt dynamics. Most northern Member
States have positive primary balances, although they are usually small. France and
the United Kingdom are both in similar positions as their primary budget positions are
negative and therefore increasing public debt levels. In Italy, the balance of the pri-
mary surplus is around 3 percent which is insufficient to bring public debt down from
N. 1 - 2 0 1 4
36
its high 134 percent, especially given that it is a stagnating economy. Most estimates
claim that in order to comply with the Fiscal Compact, Italy would need a primary
surplus of more than 5% for the next 20 years. This seems hardly realistic.
38
Not surprisingly, we have witnessed in most countries consistent efforts to increase the
primary balance, although in recent years consolidation fatigue has set in. The usual
indicator to assess the impact of fiscal policy on economic activity is the cyclically
adjusted primary balance. All Member States have tightened their fiscal policy by in-
creasing their cyclically adjusted primary balances in 2010 and 2011 and this has
clearly contributed to the subsequent double-dip recession. However, in 2013 re-
newed efforts of fiscal consolidation have been made in Belgium, the Netherlands,
France and moderately in Germany and Italy.
39
In spite of the consolidation efforts, the overall picture is that Europe is caught in a
debt trap. Debt levels are high and rising because growth is low or negative. High
debt levels undermine trust in Europe’s economic governance, which pushes up the
risk premia in public debt, which further harms economic growth. But growth cannot
be stimulated by public borrowing, because debt levels are already at the edge of
non-sustainability. Hence, fiscal policy is powerless. What else can be done to stimu-
late economic growth?
One argument is that the ECB could do more to stimulate growth. But interest rates
are already close to zero and the ECB has massively provided liquidity to the banking
system. These measures have stopped the disruptive fire sales of Euro assets, but they
have had little impact on economic growth and inflation has fallen. Hence, mone-
tary policy is out of ammunition.
R A P P O R T O C E R
37 37
BOX 1. THE PRODUCTION FUNCTION
A typical production function of the Cobb-Douglas version is formulated like this:
Where Y is potential output, K is capital input, L is labour input and is the share of capital
input relative to labour. This can we written in logs
Where small caps indicate logarithms. It is usually assumed that the factor proportion is
constant.
The rate of growth of potential output is then
Total Factor Productivity, also called Solow-residual, is calculated as
With the growth rate
From this equation it is clear that TFP will fall if the reduction in output exceeds the combined
effect of the rate or change in capital and labour employment.
N. 1 - 2 0 1 4
38
BOX 2. EC’S ESTIMATIONS OF POTENTIAL OUTPUT
Since Fiscal Compact has been implemented, output gap has become a crucial variable for
assessing economic and fiscal policy in EU countries. As we shown in Box 1, the mathematical
representation of potential GDP is a Cobb – Douglas production function:
,
where and are the elasticities of L and K. The trend components of L
and TFP are extracted by statistical filtering while the K series is not smoothed; instead actual
capital stock is used (1).
Labour contribution to potential output is the product of the trends of unemployment, working
age population, participation rate and average hours worked. The latter three components
are obtained applying the Hodrick-Prescott filter to the original series. Forecast values of par-
ticipation rate and average hours worked derive from autoregressive models extended six
years ahead. For working age population Eurostat’s forecasts are used. The trend of the un-
employment rate - the so called non – accelerating wage rate of unemployment (NAWRU) is
obtained by a bivariate Kalman filter procedure on unemployment rate and Phillips curve. The
more general representation of the Phillips curve is
where is nominal wages and is the unemployment rate. The remaining variables are
exogenous: is labour productivity and and are wage share and terms of trade
respectively. The inclusion of exogenous variables in the Phillips curve differs for some countries
(e.g. the Phillips curve of Italy does not include any of the exogenous variables).
Finally, TFP’s trend is also calculated by Kalman filer, making use of a capacity utilization index.
Being an unobservable variable, potential GDP series is re-estimated every time new observa-
tions become available. Taking a look at the vintages of the potential GDP series there is a strik-
ing evidence of its variability. Figure A depicts the potential growth estimates for Germany,
France, Italy, Spain, Portugal, Greece, Ireland and Portugal in 2007, 2010 and 2014. In all coun-
tries potential growth has been revised downward during the most recent forecasts. For in-
stance, potential GDP growth estimations for Ireland in 2004 – 2006 have worsen by 0.7 to 1.8 pp
in 2010 compared to the estimations of 2007. The difference for Italy and Greece is about -1 pp.
The uncertainty in estimating potential GDP is largely attributed to the Nawru estimates. Figure
B contains the results of simulations of Italy’s potential growth for different Nawru hypothesis in
2012 – 2015. Simulations have been implemented with the EC’s methodology and leaving un-
changed the other determinants. Nawru itself is subject to ex post revisions. As we show in
__________________________________
(1) Since the capital stock is an indicator of overall capacity there is no justification to smooth this
series in the production function approach. “The production function methodology for calculat-
ing potential growth rates and output gaps” D’Auria et al (2010), European Commission Econom-
ic Papers 420, July (2010).
R A P P O R T O C E R
39 39
figure C Nawru seems to move along with the actual unemployment rate. When the unem-
ployment rate is stable or declining, Nawru, especially in peripheral countries, is estimated to
be low too. As unemployment jumped, during the crisis, Nawru ex post revisions have made
estimations suddenly shift upwards by 5 pp in peripheral countries. Hence, we are tempted to
conclude that the Nawru is not actually capturing long run trends, but it is influenced also by
short run - demand driven - dynamics.
Leaving aside theoretical problems in the choice of both the PC specification and the pro-
duction function, there are problems with the econometric methodology as the estimation of
potential variables depends strongly on assumptions regarding 1) the forecast horizon and the
underlying macroeconomic assumptions, 2) the initialization parameters for the Kalman filter
and 3) the choice of the smoothing parameter for the HP filter. With respect to the first point,
different forecasting horizons result in a different Nawru. As to the second point, there is a high
degree of discretion in the choice of the initialization parameters for the trend and
Figure A. EC’s potential growth forecasts
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Italy
-2
0
2
4
6
8
10
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Ireland
0.8
1.2
1.6
2.0
2.4
2.800
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
France
-2
-1
0
1
2
3
4
5
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Spain
-4
-2
0
2
4
6
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Greece
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Germany
-2
-1
0
1
2
3
4
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
potential gdp growth estimates 2007
potential gdp growth estimates 2010
potential gdp growth estimates 2014
Portugal
Source: EC forecasts.
N. 1 - 2 0 1 4
40
Figure B. Estimation of potential GDP with different Nawru hypothesis
1340
1360
1380
1400
1420
1440
1460
1480
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
EC estimates Nawru 10 Nawru 9 Nawru 8.6
Nawru 8 Nawru 7 Nawru 6
Source: CER estimates.
Figure C. EC’s Nawru estimations
4
6
8
10
12
14
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Italy
2
4
6
8
10
12
14
16
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Ireland
7
8
9
10
11
12
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
France
5
10
15
20
25
30
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Spain
5
10
15
20
25
30
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Greece
4
6
8
10
12
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Germany
4
6
8
10
12
14
16
18
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15 NAWRU estimates 2007
NAWRU estimates 2010
NAWRU estimates 2014
unemployment rate
Portugal
Source: EC forecasts.
R A P P O R T O C E R
41 41
cycle components (2); especially in cases when there is a turning point in the underlying series,
as it happened with the recent crises, the sensitivity of the results to choice of the parameters
is extremely high. The aim of the Commission in the choice of such parameters is to keep the
historical series of the Nawru unchanged, but this may result in a overestimation of structural
unemployment in the forecasting horizon, with obvious implication for the forecast of structural
budgets and the respect of the Stability and Growth Pact limits. Finally, the Hodrick Prescott
filter, used to calculate the other components of labour supply is itself subject to revisions (3) in
order to maintain a coherence with actual trends, especially in participation rates and hours
worked. This causes further instability in the forecasted series.
All in all, while we cannot argue that such discretion is a way to impose structural reforms in-
stead of the use of cyclical instruments, we should question whether the use of a methodolo-
gy, with an intrinsic degree of discretion and a high instability of the forecasts, should be used
by the Commission as a base to define the necessary adjustment of Members States, espe-
cially in times of crises when social cost of austerity measures are particularly high.
(2) This point has been made clear by the Italian Ministry of Finance in the latest Economic and
Financial Plan (DEF 2014). See the box therein called “Sensibilità dei saldi strutturali alla metodo-
logia di calcolo dell’output gap”.
(3) See D’Auria et al (2010), footnote 8 in page 12.
N. 1 - 2 0 1 4
42
BOX 3. NET LENDING LINKAGES AMONG CORPORATIONS, GOVERNMENT AND HOUSEHOLDS
By using Eurostat data on the net position of institutional sectors in Euro Area countries we es-
timate the reaction of corporate borrowing/lending to changes in the net position in both
households and government. Our dataset consist of a panel made of 17 Euro Area members
(we exclude Malta due to lack of data) over the period 1999-2013 for a total of 255 observa-
tions which restrict to 244 due to some missing data for Ireland and Luxembourg. The equation
to be estimated is the following:
(B1.1)
Where Corp, Gov and HH are the net lending/net borrowing positions in percentage of GDP
of corporations, government and households for country i at time t; γi and μt are country and
time specific effects and εi,t is the error term. Equation (1) will be estimated using the standard
fixed effects (FE) and random effects (RE) approaches (columns 1 and 2 of table B1.1 respec-
tively) as well as the instrumental variables estimator (IV, columns 3 and 4 of table B1.1). The
latter is used in order to take into account the potential endogeneity of the two regressors due
to reverse causality.
The results are shown in table A and indicate that governments’ net borrowing/lending has a
negative and significant impact on the corporate sector’s net position. The significance of this
relation is robust to the different estimators but the most reliable one should be that in column
3 (IV1) where we only instrument the household position. This is because endogeneity tests
(available upon request) while confirming the endogeneity of households, reject this assump-
tion for the government budget. This implies that the estimates in column 4 (IV2) are less con-
sistent as they imply an excessive use of instruments.
Table A. Corporate net lending estimates
FE RE IV1 IV2
Governement -0.756*** -0.738*** -0.650*** -0.583**
[0.158] [0.145] [0.175] [0.279]
Households -0,1 -0,2 0,4 0,4
[0.265] [0.221] [0.324] [0.328]
R2 0,4 0,4 0,5 0,5
N 244,0 244,0 176,0 176,0
Hausman 8,5
P-value 0,9
Hansen J 1,0 2,1
p-value 0,8 0,8
Endogenous HH HH, Gov
Standard errors in brakets; * significant at 10% level, ** significant at 5% level, *** significant at 1%
level; Hausman=Hausman test for FE against RE; Hansen J=test for overidentifying restrictions.
R A P P O R T O C E R
43 43
Although endogenous, the household position does not affect the corporate sector. As we
argue in the main text, this result is expected in a monetary union as saving move across coun-
tries in order to find the highest yields.
The negative sign of the Government’s coefficient has two opposite explanations: first, crowd-
ing out effects, i.e. government deficits are financed by the corporate sector; they therefore
move resources away from productive investment. Second and alternatively, Keynesian ef-
fects arise when governments step in to compensate for lack of demand in the private corpo-
rate sectors. In Box 4 we will check which of the two interpretations is the most suitable to ex-
plain the current reality.
N. 1 - 2 0 1 4
44
BOX 4. THE CROWDING OUT VS KEYNESIAN EFFECTS OF PUBLIC EXPENDITURE ON THE COR-
PORATE SECTOR: A GRANGER CAUSALITY TEST
In Box 3 we found that the levels of public sector net lending/borrowing are negatively related
to the net position of the corporate sector. The two competing explanations are a crowding out
effect, where fiscal deficits drag resources from the corporations, and a Keynesian effect, where
the public sector compensates for the lack of demand resulting from lower borrowing by corpora-
tions. Crowding out effects arise when the causality goes from higher government to lower corpo-
ration borrowing, while in the case of Keynesian effect, causality goes from lower corporations bor-
rowing to higher public sector deficits.
In this box we formally test these assumptions by running Granger Causality tests on the net position
governments and corporations. The results are shown in table A, where the first two rows report the
results for the Euro Area as a whole, using alternatively annual and quarterly data. In the second
case we run the test on aggregate data so that spillovers effects among countries are taken into
account. In addition, these data allow us to consider only non-financial corporations.
The results indicate that for the Euro Area aggregate Keynesian effects prevail as the direction of
causality goes from corporations to governments. This result is more evident when looking at quar-
terly data, indicating that when abstracting from financial corporations and taking into considera-
tion the interactions between all Member States in the Euro Area, the evidence points to stronger
Keynesian effects. As for individual countries, the evidence is mixed: on the one hand we find that
Keynesian effects dominate in France and Austria while we find suggestive evidence of crowding
out effects in the Netherlands, Cyprus and to a lower extent in Ireland. For the remaining countries
there is either bidirectional causality (Germany, Spain) or no relation at all.
Table A Granger causality tests
Gov causes Corp Corp causes Gov
Euro Area annual 2.40* 6.25***
Euro Area quarterly 1,4 5.60***
Austria 3.75* 4.73**
Belgium 0,9 0,8
France 1,5 3.42*
Germany 6.67** 3.68**
Greece 0,2 0,0
Ireland 11.11** 5.55*
Italy 0,0 1,1
Netherlands 4.59** 3,7
Portugal 0,6 2,3
Spain 3.83* 3.36*
Cyprus 4.85** 1,4
Estonia 1,1 1,0
Latvia 1,9 3,1
Slovakia 1,5 0,5
Slovenia 1,3 2,6
* significant at 10% level, ** significant at 5% level, *** significant at 5% level. Euro Area quarterly
uses 12 months rolling window on ECB quarterly data.
R A P P O R T O C E R
45 45
Cost competitiveness and institutional setting
40
The competitiveness problem in the European Union has shaped the economic and
political debate intensely since the start of the global financial crisis. The main focus
has been on the unequal development of cost competitiveness in Member States re-
flected in the external position in terms of current accounts. An additional problem
lies in the loss of competitiveness of the Euro Area as a whole with respect to the oth-
er main advanced economies. As we can see from figure 12, over the last 15 years
unit labour costs (ULC) have risen rapidly in the EU, and especially in the Euro Area,
relative to the US and Japan. This pattern mirrors, of course, exchange rate move-
ments, but it is also influenced by the internal ULC dynamics, especially in southern
Europe; in any case, even for Germany the situation is not satisfactory as the ULC
gap with United States has increased by 15% between 1999 and 2013.
One of the causes of such slowdown is the relatively low productivity increase in the
service sector, where research and development spending is weak. The Italian Insti-
tute of Foreign Affairs (IAI) has stressed the problems of innovation policy in the EU
and the slow growth of R&D development with respect to the US and China in its re-
cent Global Outlook (7).
41
The relative loss of competitiveness is also evident with respect to the UK and Japan.
Having performed similarly to the rest of the Euro Area up to 2007, the UK has benefit-
ted from exchange rate devaluations during the global financial crisis and now the
overall exchange rate-adjusted change in ULC is in line with the German one.
A strong euro relative to the other main currencies is one of the main issues and the
idea that the ECB should seek to devaluate the euro is gaining consensus among
scholars. We will address this issue in the next chapter, while we will review here the
developments of ULCs and capital efficiency and try to understand to what extend
institutional causes, related to labour market structures and their reforms, and wage
bargaining processes, have contributed to this pattern. We will further investigate the
sectoral dimension of such processes by comparing the dynamics in manufacturing,
construction and in the services sector. We will see how the aggregate path of wag-
es, productivity and ULCs is the result of important intersectoral reallocation, which
explain particularly well the German case and its difference with the rest of Europe.
(7) Global Outlook presentation 18th March 2014.
N. 1 - 2 0 1 4
46
Figure 12. Unit labour costs in main advanced economies
0,6
0,8
1,0
1,2
1,4
1,6
1,8
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
EU28 EA18 Germany Italy
United Kingdom United States Japan Canada
Source: OECD.
CAPITAL AND EFFICIENCY AND THE CER COMPETITIVENESS INDEX
42 The role of capital efficiency in countries' competitiveness is shown by the develop-
ment of the Cer Competitiveness Index, introduced in the previous issues of Rapporto
Europa. This index calculates the degree of over- or undervaluation according to the
difference with the equilibrium level of ULCs, based on the assumption of a return to
capital identical to the average Euro Area one. The performance of this index in ex-
plaining external competitiveness is significantly better than standard indices for ULCs
(8), because they also take into consideration the importance of the capital effi-
ciency and the profit rate alongside labour costs.
43 In table 3 we show the degree of over- and under-valuation of ULCs in comparison
with their equilibrium level (9). As we can see, the relative competitive position is dif-
ferent from that obtained by simply comparing ULCs with the Euro Area average.
Data in table 3 are ordered according to the degree of undervaluation, a negative
value indicates higher competitiveness as the return on capital is above the Euro av-
erage while positive values indicate overvaluation and below average competitive-
ness.
44 When European monetary union was established in 1999, Germany and Austria were
overvalued, together with Greece and, to a lower extent, Spain. In the other coun-
tries, ULC were undervalued and this was particularly true for the emerging econo-
mies of Eastern Europe like Slovakia and the Baltic States. Between 1999 and 2007,
(8) See S. Collignon and P. Esposito: "Unit Labour Costs and Capital efficiency in the Euro Area: a
new competitiveness indicator”, in S. Collignon and P. Esposito (eds) Competitiveness in the Eu-
ropean Economy, Routledge, London, 2014.
(9) Ibidem.
R A P P O R T O C E R
47 47
Northern European countries increased their competitiveness, especially Germany (-
12%), Austria (-6.2%) and the Netherlands (-6%). A strong competitive gain was rec-
orded also in Greece, whose ULC relative to the equilibrium level fell by almost 20%.
N. 1 - 2 0 1 4
48
Table 3. Over and under-valuation of Unit labour Costs
change change
1999 99-07 2007 07-12 2012 2013
Slovakia -46,7 -7,6 -54,3 0,1 -54,2 -55,0
Latvia -32,1 0,6 -31,5 -6,7 -38,2 -37,7
Luxembourg -33,0 -6,3 -39,3 7,2 -32,1 -34,2
Ireland -24,7 7,2 -17,5 -6,2 -23,7 -22,4
Cyprus -16,3 -0,2 -16,5 -5,2 -21,6 -21,1
Estonia -19,7 -2,7 -22,5 0,4 -22,0 -18,5
Portugal -9,4 5,5 -3,9 -3,6 -7,5 -9,1
Finland -13,4 -2,3 -15,7 6,1 -9,6 -8,3
Netherlands -0,9 -6,0 -6,9 1,3 -5,5 -6,5
Germany 8,8 -12,0 -3,2 -2,4 -5,6 -5,9
Slovenia -12,4 -0,3 -12,8 9,5 -3,3 -3,4
Belgium 0,2 -4,1 -3,9 1,5 -2,3 -1,3
Spain 1,8 11,2 13,1 -7,7 5,4 1,9
Italy -8,2 6,2 -2,0 3,4 1,4 2,6
Austria 12,4 -6,2 6,2 -0,6 5,6 7,9
France -3,5 7,0 3,5 3,7 7,1 8,0
Greece 28,0 -19,8 8,2 5,2 13,4 13,4
Source: own elaboration on AMECO.
Figure 13. The Cer Competitiveness index:
a comparison of main advanced economies
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Germany France ItalyJapan United Kingdom United States
Le
hm
an
Source: own elaboration on AMECO.
R A P P O R T O C E R
49 49
Figure 14. Cer Competitiveness Index and its components in core
Euro Area countries, 1995-2015
.45
.50
.55
.60
.65
.70
0.95
1.00
1.05
1.10
1.15
96 98 00 02 04 06 08 10 12 14
Austria
.5
.6
.7
.8
0.94
0.96
0.98
1.00
1.02
96 98 00 02 04 06 08 10 12 14
Belgium
.50
.55
.60
.65
.70
.75
0.92
0.96
1.00
1.04
1.08
1.12
96 98 00 02 04 06 08 10 12 14
Germany
.40
.45
.50
.55
.60
.65
0.95
1.00
1.05
1.10
1.15
96 98 00 02 04 06 08 10 12 14
Spain
.4
.5
.6
.7
.8
0.80
0.85
0.90
0.95
1.00
96 98 00 02 04 06 08 10 12 14
Finland
.48
.52
.56
.60
.64
.68
0.95
1.00
1.05
1.10
96 98 00 02 04 06 08 10 12 14
France
.3
.4
.5
.6
.7
0.8
1.0
1.2
1.4
1.6
96 98 00 02 04 06 08 10 12 14
Greece
.3
.4
.5
.6
.7
0.7
0.8
0.9
1.0
96 98 00 02 04 06 08 10 12 14
Ireland
.3
.4
.5
.6
.7
0.80
0.85
0.90
0.95
1.00
1.05
96 98 00 02 04 06 08 10 12 14
Italy
0.4
0.6
0.8
1.0
1.2
0.6
0.7
0.8
0.9
1.0
96 98 00 02 04 06 08 10 12 14
Luxembourg
.4
.5
.6
.7
.8
0.90
0.95
1.00
1.05
1.10
96 98 00 02 04 06 08 10 12 14
Netherlands
.4
.5
.6
.7
0.84
0.88
0.92
0.96
1.00
96 98 00 02 04 06 08 10 12 14
Unit labour cost Equilibirum unit labour cost Cer Competitiveness Index (right axis)
Portugal
Source: own elaboration on AMECO.
A deterioration of the competitive position was experienced by other peripheral
countries (Ireland, Spain, Italy and Portugal) together with France. The Spanish loss
was particularly severe (12%) making the country the least competitive in terms of re-
turn to capital.
45
With the global financial crisis and the subsequent adjustment, a partial realignment
of competitive positions took place. Spain, Ireland and Portugal reduced the over-
valuation of their ULCs, although the cost in terms of unemployment and GDP loss
was high. At the same time, while Germany and Austria kept on increasing their rela-
tive competitiveness, countries like Italy and France did not revert the negative trend
and became overvalued, and Greece lost part of the gain accumulated up to 2007.
N. 1 - 2 0 1 4
50
Between 2012 and 2013 Spain and Portugal continued the reduction of the ULC
overvaluation with an improvement of 3.5% and 1.6% respectively, while in Italy and
France competitive losses have continued. As we can see from the last column in
table 3, Italy and France are now at the bottom of the competitiveness rank togeth-
er with Greece and Austria while Spain and Portugal are back to their 1999 position.
46 The disadvantage experienced by the countries at the bottom of the rank is due
not only to rising ULCs, but also to a substantial stability of their equilibrium level, in
particular in Italy and France (see figure 14), while northern countries, above all
Germany and the Netherlands, gained competitiveness thanks also to rising equilibri-
um ULCs. Movements in the equilibrium ULCs are the result of both changes in the
average ULC and capital efficiencies relative to the European average, with a high-
er sensitiveness with respect to capital efficiency. As we will see in the next sections,
the evolution of the average capital efficiency (ACE) has been a key factor in ex-
plaining the competitive dynamics of the countries.
47 In figure 13 we show the dynamics of CCI for the main advanced economies. The
picture is quite different from the simple ULC comparison of figure 12. The United
Kingdom, Japan, and the United States have improved their competitiveness signifi-
cantly, while France and Italy continued to record increases in unit labour costs that
have caused overvaluations with respect to the Euro Area average. However, it is in-
teresting, that the ULC-competitive levels in France and the UK are now identical.
Germany has eliminated its wage cost overvaluation in the first half of the 2000s, and
is now on a stable undervaluation advantage. The differences are mainly due to the
dynamics of capital accumulation and capital efficiency. For example, in Japan the
competitive loss between 2000 and 2007 was partly due to the deteriorating capital
efficiency with respect to the Euro Area which offset improvements in the nominal
exchange rate. A similar argument holds for UK since the beginning of the global fi-
nancial crisis. The competitive advantage of the USA is due to improvements in la-
bour and capital productivity and, of course, in the weakening dollar.
UNIT LABOUR COSTS AND LABOUR MARKET ADJUSTMENTS
48 The dynamics of cost competitiveness, as measured by ULCs, are the result of multi-
ple forces. From the two basic components of wage share and labour productivity
we can isolate the contribution of various factors related to the demand side and to
the structure of labour markets. In Box 5 “The decomposition of ULC growth”, we de-
compose the growth rate of ULCs into the growth rate of five components (see
equation (6)): the average wage, the wedge between wages and labour compen-
sation (essentially social contributions), the average number of hours worked per
employee and labour productivity per hour worked. The latter is further decomposed
in order to isolate changes in potential output from changes in the output gap.
These five components allow us to understand the reasons behind ULC gains and
R A P P O R T O C E R
51 51
losses: wage growth is related to the process of wage bargaining while a high fiscal
wedge (the difference between gross wages and total labour costs) indicates a det-
rimental effect of taxation on labour costs, but it also represents an indicator of the
use of different types of labour as forms of precarious work, which have, contrary to
the standard fixed term contracts, the general advantage of a lower rates of social
contributions.
49 The three components of labour productivity provide interesting information about
the adjustment process during the crises and about labour market reforms. The aver-
age number of hours worked was reduced everywhere during the last decade, es-
pecially because of the change for full time contracts from 40 to 37 or 35 hours per
week in many countries; in addition, changes in the working time are the channel
through which countries can face temporary downturns in the economic activities
without increasing unemployment. While such employment stabilisation is desirable in
case of cyclical downturns, it may have the disadvantage of avoiding restructuring
processes, which would improve competitiveness in the long run. Finally, hourly la-
bour productivity is more closely related to supply side technological factors, while
the contribution of the output gap indicates the demand side effect.
50 The resulting decomposition for the main Euro Area countries is shown in figure 15,
where we also add the dynamics of ACE in order to reconcile ULC Figures with the
Cer Competitive Index described above. The comparison between ACE and ULC
growth gives additional information on the determinants of the German perfor-
mance with respect to the rest of the Euro Area and in particular with respect to
southern Europe. Between 1999 and 2013 the German capital efficiency grew on
average by 1% every year while ULCs fell (in particular between 2003 and 2007)and
then increased in recent years because of the accelerating wage dynamics.
51
ULC have increased constantly since the end of the 1990s in Italy, France, Portugal and
Spain. At the same time, in these countries ACE growth was negative. The dynamics for
the Netherlands and Greece is in between that of Germany and Southern Europe,
with positive ACE growth together with deteriorating ULCs. As we have seen in table 3,
these dynamics resulted there in improved competitiveness in terms of the CCI.
This overall picture is the consequence of different dynamics in the ULC components.
In Germany, wage restraint up to 2008 coupled with increasing productivity per hour
improved competitiveness, while the cyclical component was of minor importance.
After the crisis, the steeper wage increases brought ULC growth into a positive territo-
ry. In Italy and Spain the low growth of potential GDP coupled with a strong wage
drift, largely due to rising unemployment, which accelerated the ULC dynamics; in
France and Portugal as well, wage bargaining was the main factor for the deteriora-
tion of ULCs, notwithstanding the higher growth rate of hourly labour productivity
calculated on potential GDP. A similar argument holds for the Netherlands, where
N. 1 - 2 0 1 4
52
wage growth was boosted by a substantial rise in the amount of social contributions.
52 The behaviour after the crisis is more differentiated. While in Germany wages actually
increased, in the rest of the area there has been strong wage moderation. This is par-
ticularly true in Spain and Greece where low or negative wage growth was coupled
with a rising hourly productivity due to labour shedding. A recovery in the cyclical
component, according to the EC forecasts, will further improve the cost competi-
tiveness of these countries.
In France, the lower wage moderation is balanced by a higher growth in potential
labour productivity, while in Italy, given the relative stability of total employment, the
slower ULC growth is almost entirely due to the low wage growth. Finally, in the Neth-
erlands the rise of ULC in 2012 seems to be due to the rising wedge, which is likely to
be connected with the employment protection mechanisms.
Figure 15. ULC decomposition
Germany
-6
-4
-2
0
2
4
6
8
10
1999 2001 2003 2005 2007 2009 2011 2013 2015
Italy
-6
-3
0
3
6
9
12
15
1999 2001 2003 2005 2007 2009 2011 2013 2015
France
-6
-4
-2
0
2
4
6
8
1999 2001 2003 2005 2007 2009 2011 2013 2015
Spain
-10
-8
-6
-4
-2
0
2
4
6
8
10
1999 2001 2003 2005 2007 2009 2011 2013 2015
Greece
-20
-15
-10
-5
0
5
10
15
20
1999 2001 2003 2005 2007 2009 2011 2013 2015
Netherlands
-8
-6
-4
-2
0
2
4
6
8
10
1999 2001 2003 2005 2007 2009 2011 2013 2015
R A P P O R T O C E R
53 53
Portugal
-6
-4
-2
0
2
4
6
8
1999 2001 2003 2005 2007 2009 2011 2013 2015
-10
-5
0
5
10
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
Wage Wedge Avg. Hours Potential HLP Ciclycal HLP ULC ACE
Source: own elaboration on AMECO, OECD.
N. 1 - 2 0 1 4
54
Figure 16. Employment growth decomposition: 2009
-12
-10
-8
-6
-4
-2
0
2
4
Irelan
dSpa
in
Finlan
d
Portu
gal
Italy
U.K.
Franc
e
Nethe
rland
s
Austri
a
Greec
e
Belgium
Germ
any
Poland
U.S.
Avg. Hours 2009 Total Hours 2009 Employment 2009
Source: own elaboration on AMECO.
Figure 17. Employment growth decomposition: 2012-2013
-15
-12
-9
-6
-3
0
3
6
Greec
e
Portu
gal
Spain
Italy
Nethe
rland
s
Finlan
d
Franc
e
Poland
Belgium
Irelan
d
Germ
any
Austri
aU.K
.U.S
.
Avg. Hours 2012-13 Total Hours 2012-13 Employment 2012-13
Source: own elaboration on AMECO.
53 In the picture just described, an important driver - especially during the two crises -
originates from employment stabilisation mechanisms, which are explained fairly well
by the reduction of average hours worked. In normal times, as we can see from fig-
ure 15, this component raised ULCs, in particular in Germany, Italy and France, where
the full time work load was reduced during the last decade. This was coupled with a
boom in the use of flexible contracts with reduced working hours, in particular in
Germany and Italy. The ability to compensate for such structural deterioration of ULC
made up most of the difference between Germany and the other countries.
In periods of crisis, changes in the average hours worked give a clear indication of
the intensity of restructuring. In figures 16 and 17 we decompose employment growth
into changes in total and average hours worked. This is done for the two sub-periods
covering the global financial crisis in 2009 (figure 16) and the European debt crisis
(figure 17).
R A P P O R T O C E R
55 55
54 In 2009, total employment shrank everywhere except in Poland - the only country
experiencing positive GDP growth – and Germany, where it kept substantially stable.
In all other countries, including the United States, the downturn in economic activity,
as calculated by the total hours worked, resulted in a proportionally lower employ-
ment reduction because average hours worked were reduced. In Italy and Germa-
ny, this was made possible by the employment stabilization measures such as the
Cassa Integrazione Guadagni and the Kurtzarbeit. Germany, and also Austria, has
entirely sterilised the reduction in overall hours worked by making everyone work less,
without recurring to layoffs. To a lower extent this happened also in Italy, France and
UK while Ireland, Spain, Finland and Portugal adjusted mainly by cutting employment.
55
In the crises of 2012-2013 the group of southern Europe, with the exclusion of Ireland,
kept on losing employment due to the GDP contraction, but while in Italy the loss
was, again, partially compensated by a reduction of the average working load, in
Greece and Portugal the collapse in economic activity was associated with labour
shedding and a more intense use of employees as the average number of hours
worked per person actually increased. A similar result holds for Spain, where the 2%
reduction in the average hours worked does not balance the 9% loss in employment.
56 The implication of such dynamics is that Italy continued losing competitiveness in the
last years, as we have seen in the previous paragraph, and will be probably further
penalised in the ongoing process of recovery, increasing the gap with the rest of the
Euro Area. Instead, the other southern countries have improved their productivity
and will be relatively better positioned to exploit the chances of the economic re-
covery, although the social costs of austerity policies are extremely high.
SECTORAL DYNAMICS 57 In light of the evidence on the adjustment process collected in the previous para-
graphs, in this section we aim at understanding whether this competitive gap is also
the result of differentiated labour market adjustments in the main economic branch-
es. If this is the case, the policy implications are substantially different from the typical
EU institutions’ recommendations of undergoing structural reforms and foster invest-
ment in technology. Our assumption is that the wage bargaining process, together
with labour market reforms has contributed to the productivity slow down and, if this
is true, the Euro Area institutions should counterbalance these effects by improving
wage coordination across the currency area.
58 In figures 18-20 we report the ULCs decomposition in the three sectors for Germany,
Italy, Spain and France, the four biggest economies of the Euro Area.
It is no surprise that the bulk of competitive gains for the German economy come
from the manufacturing sector. As we can see from figure 18, the dynamics of ACE
and ULCs in manufacturing follows closely the aggregate path during the period
N. 1 - 2 0 1 4
56
2003-2007, when German ULCs declined and net exports boomed. Although with
sectoral data we cannot observe the effects of the cycle due to the lack of official
data on potential output, it is clear the role played the hourly labour productivity,
which increased at a faster pace compared with the average wage. Interestingly
enough, movements in the number of hours worked are significant only in the years
around the global financial crisis, while most of the changes in this variable come
from the service sector and construction.
R A P P O R T O C E R
57 57
Figure 18. ULC decomposition and ACE in manufacturing (annual % growth)
Germany
-21
-14
-7
0
7
14
21
1999 2001 2003 2005 2007 2009 2011
Italy
-15
-10
-5
0
5
10
15
1999 2001 2003 2005 2007 2009 2011
France
-10
-8
-6
-4
-2
0
2
4
6
8
1999 2001 2003 2005 2007 2009 2011
Spain
-15
-10
-5
0
5
10
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
-21-14
-707
1421
19961997199819992000200120022003200420052006200720082009201020112012
HLP Compensation Avg. Hours ACE ULC
Source: own elaboration on AMECO, OECD.
Figure 19. ULC decomposition and ACE in services
Germany
-4
-3
-2
-1
0
1
2
3
4
5
1999 2001 2003 2005 2007 2009 2011
Italy
-4
0
4
8
12
16
1999 2001 2003 2005 2007 2009 2011
France
-6
-4
-2
0
2
4
6
1999 2001 2003 2005 2007 2009 2011
Spain
-5,0
-2,5
0,0
2,5
5,0
7,5
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
-21-14
-707
1421
19961997199819992000200120022003200420052006200720082009201020112012
HLP Compensation Avg. Hours ACE ULC
Source: own elaboration on AMECO, OECD.
N. 1 - 2 0 1 4
58
Figure 20. ULC decomposition and ACE in construction
Germany
-9
-6
-3
0
3
6
9
12
1999 2001 2003 2005 2007 2009 2011
Italy
-8
-6
-4
-2
0
2
4
6
8
10
12
1999 2001 2003 2005 2007 2009 2011
France
-4
-2
0
2
4
6
8
1999 2001 2003 2005 2007 2009 2011
Spain
-20
-15
-10
-5
0
5
10
15
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
-21-14
-707
1421
19961997199819992000200120022003200420052006200720082009201020112012
HLP Compensation Avg. Hours ACE ULC
Source: own elaboration on AMECO, OECD.
59 Services seem to be particularly important in absorbing the new employment creat-
ed with the labour market reforms implemented between 1995 and 2003. Increases
in hourly productivity and a flat wage dynamics allowed keeping ULCs low despite
the increase in minijobs. The main difference with the manufacturing sector lies in the
negative ACE dynamics as result of the pace of capital accumulation (figure 21). This
means that while in manufacturing the return on capital increased, it shrank in ser-
vices so that also the effects on wage earners and capital owners go in opposite di-
rections. As we will argue below, delocalisation activities of German firms help to ex-
plain this result, especially in light of the reduction of the capital stock in manufactur-
ing. In Germany, the construction sector boomed after Reunification in the early
1990s, but when the bubble burst in 1995 and the reunification effects vanished, it
contracted in a similar way to what we observe today in Spain.
60 In the other countries, with few exceptions, we observe ULCs increases and a gen-
eral reduction in capital efficiency. In Italy, up to 2007, competitive losses are higher
in the service sector due to flat productivity and strong wage increases up to 2007. In
manufacturing, after 2003 there has been a mild positive growth in hourly productivi-
ty with the result of lower competitive losses. In France, strong increases in hourly
productivity compensated the high wage dynamics and the reduction in the aver-
age number of hours worked in manufacturing, with the result of a negative ULC dy-
R A P P O R T O C E R
59 59
namics. Such good performance is not enough to compensate for the high competi-
tive losses in the service sector, where productivity growth was lower and the wage
dynamics sustained. France is different from Germany in that changes in the number
of hours worked are similar in services and manufacturing. Finally, the French con-
struction sector appears to be in total decline, with high wage increases, coupled to
negative dynamics of productivity and average hours worked.
61 In Spain the main problem up to the global financial crisis was the strong wage dy-
namics and the low growth of productivity, but while in the manufacturing sector in-
creases of productivity per hour partially have compensated the wage growth, in
the service sector productivity have stagnated and in construction it has even de-
clined. Similarly to France, the reduction of the average hours worked has affected
the three branches in a similar way.
Figure 21. Annual growth of net capital stock
N. 1 - 2 0 1 4
60
-2
-1
0
1
2
3
4
5
90 92 94 96 98 00 02 04 06 08 10 12
Austria
-12
-8
-4
0
4
8
90 92 94 96 98 00 02 04 06 08 10 12
Finland
-4
-2
0
2
4
6
90 92 94 96 98 00 02 04 06 08 10 12
France
-8
-4
0
4
8
12
90 92 94 96 98 00 02 04 06 08 10 12
Germany
-4
-2
0
2
4
6
8
90 92 94 96 98 00 02 04 06 08 10 12
Italy
0
2
4
6
8
10
90 92 94 96 98 00 02 04 06 08 10 12
Construction Manufacturing Services
Spain
Source: OECD, own estimates.
R A P P O R T O C E R
61 61
62 After 2007 additional differences have emerged in the adjustment path. On the one
hand we find Spain, whose strong adjustment path described in the previous section
is concentrated in construction - as a result of the collapsed housing bubble - and in
manufacturing. For Italy the relative employment stability due to the automatic stabi-
lizers is concentrated in manufacturing, while ULC changes were less pronounced in
the service sector. In Germany, similar employment dynamics are found in manufac-
turing and services, but the latter accounts also for most of the wage increases ob-
served at aggregate level. This result is in line with the idea that low quality/low wage
jobs are located in services.
63 In France, after the crisis the wage dynamics in the service sector have not changed
while they even have accelerated in manufacturing after 2009. Reductions in the
average number of hours worked during the crisis are concentrated in manufactur-
ing, but after that the productivity dynamics started to recover.
64 Summing up, the evolution of cost competitiveness in the three branches reveals in-
teresting insights on the nature of aggregate competitive gains and losses. The Ger-
man performance is the result of the increased profitability of the manufacturing sec-
tor, while the service sector has absorbed the additional labour supply introduced by
labour market reforms. With different degrees, the other countries behaved in the
opposite way, experiencing competitive deteriorations and reductions in the return
to capital. In this process, wage and salary earners have benefitted from a redistribu-
tion of GDP at the expense of capital owners.
ULC, CAPITAL EFFICIENCY AND DELOCALIZATION 65 The German competitive gain in manufacturing is due to rising ACE and diminishing
ULCs with the result of improvements on the profit margins. As we can see from figure
21, the average annual growth of capital stock has been negative or, at best, null
since 1999. A faster reduction in the stock of capital was experienced during the pe-
riod 2003-2007, when the ULC dynamics was negative. Only in French manufacturing
we observe a similar pattern, although it did not result in increasing ACE while, as we
have seen in the previous figures, ULC shrank in most of the years since 1999.
66 The main explanation for this development can be probably found by looking at the
role of delocalization activities of German firms. There is plenty of evidence describ-
ing the benefits of outsourcing in improving productivity in manufacturing for Ger-
man firms (10). Productivity gains occur mainly by delocalizing capital intensive and
(10) See Marin (2010) "The opening up of eastern Europe at 20-jobs, skills, and a reverse maqui-
ladoras in Austria and Germany," Working Papers 421, Bruegel; CER Rapporto 3/2012
N. 1 - 2 0 1 4
62
low skill intensive stages of production, leaving at home the fragments with a high
content of skilled labour and those requiring lower amount of fixed capital, but of
better quality. Within this process, the domestic capital stock would increase its aver-
age efficiency but, at the same time, also its rate of return as high tech capital has a
higher depreciation rate. If we add to this the impact of labour market reforms, the
Agenda 2010 program, in introducing wage moderation, we have a clear explana-
tion for the country’s competitive gains.
67 In more recent years, Germany has been subject to many pressures, both domesti-
cally and from international authorities, for increasing wages and domestic expendi-
ture and, at the same time, gains from outsourcing are fading out since CEECs are
converging to the western standards of living. This implies that such a virtuous process
has come to an end and in the next years we should expect a dynamic of cost
competitiveness more in line with the other northern European countries.
68 As to the other countries, both in Spain and Italy the manufacturing capital stock has
increased together with ULCs. If we consider that in these countries the TFP dynamics
has been at best flat, we should conclude that delocalisation activities did not foster
firms’ competitiveness; instead, they suffered from increasing competition from
CEECs because they did not specialise in high tech/skill intensive stages of produc-
tions.
SECTORAL REALLOCATION AND EFFICIENCY GAINS 69 In this section we go a bit deeper in the analysis of sectoral dynamics by presenting
the results of a decomposition of the main ULC components into intersectoral and in-
tra sectoral effects. The details of the decomposition are presented in Box 6 “Direc-
tion and intensity of sectoral reallocation” and give rise to three different effects: a
within-sectors effect, which is directly connected with gains and losses in the effi-
ciency of branches; a between-sectors effects, which points to the role of structural
changes and, finally, an interaction effect. The latter can be interpreted as a dynam-
ic indicator for the changing specialisation of a country. A negative value of this term
indicates that specialization is moving toward branches experiencing negative
changes of the variable while a positive value indicates specialization in branches
with a increasing levels of the underlying variable.
WITHIN SECTORS CHANGES 70 Within groups effects (figure 22), which we assume to be an indicator of the sectors'
efficiency, present some interesting differences with the aggregate performance.
First of all, we look at it from the point of view of labour compensation. While it is con-
firmed that lower increases between 1999 and 2007 were taking place in Germany, it
is interesting to notice that Portugal and Spain rank right after Germany and before
Austria. On the contrary Greece, and to a lower extent Italy, experienced within sec-
R A P P O R T O C E R
63 63
tors wage increases close to those experienced by the two high wage countries
France and the Netherlands. At the same time, the rank for productivity increases re-
turns a clear dichotomy between Germany and the other core countries on the one
hand, and southern European countries on the other. The performance of Greece
and Italy, taken away composition effects, is particularly disappointing as within sec-
tors productivity growth was negative. These two effects give a mixed picture if we
look at the ULC dynamics. In particular, while it is confirmed that the efficiency effect
for Germany and Austria is important to explain the relative stability of their ULC, we
find that Italy experienced increases slightly below those recorded by France and
the Netherlands. Instead, Spain, Portugal and Greece experienced the highest
competitiveness losses due to the combined effect of high wage growth and low
productivity increases.
N. 1 - 2 0 1 4
64
Figure 22. Gains and losses in the sectors' efficiency (within groups effect)
Compensation
-2
0
2
4
6
8
10
2007 2011
Hourly labour productivity
-6
-4
-2
0
2
4
6
8
2007 2011
U L C
-2
0
2
4
6
8
10
12
14
2007 2011
Source: own elaboration on Eurostat.
71 In the period 2007-2011 the picture changes dramatically: Spain and Portugal im-
proved their sectoral efficiency in terms of ULC thanks to wage moderation - espe-
cially in Portugal - and to increases in productivity in Spain. All other countries experi-
enced a similar growth in the efficiency component of ULC so that divergences
should be stabilized or slightly reduced. However, we have to stress that the loss of ef-
ficiency in terms of productivity continued also after the crisis in Greece and Italy. In
the case of Greece, the productivity dynamics totally offset the effect of a zero
wage growth.
SECTORAL REALLOCATION AND CHANGES IN THE SPECIALIZATION PATTERNS 72 On average, as we can see in figure 23, the effect of between groups changes in
labour compensation is small with respect to within groups changes for all three vari-
ables between 1999 and 2007. Nevertheless, not everywhere this effect is negligible.
The impact is negative in all countries except in Greece, Portugal and France where
variations are, in any case, close to zero. Germany indeed benefitted more from
such reallocation, pushing further down the already low within groups increases
thanks mainly the dynamics of constructions and the public sectors. Also in Austria,
and to a lower extent in Italy, the sectoral reallocation toward low wage sectors
helped to mitigate the labour cost growth. The public sector has given a relevant
contribution in these countries too, but for Austria, similarly to Germany, constructions
played an important role, while in Italy the second most important contribution
Compensation
-5
0
5
10
2007 2011
Germany Portugal
Spain Austria
Italy Greece
France Netherlands
R A P P O R T O C E R
65 65
comes from the textile industry.
Figure 23. Sectorial reallocation (between groups effect)
Compensation
-0,8
-0,6
-0,4
-0,2
0,0
0,2
0,4
0,6
2007 2011
Hourly labour productivity
-2
0
2
4
6
8
10
12
14
2007 2011
U L C
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
2007 2011
Source: own elaboration on Eurostat.
Figure 24. Change in specialization (interaction effect)
Compensation
-0,8
-0,6
-0,4
-0,2
0,0
0,2
2007 2011
Hourly labour productivity
-12
-10
-8
-6
-4
-2
0
2
2007 2011
U L C
-3,5
-3,0
-2,5
-2,0
-1,5
-1,0
-0,5
0,0
0,5
2007 2011
Compensation
-5
0
5
10
2007 2011
Germany Portugal
Spain Austria
Italy Greece
France Netherlands
Compensation
-5
0
5
10
2007 2011
Germany Portugal
Spain Austria
Italy Greece
France Netherlands
N. 1 - 2 0 1 4
66
Source: own elaboration on Eurostat.
R A P P O R T O C E R
67 67
For all southern countries but Portugal, an additional contribution in mitigating the
wage dynamics comes from a changing specialisation toward sectors with a low or
negative growth of this variable (figure 24).
73 As to labour productivity, between 1999 and 2007 the effect of sectoral reallocation
is important for Italy, where it totally offsets the loss in efficiency, for Greece and
Spain. In all cases, the main part is due to constructions and real estates and, only for
Italy, tourism and legal activities. In Greece and Spain the gains from the sectoral re-
allocation process are totally offset by the low productivity growth of the main
branches involved.
74 Finally, the sectoral reallocation process between 1999 and 2007 has been extremely
important for the unit labour costs dynamics. Both in France and Spain the strong re-
location toward sectors having low and diminishing ULC helped to mitigate the loss
of efficiency. For the former, the highest contribution comes from the public sector
and wholesale and retail trade; for Spain tourism, transport equipments and textile
are among the main contributors. Interestingly enough, in both Germany and
Greece, the relocation toward high ULC sectors is more than offset by the fact that
these sectors experienced a competitive gain (i.e. negative interaction effect). The
effect is driven by the computer industry in Germany and by transportations (espe-
cially maritime) services in Greece. For the remaining countries both the static and
dynamic structural effects are of low importance for ULC.
75 Since the global financial crisis, structural dynamics have become less important in
explaining the aggregate path. Only in Spain we observe important compositional
effects, with an increased importance of both high wage and high productivity sec-
tors which, nevertheless, result in a reductions of ULC. The collapse of the construction
sector subsequent to the end of the bubble is the main driver behind this pattern, fol-
lowed by trade activities. In Greece the increasing importance of sectors where ULC
went substantially down (construction and trade) helped to keep to overall dynamic
low.
76 Summing up, both efficiency effect (within groups) and structural change have been
important in explaining the dynamics of labour costs and productivity up to 2007. The
German success is a striking case, while efficiency gains in productivity and wage
moderation were important, a substantial part of the ULC changes explained by the
expansion of low wage sectors, which also experienced a low or negative ULC
growth. Structural effects were important in mitigating the efficiency loss for southern
European countries and, in the case of Spain, we observe substantial gains from
structural change in the following years, confirming the positive pattern emerged in
previous sections.
N. 1 - 2 0 1 4
68
R A P P O R T O C E R
69 69
BOX 5. THE DECOMPOSITION OF ULC GROWTH We decompose ULC growth in order to find evidence on how the economic adjustment is influ-
enced by factors related, on the one hand, to the structure of labour cost and labour market poli-
cies and, on the other hand, to the evolution of potential GDP and the cyclical component.
Total employment can be expressed as the ratio of total to average hours worked, that is, if we call
H the total number of hours worked and k the average hours worked per year, total employment is
given by:
kHE / (1)
and consequently, total labour productivity is:
H
kGDPTLP
* (2)
which represent the product between hourly labour productivity (HLP) and average hours
worked. HLP can be further decomposed in order to separate the effects of potential GDP
(PGDP) and the cyclical component:
kcycPHLPkPGDP
GDP
H
PGDPTLP **
(3)
where PHLP is the potential hourly labour productivity and cyc is the ratio between actual
and potential GDP, which captures demand side effects. This expression is purely multiplica-
tive, an important characteristics that allows the easy decomposition of the growth rates of
ULC. By the same token, we apply a similar transformation to the average compensation
per person employed (LC), which can be separated into wage (W) and other employers'
costs, mainly including social contributions (C), and transformed into a multiplicative form as
shown in equation (4):
cWW
CWCWLC *1
(4) where
W
Cc 1
The latter term is in practice the ratio of LC to W and represents the factor by which the av-
erage wage is to be multiplied in order to obtain LC. By combining equation (3) and (4) we
get our formulation of unit labour costs:
kcycPHLP
cWULC
**
* (5)
with this specification, the log growth rate of ULC is given by:
cyclphpkcwclu (6)
The components of equation (6) are shown in figure 15 for selected countries.
N. 1 - 2 0 1 4
70
BOX 6. DIRECTION AND INTENSITY OF SECTORAL REALLOCATION
We decompose changes in ULC, wages and hourly labour productivity in order to disentan-
gle the contribution of sectoral reallocation and that of within sector changes. If we express
the variable for the total economy as the sum of sectoral values weighted with the contribu-
tion of each sector to the total value, for each of the three variables, the decomposition is
simply the total differential of a linear expression:
(7)
where Y=ULC, Wage, HLP, subscript i indicates the sector and subscript t is the time index.
The first term of the RHS represent the within sector effect, i.e. the change with constant
weights; the second term is the between sectors effect, i.e. the pure effect of weights
changes while the last term is the interaction effect. The interaction component represents
the change in the variable attributable to both changes in weights and levels in sectors.
The results of the decomposition are shown in figures 22-24 where the upper panel of each
period report the change between 1999 and 2007 while the lower panel shows the same
figure for 2007-2011.
R A P P O R T O C E R
71 71
N. 1 - 2 0 1 4
72
External trade, imbalances and the exchange rate
77 The external performance of the European countries has generally improved in during
the last year. The Euro Area as a whole recorded in 2013 a current account surplus of
221bn€, almost doubling the figure for 2012 (125bn€). As we can see in figure 25,
among Member States the improvement was generalised and it was particularly pro-
nounced in southern European countries, where the contraction of domestic demand
due to the massive use of austerity measures, has reduced not only the demand for
import but also the overall GDP growth. At the end of 2013 all southern European
countries recorded a positive or zero current account balance, while the main surplus
countries, i.e. Germany and the Netherlands recorded further improvements on a
yearly bases and now they are both positioned well above the 6% threshold, which
according the Macroeconomic Imbalances Procedure, should be considered exces-
sive. Among the other core countries we find a mixed situation: in Austria we observe a
fairly stable surplus above 2% while Belgium and Finland have been in a deficit position
since the end of 2011. The French position is more worrying as its deficit is at -2%, with a
tendency to deteriorate.
78 The balance of trade usually reflects the main contribution to the overall current ac-
count figures. Services' net contribution is usually lower and with opposite sign. In 2013
things have changed since the balance of services has also recorded an improve-
ment in most countries, in particular, as we will see in the next section in figure 33,
thanks to trade with extra Euro Area economies.
79 In the monetary union, aggregate figures for national current account and trade
balances mix intra and extra Euro Area trade flows, with the former being affected
by the euro exchange rates and the equilibrium of the balance of payment with the
rest of the world. Lacking official figures on intra and extra Euro Area current ac-
counts (11), we can focus only on goods' trade in order to provide information on in-
ternal and external movements.
80 Trade balances are shown in figure 26 and, contrary to the aggregate data, some
interesting differences emerge among countries in terms of intra and extra Euro Area
dynamics. In aggregate, the area's trade balance improvement in the last two years
is mainly due to the extra EU component, which turned positive in 2013 for the first
(11) The emphasis is on current account data, not trade. Eurostat provides data for the extra Euro Ar-
ea position of member states, but the information is limited to no more than 2 years. Only for Germany
there is a complete series starting form 2004, and this is reported in figure 35.
R A P P O R T O C E R
73 73
Figure 25. Current account and trade balances (% of GDP)
in main European economies
-6
-4
-2
0
2
4
6
8
05 06 07 08 09 10 11 12 13
Austria
-6
-4
-2
0
2
4
05 06 07 08 09 10 11 12 13
Belgium
-6
-4
-2
0
2
4
6
8
05 06 07 08 09 10 11 12 13
Finland
-6
-4
-2
0
2
05 06 07 08 09 10 11 12 13
France
-4
-2
0
2
4
6
8
05 06 07 08 09 10 11 12 13
Germany
-30
-20
-10
0
10
20
05 06 07 08 09 10 11 12 13
Greece
-10
0
10
20
30
05 06 07 08 09 10 11 12 13
Ireland
-6
-4
-2
0
2
05 06 07 08 09 10 11 12 13
Italy
-20
0
20
40
60
05 06 07 08 09 10 11 12 13
Luxembourg
-2
0
2
4
6
8
10
12
05 06 07 08 09 10 11 12 13
Netherlands
-15
-10
-5
0
5
10
05 06 07 08 09 10 11 12 13
Portugal
-12
-8
-4
0
4
8
05 06 07 08 09 10 11 12 13
Slov akia
-8
-4
0
4
8
05 06 07 08 09 10 11 12 13
Slov enia
-12
-8
-4
0
4
8
05 06 07 08 09 10 11 12 13
Spain
-8
-4
0
4
8
05 06 07 08 09 10 11 12 13
Current account Goods Services
UK
Source: own elaboration Eurostat.
time since 2000 and boosted the area's surplus in goods trade up to 1.8%. The main
contributors to such result are Germany, Italy, Spain and Finland, but also in the other
countries extra EU trade increased, the only exception being Ireland and the Nether-
lands.
N. 1 - 2 0 1 4
74
Figure 26. Total, intra EU and intra Euro Area trade balances in % of GDP
-8
-6
-4
-2
0
2
4
2000 2002 2004 2006 2008 2010 2012
Austria
-8
-4
0
4
8
12
2000 2002 2004 2006 2008 2010 2012
Belgium
0
1
2
3
4
5
6
2000 2002 2004 2006 2008 2010 2012
Germany
-2
-1
0
1
2
2000 2002 2004 2006 2008 2010 2012
Euro Area (12)
-6
-4
-2
0
2
2000 2002 2004 2006 2008 2010 2012
Spain
-3
-2
-1
0
1
02 03 04 05 06 07 08 09 10 11 12 13
EU (28)
-4
-2
0
2
4
6
2000 2002 2004 2006 2008 2010 2012
Finland
-5
-4
-3
-2
-1
0
1
2000 2002 2004 2006 2008 2010 2012
France
-12
-10
-8
-6
-4
2000 2002 2004 2006 2008 2010 2012
Greece
4
8
12
16
20
24
2000 2002 2004 2006 2008 2010 2012
Ireland
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2000 2002 2004 2006 2008 2010 2012
Italy
-40
-20
0
20
40
2000 2002 2004 2006 2008 2010 2012
Netherlands
-8
-6
-4
-2
0
2
4
2000 2002 2004 2006 2008 2010 2012
Poland
-12
-10
-8
-6
-4
-2
0
2000 2002 2004 2006 2008 2010 2012
Portugal
-6
-5
-4
-3
-2
-1
0
2000 2002 2004 2006 2008 2010 2012
Intra Euro Area (18) trade balance Intra European Union (28) trade balance Extra EU (28) trade balance
United Kingdom
Source: own elaboration on COMEXT.
81 Internal dynamics are a different story, with France, Germany and Finland experienc-
ing a continuous deterioration of their balances since the global financial crisis, alt-
hough a stabilisation occurred in 2013. On the other hand, all southern European
countries improved their balance within the area after the crisis. In this group, the
Spanish performance with the EU is the most outstanding since in 2013, for contrary to
the other countries, whose balance stabilised, Spain further improved its net position.
R A P P O R T O C E R
75 75
82
At first look, the external performance of the Euro Area vis a vis the rest of the world
(figure 33) is positive, with a surplus in the current account due mainly to the trade
component and this dynamics is shared among most of the Member States. Internal
trade is, instead, rebalancing which may appear as a good sign since exports are
making a positive contribution to GDP growth. This has raised optimisms among some
scholars (12) who see a fundamental stabilisation of the competitiveness of Southern
European economies due to the positive trade performance. We are less optimist
because the contribution of the import contraction in southern European countries
played a fundamental role, too. As we can see in figure 27 the contribution of net
export to GDP in 2012 for this group was mainly due to the import reduction. In 2013
the export contribution is null in Italy and slightly positive in Greece, while imports fur-
ther reduced. Only in Spain and Portugal is the export dynamic still sustained.
83 The import dynamics is mainly the reflection of a drop in domestic demand as goods
involved in Global Value Chains respond more to export changes. As we show in fig-
ure 28, the contribution of consumption and investment to GDP has been negative in
the last three years, and in general its contribution has been higher than that of im-
ports. This is also true in 2013, so we do not see signs of a substitution of imported
goods for domestically produced ones, meaning that the current stabilisation is likely
to be temporary.
84 As to Northern Europe, the contribution of export to GDP growth in 2013 was lower
than the year before and in particular in Germany (figure 29) while the dynamics of
domestic demand is low but mainly positive (figure 30) because northern countries
did not experience a GDP contraction.
85 For most of the Member States, the share of extra Euro Area/EU exports had a ten-
dency to increase substantially, but in 2013 it has stabilised. A similar pattern is found
for imports, with inflows from the rest of the world overcoming intra area import in Italy
and Greece, two countries whose import form emerging market had a particularly
detrimental effect on the domestic industry (13).
(12) See R. Auer “The increasing competitiveness of the southern Eurozone”, in
http://www.voxeu.org/article/increasing-competitiveness-southern-eurozone.
(13) Guerrieri P. and Esposito P., (2013) “Macroeconomic Imbalances in the Euro Area: the role of ex-
ternal performance", in L. Paganetto (ed), Public Debt, Global Governance and Economic Dyna-
mism, Springer, New York.
Giovannetti, G., Sanfilippo, M. and Velucchi, M., (2012), "The Impact of China on Manufacturing Ex-
ports of Italy and Germany", EUI-RSCAS Working Paper, n. 26.
N. 1 - 2 0 1 4
76
Figure 27. Contributions of the external sector to GDP growth
in southern Europe and Ireland
-2
-1
0
1
2
3
4
5
6
7
Export Import Balance Export Import Balance Export Import Balance
2011 2012 2013
Italy Spain Ireland Greece Portugal
Source: AMECO.
Figure 28. Contributions of consumption and investment to GDP growth
in southern Europe and Ireland
-8
-7
-6
-5
-4
-3
-2
-1
0
1
Cons PVT Cons Gov Inv Cons PVT Cons Gov Inv Cons PVT Cons Gov Inv
2011 2012 2013
Italy Spain Ireland Greece Portugal
Source: AMECO.
Figure 29. Contributions of the external sector to GDP growth in core Europe
-5
-4
-3
-2
-1
0
1
2
3
4
5
Export Import Balance Export Import Balance Export Import Balance
2011 2012 2013
Germany Netherlands Austria France
Source: AMECO.
R A P P O R T O C E R
77 77
Figure 30. Contributions of consumption and investment to GDP growth
in core Europe
-1,5
-1,0
-0,5
0,0
0,5
1,0
1,5
2,0
Cons PVT Cons Gov Inv Cons PVT Cons Gov Inv Cons PVT Cons Gov Inv
2011 2012 2013
Germany Netherlands Austria France
Source: AMECO.
86 Summing up, the developments of the last 2-3 years suggest that the Euro Area is be-
coming more export oriented while internal flows are mainly influenced by the tem-
porary drop in domestic demand. The lack of domestic demand has also affected
imports from outside the area, leading to a current account surplus and consequent-
ly to the appreciation of the euro (see below). In the immediate future, with the re-
covery of both demand and imports from southern Europe the surplus is likely to go
back to values close to zero and imbalances among Member States will show up
again.
87 This is not necessarily bad news since it could help to bring the euro-dollar exchange
rate down to the levels desired by some of the devaluation supporters. If we consider
that most of the increase in Member States' trade balances is due the slowdown of
imports from outside the EU, the expected recovery in domestic demand is likely to
induce such exchange rate effects. In this context the re-emergence to some levels
of trade and current account imbalances will be of little concern as the financial
markets are now more stable and the EU surveillance is now more strict. Speculative
bubbles in the new framework are less likely to occur, and the progresses toward a
banking union (see chapter 4) will eliminate the main problems connected with ex-
cessive deficit in the international investment position. In the next section we will
closely look at the exchange rate issue as this has become a major policy issue. Es-
pecially in France and Italy, the ECB has been urged to intervene and devaluate the
currency in order to give a boost to the export performance.
EXCHANGE RATE POLICY AND COMPETITIVENESS
88 With European countries showing only weak signs of recovery and the increased
strength of the euro relative to the dollar and the yen (figure 31), some analysts and
N. 1 - 2 0 1 4
78
Figure 31. Exchange rate of the euro with the main currencies
0,4
0,6
0,8
1,0
1,2
1,4
1,6
1,8
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
GBP JPY/100 USD
Source: Eurostat.
politicians put forward the idea that the ECB should intervene in order to reign in the
appreciation of the euro. The current level of the exchange rate with the dollar is
around 1.39, far from the maximum level reached before the global financial crisis
but still substantially above the level at the begin of the last decade. In the current
situation, with a sluggish recovery in the Member States, a depreciation of the euro
to levels below USD 1.30 is seen as a useful mechanism to give an additional boost to
the export performance of European countries.
89 The exchange rate is an important variable, because on the one hand it determines
relative prices and therefore the return on capital and competitiveness. But on the
other hand, because exchange rates are determined as asset prices in foreign ex-
change markets, they are highly volatile and this creates uncertainty, which influ-
ences investment and capital flows.
90 Since its introduction, the Euro appreciation has reflected not only the relative loss of
price competitiveness of the Euro Area with respect to USA, but also the evolution of
global imbalances in global payments. Emerging markets have become net export-
ers who seek to diversify the currency composition of their reserve holdings. The Fed-
eral Reserve has accommodated this tendency by injecting huge amounts of liquidi-
ty into the system, which is then spread into the rest of the world by the large current
account deficit. The ECB instead, has historically left the exchange rate free to fluc-
tuate because it fears that interventions could undermine the primary target of price
stability. In addition, the Euro Area has had current account surpluses, especially in
recent years, and portfolio investment into the Euro Area has exceeded capital out-
flows for FDI. This has resulted in excess demand for euro and caused the apprecia-
tion of the currency. However, it is interesting that the volatility between the two main
global currencies has come down significantly in recent years, which should support
trade and investment in Europe despite the moderate appreciation (figure 32). The
R A P P O R T O C E R
79 79
current volatility is in line with its historical level between 1999 and 2007 or even slightly
lower.
N. 1 - 2 0 1 4
80
Figure 32. Volatility of the euro/dollar-exchange rate
.0000
.0001
.0002
.0003
.0004
.0005
0.8
1.0
1.2
1.4
1.6
1.8
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Exchange rate volatility Daily exhange rate (right axis)
11th
Sept. 2
001
Subpri
mes c
risis
Lehm
an
Baliout G
reece
Note: volatility is the conditional standard deviation obtained from a garch (1,1) model.
Source: own elaboration on Eurostat data.
91 However, there have also been advantages from having a strong euro, in particular
by keeping down the cost of energy for European firms, although the cheaper im-
ports have contributed to the worsening of trade balances, leaving more room for
the penetration of imported goods from emerging economies like China.
92 Whether the euro is overvalued is still a matter of debate. In 2010 Martin Feldman
(2010) (14) argued that the euro is not overvalued and that the increasing amount of
financial flows coming from emerging markets requires a strong and appreciating
currency in order to run a trade deficit, like US, and to become a net importer of fi-
nancial flows (15). Two years later he changed his mind and argued that a mix of
productivity increasing policies, moderate wage growth and a one-time devaluation
of the euro would foster a virtuous adjustment of the Euro Area (16). At the same time
important economists like Nouriel Roubini advocated a devaluation of the euro by
30% to boost the economy (17).
(14) Martin Feldman, (2010, "Is the Euro Overvalued?", The Project Syndicate, http://www.project-
syndicate.org/commentary/is-the-euro-overvalued-#ktzPbExv4X4uqRkp.99
(15) By becoming a deep financial market for foreign capital, the euro could also become an instru-
ment for stimulating domestic growth, as can be seen in the UK.
(16) See http://dollarcollapse.com/currency-war-2/welcome-to-the-currency-war-part-2-massive-
euro-devaluation/ among the other criticisms reporter by the author of the article, he pointed out that
a devaluation could also lead to a currency war.
(17) See for example https://mises.org/daily/5904/Will-Currency-Devaluation-Fix-the-Eurozonehttp://www.cnbc.com/id/47356767.
R A P P O R T O C E R
81 81
93 New momentum to the political debate was given by a study of the Deutsche Bank
(18) published in 2012 which estimates the optimal level of the euro dollar exchange
rate for the members of the monetary union. The study indicated USD 1.24 and 1.17
per euro as the proper parity for France and Italy respectively, while for Germany the
"threshold of pain" is at 1.79. With this evidence, the French Economics Minister Ar-
naud Montebourg (19) called in early 2013 for an intervention of the ECB in order to
give oxygen to the Euro Area after the disasters caused by the excessive use of aus-
terity policies. The French President Hollande and the new Prime Minster Vals have al-
so supported the idea that the Euro Area should have an active exchange rate poli-
cy. In March 2014, ECB President Mario Draghi responded that the strengthening of
the currency may require further monetary stimulus.
94 Although the argument of those in favour of a devaluation may look convincing,
there are important drawbacks in such policy. First, a devaluation could have infla-
tionary effects through import prices, notably energy, and reduced control of capital
flows (20). Secondly, interventions change the structure of the ECB balance sheet.
The accumulation of foreign reserves – in case of active exchange rate policy - im-
plies a restructuring which would leave less room for the ECB to implement OMT and
play the role of lender of last resort. It might thereby have less control over the money
supply and less capacity to deal with the internal aspects of the Euro crisis. Third, the
devaluation of the euro may not have the expected effects on the export perfor-
mance of Southern European countries. A recent study by the German Council of
Experts (21) indicates that the benefits form exchange devaluation would go mainly
to Germany and France, while in Italy a reduction in labour costs seems to be more
important. The emergence of Global Value Chains (GVC) is another factor behind a
potentially unsuccessful a competitive devaluation. As pointed out by Altomonte
(2014) (22), when goods are produced in multiple countries a boost to exports from
lower exchange rate would raise also imports with uncertain effect on the trade bal-
ance. The same study suggest that even small medium enterprises, less involved in
GVC, would be little affected as they are mainly oriented to the European market.
95 In order to understand whether a devaluation policy has some effects one should first
be clear on the reasons for the current strength of the currency. In what follows we
will argue that the euro appreciation is the result of the high increase in its current
account surplus and the proper policy action should be to restore growth by
(18) Deutsche Bank, Focus Europe, 25th January 2013, Gilles Moëc «Where is the FX ‘pain threshold’?»,.
(19) Dominique Baillard, « L’euro trop fort…surtout pour la France et l’Italie! »
http://www.rfi.fr/emission/20131024-euro-trop-fort-surtout-france-italie/
(20) See footnote 16.
(21) Sebastian Breuer and Jens Klose. Who gains from nominal devaluation? An empirical assessment
of Euro-area exports and imports. German Council of Economic Experts Working Paper 04/2013
(22) See http://www.bruegel.org/nc/blog/detail/article/1196-exchange-rates-and-gvcs/).
N. 1 - 2 0 1 4
82
Figure 33. Euro Area current accounts (12 months rolling window) in % of GDP
-1.6
-1.2
-0.8
-0.4
0.0
0.4
0.8
1.2
1.6
2.0
2.4
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Current account Balance of goods
Balance of services Current transfers
Income tranfers Source: Eurostat.
fostering the recovery of domestic demand while foreign exchange interventions by
the ECB may be ineffective.
96 In order to test the effectiveness of a direct intervention from the ECB to lower the
exchange rate, in Box 7 “What drives the exchange rate appreciation? evidence
from a var based analysis”, we present a VAR estimation of the impact of changes in
foreign exchange reserves on the exchange rate dynamics. The impulse response
function (figure A) indicate that basically an exogenous shock to foreign exchange
reserves aimed at stabilizing or depreciating the euro has no effect. By contrast, the
exchange rate seems to respond significantly to changes in the current account po-
sition (figure B) with such effect driven mainly by the balance of trade in goods (fig-
ures C and D). These results suggest that the accumulation of foreign exchange re-
serves by the ECB aimed at bringing down the euro can be ineffective as its current
value is mainly the result of the high international net lending which results from the
current account surplus. The implication is that the strength of the euro is due to the
recession in many countries which kept imports low and improved the net position
with the rest of the world.
97 This is confirmed by figure 33, which shows that since the end of 2011 when austerity
kicked in, the Euro Area current account balance started to improve, reaching a
level of 2.2% at the end of 2013, far above the maximum pre-crisis level of 0.8 which
was reached at the begin of 2005. The recent result is mainly due to trade in goods
(1.8%) but positive contributions come also from services (1.1%) and income flows
(0.6%) while the contribution of current transfers is negative (-1.3%). With respect to
the period 1999-2009 the contribution of services trade is substantially higher while the
R A P P O R T O C E R
83 83
balance of goods is slightly above the maximum reached in 2005, although since the
end of 2011 we observe a 1 to 1 relation between movements in the current account
N. 1 - 2 0 1 4
84
Figure 34. Share in the Euro Area trade balance in 2013 and contribution
to its change between 2011 and 2013
-60
-30
0
30
60
90
120
150
Nethe
rland
s
Spain
Greec
e
Luxe
mbo
urg
Cypru
s
Portu
gal
Malt
a
Slovak
ia
Estonia
Sloven
ia
Finlan
d
Belgium
Austri
a
Franc
e
Irelan
dIta
ly
Germ
any
contribution to 2011-2013 change share 2013
Source: own elaboration on Eurostat-COMEXT.
Figure 35. Intra and extra Euro Area current account balance
for Germany (% of GDP)
0
1
2
3
4
5
6
7
2005 2006 2007 2008 2009 2010 2011 2012 2013
Extra EU Intra EU
Source: own elaboration on Eurostat.
and the balance of trade. Given that the increase in the balance of services is
common to all Euro Area countries (23) (again figure 25) and fairly stable, it is likely
that the fast increase in net exports of goods contributed to the appreciation of the
euro by increasing the current account position with the rest of the world. If this is
true, the strong euro can be considered a by-product of the austerity measures im-
posed to southern European countries. Policy action then should be taken not by the
ECB, which is already doing much in terms of economic stimulus, but by national
governments who are instead constrained by the respect of the fiscal compact.
(23) The German deficit is likely to be the result of the transit of most of its trade flows through the Port
of Rotterdam.
R A P P O R T O C E R
85 85
98 Additional insights come from the Member States’ contribution to the Euro Area posi-
tion. If we look at figures 34 and 35 we can see both trade and current account bal-
ances of the Euro Area are entirely driven by the German balance with non EA
countries. The German trade balance accounts for 2.2 of the area's GDP and, all to-
gether the other countries would show a modest deficit (-0.4%) due in particular to
the Netherlands which, in any case, more than compensates with intra area exports.
In figure 3.9 we can also see that Germany contributed by one third to the overall in-
crease in the Euro Area trade balance, slightly above the contribution of Italy (26%)
and far above that of France (9.6%) and Spain (12.2%).
99 With this evidence we can assume that the recent appreciation of the euro is, on the
one hand, the result of the of the contraction in domestic demand in most of the
countries and especially in Southern Europe and, on the other, the effect of the in-
creasing surplus of the German Economy outside the Euro Area. The policy implica-
tion is that the increase of domestic demand is as important in Germany as in south-
ern Europe and, perhaps, even more as Germany is less constrained by the SGP and
is therefore able, alone, to strongly influence the Area's balance of payments. A
change in the European fiscal policy toward more expenditure driven policies, with
the softening of the constraints imposed by the fiscal compact is then fundamental,
since it will also help to reduce the strength of the euro without imposing the burden
of such intervention to the ECB.
N. 1 - 2 0 1 4
86
BOX 7. WHAT DRIVES THE EXCHANGE RATE APPRECIATION? EVIDENCE FROM A VAR
BASED ANALYSIS
The ECB intervention in order to stabilize or reduce the level of the exchange rate with the US
dollar would consist of the accumulation of foreign exchange reserves. In this box we test
whether a change in foreign reserves affects the exchange rate dynamics by estimating a
Vector Auto Regressive (VAR) model which relates changes in the exchange rate to the cur-
rent account position and to the variation of foreign exchange reserves. The VAR specification
is a system of equations where each of the three variable is alternatively the dependent one
and is expressed as function of its lagged levels as well as the lags of the other two variables as
in equations 1- 3:
tttttttt ZZXXYYY ,12716251423121 (1)
tttttttt ZZXXYYX ,22716251423121 (2)
tttttttt ZZXXYYZ ,32716251423121 (3)
where Y=Δ(Exchange rate), X=current account balance, balance of goods, balance of ser-
vices, Z=change in reserves. The VAR is estimated on a sample of quarterly data from Q1-1999
to Q4-2013. This formulation allows us to calculate impulse response functions (IRF) which de-
scribe the evolution of the variables in the system in response to an exogenous shock to one of
the three variables. IRF are calculated using the Cholesky decomposition which implies an or-
dering of the variables from the least endogenous (i.e. the one subject to the initial exogenous
shock) to the most endogenous. In order to test the significance of an ECB intervention aimed
at reducing the exchange rate we first verify the impact of an exogenous shock to foreign ex-
change reserves. The IRF function is shown in figure A, as we can see a standard deviation in-
crease in foreign reserves – 0.24% of GDP– has a very small effect on the exchange rate (close
to 1 cent) so that a reduction of the exchange rate by 15 cents would cost 3.6% of the Euro
Area GDP in terms of accumulation of foreign reserves. Given the size of the ECB balance
sheet this amount seems to be not easily compatible with the monetary policy target.
The effect of a change in the current account balance appears to be much more effective in
moving the exchange rate. As we show in figure B an exogenous s.d. shock to the current ac-
count balance (1.1% of GDP) has a cumulated effect on the exchange rate of almost 3 cents
after a year and 4.7 cents after two years. In figure C we show that this effect of current ac-
count changes is driven by the balance of trade in goods, while a shock to the balance of
services (figure D) has practically no effect on the exchange rate dynamics. Given that the
standard deviation of the trade balance is 0.7% of GDP, a reduction of the surplus form 2.2% to
0.1% would lower the exchange rate by 13-14 cents.
Although one may argue that the lack of responsiveness of the exchange rate to reserve
management is due to that fact such interventions have never been implemented
102R A P P O R T O C E R
87
87 87
systematically, we find evidence that the rebalancing of the current accounts would be signif-
icantly more effective and less costly in bringing down the exchange rate.
Figure A. Cumulated response of exchange rate changes
to changes in foreign exchange reserves
-.04
-.02
.00
.02
.04
.06
.08
.10
1 2 3 4 5 6 7 8 9 10
Figure B. Cumulated response of exchange rate changes
to the current account to GDP ratio
-.08
-.04
.00
.04
.08
.12
1 2 3 4 5 6 7 8 9 10
Figure C. Cumulated response of exchange rate changes
to the balance of goods to GDP ratio
-.08
-.04
.00
.04
.08
.12
1 2 3 4 5 6 7 8 9 10
N. 1 - 2 0 1 4
88
Figure D. Cumulated response of exchange rate changes
to the balance of services to GDP ratio
-.04
-.02
.00
.02
.04
.06
.08
.10
1 2 3 4 5 6 7 8 9 10
102R A P P O R T O C E R
89
89 89
N. 1 - 2 0 1 4
90
European Banking Union: state of the art and critical aspects
100 With the intensification of the economic and financial crisis, the Euro Area banking
sector has shown a dramatic increase in its fragmentation. A higher correlation be-
tween perceived risks in the banking market and in the domestic sovereign bond
market has also appeared.
The European Banking Union (EBU) could be an important factor able to rebuild a
correctly functioning banking market, thereby helping economic recovery. The EBU
project started in June 2012, when European Union Member States (MS) planed
some ambitious targets to be reached in 5/6 years.
The EBU is formed by a system of harmonized rules (single rulebook) and by three
main pillars:
i) the Single Supervisory Mechanism (SSM),
ii) the Single Resolution Mechanism (SRM),
iii) the Single Deposit Guarantee Scheme (SDGS).
101 However, the current EBU’s structure has several critical shortcomings that could limit
its potential benefits, in particular with respect to stopping the “deadly embrace” be-
tween banks and their governments.
The remainder of the chapter is organized as followed: in the first Section we report
some evidence of fragmentation in the Eurozone banking market, while in the follow-
ing three sections we describe the state of the art and the critical aspects for each
EBU’s pillar. In the last Section we take our conclusions.
FRAGMENTATION IN THE EURO AREA BANKING MARKET
101
A clear indication of the level of fragmentation in the Euro Area banking market is of-
fered by the dynamics of interest rates to non-financial corporations and households.
With respect to non-financial corporations, the spread between the maximum and
minimum levels granted in the different Eurozone countries has increased until the
end of 2010, when the financial crisis affected sovereign bonds, and Greece in par-
ticular (figure 36). A similar path is also found for interest rates to households for house
purchase (figure 37) and for consumer credit (figure 38).
102
A synthetic indicator of interest rates volatility in the Euro Area is represented in figure
39. After the 2008 international financial crisis, interest volatility has drastically in-
creased. However, if the interest rates applied to households are showing a stabiliza-
102R A P P O R T O C E R
91
91 91
tion process, although on a level higher than in the pre-crisis period, interest rates to
non-financial corporations exhibit very high volatility, which has come down only par-
tially in the recent period.
N. 1 - 2 0 1 4
92
Figure 36. Banking interest rates to non-financial firms - New operations
0
2
4
6
8
10
12
14
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Euro area
Note: the grey area represents the min-max corridor of Euro Area banking interest rates. The countries
included are all the members of Euro Area starting from 2003 for which the time series is available.
Source: CER's elaborations on ECB data.
Figure 37. Banking interest rates to households for house purchase - New opera-
tions
0
2
4
6
8
10
12
14
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Euro area
Note: the grey area represents the min-max corridor of Euro Area banking interest rates. The countries
included are all the members of Euro Area starting from 2003 for which the time series is available.
Source: CER's elaborations on ECB data.
SINGLE SUPERVISORY MECHANISM (SSM)
103 Among the three EBU pillars, only the Single Supervisory Mechanism, SSM, is com-
pletely defined and with an implementation timetable that will last until the end of
the current year.
On the basis of the SSM, the banking supervision of the biggest banks of the Euro Ar-
ea countries, and of those of MS that voluntarily participate in the mechanism, will be
entrusted to the European Central Bank (ECB) by November 2014.
102R A P P O R T O C E R
93
93 93
Figure 38. Banking interest rates to households for consumer credit - New operations
0
5
10
15
20
25
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Euro area
Note: the grey area represents the min-max corridor of Euro Area banking interest rates. The countries
included are all the members of Euro Area starting from 2003 for which the time series is available.
Source: CER's elaborations on ECB data.
Figure 39. Euro Area: banking interest rates volatility
0,0
0,1
0,2
0,3
0,4
0,5
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
non-financial firms households - house purchase households - consumer credit
Note: in the graph is represented the variation coefficient, equal to the ratio between standard devia-
tion and average of Euro Area members starting from 2003 and for which the time series is available.
Source: CER's elaborations on ECB data.
104
The banks under the supervision of ECB are those for which at least one the following
criteria applied:
- Total assets over € 30 billion;
- Total assets exceed € 5 billion and represent at least 20 per cent of domestic
GDP;
- Being among the three largest banks in the MS in terms of total assets.
These three criteria produce a list of around 130 banks (24 Germans, 16 Spanish, 15
Italians and 13 French), which cover 80/85 per cent of Euro Area total bank assets.
The remaining banks will stay under the supervision of national authorities. However,
the ECB will be able to take over supervision in case of potential danger for the
overall European banking system. The national supervision should be conducted un-
N. 1 - 2 0 1 4
94
der common rules in order to avoid regulatory arbitrage, which could distort market
competition and produce other situations of fragmentation.
105 In order to have a more precise picture of banks’ conditions, the ECB and the Euro-
pean Banking Authority (EBA) are conducting in-depth analysis based on three dif-
ferent phases:
a) the analysis of risk based on balance sheet through the use of CAMEL (Capital, As-
set quality, Management, Earnings e Liquidity) method;
b) the Asset Quality Review (AQR), with the aim to evaluate riskier bank assets on the
basis of balance sheet at the end of 2013. In order to assess balance sheet quality,
ECB and national authority supervisors are inspecting participating banks. With re-
spect to non-performing loans, one of the riskiest bank assets, the harmonized defini-
tion established by EBA (24) should be used. National definitions are applicable, if
they comply with EBA standards. It should be noted that government bonds are not
included in the AQR, but they are considered in the stress tests;
c) the stress tests, with the aim to assess the resilience of financial institutions in case of
adverse market developments (25). ECB and EBA fixed two minimum Common Equi-
ty Tier1 ratio (CET1) that participating banks should respect:
1. in the baseline scenario, i.e. without assuming any kind of shocks but only the pro-
jections until 2016, the threshold rate is equal to 8 per cent;
2. in the stressed scenario the threshold rate is equal to 5.5 per cent (in the previous
106 EBA stress test in 2011 the threshold rate was 5 per cent in terms of Core Tier1 ratio).
The stressed scenario will also evaluate the effects on government bonds, but with a
different approach based on their classification. They will be evaluated at fair value
when they are held for trading or available for sale, which implies the application of
market risk methodology to capture changes in market prices. With respect to gov-
ernment bonds held to maturity, they will be evaluated for the credit risk.
107 On the basis of AQR and stress test results, participating banks could be asked to
take quick actions in order to restore an adequate level of CET1, through capital in-
jections and/or reducing Risk-Weighted Asset (RWA), or to engage for medium term
actions, e.g. reducing dividends distributed. Banks in the most precarious situations
could be also resolved.
CRITICAL ASPECTS ON THE SSM
108
(24) EBA, 2014a, “EBA FINAL draft Implementing Technical Standards”, On Supervisory reporting on
forbearance and non-performing exposures under article 99(4) of Regulation (EU) No 575/2013.
(25) EBA, 2014b, “Methodology EU-wide Stress Test 2014. Version 1.8”, Preliminary.
102R A P P O R T O C E R
95
95 95
The decision not to centralize the banking supervision for all the 6,000 Euro Area
banks in the ECB, and to leave most of them under national authorities, will potential-
ly limit the effectiveness of reducing systemic risk through SSM. As observed by Brown,
Trautmann and Vlahu (26), “economic linkages between banks give rise to conta-
gion of deposit withdrawals across banks, especially when depositors are aware of
these economic linkages. Such systemic problems can be more acute for banking
systems characterized by clusters of domestic banks which share the same business
model”.
109 In Europe, examples of small size banks highly interconnected with each other and
with the same business model are present in Germany and Italy. Sparkassen are
German public saving banks. There are around 400 Sparkasse which are juridical dis-
tinct, but connected to each other through agreement of reciprocal support in case
of trouble. Moreover, these banks are also related with Landesbanken, another form
of public banks but of bigger size and that have the aim to support Sparkassen in the
investment banking activities. All together Sparkassen and Landesbanken represent
around 70 per cent of German GDP.
110 In Italy, Banche di Credito Cooperativo (BCC) are around 400 and as Sparkassen
they are juridically distinct, but highly interconnected through mutual mechanisms.
The total assets of BCC represent 13 per cent of Italian GDP. Since the start of the fi-
nancial crisis, ten BCC have defaulted.Before the financial crisis of 2007-08 there
were also present around 50 Cajas in Spain, which operated in local markets. How-
ever, as a consequence of the crisis, only 2 Cajas remained, while the others have
been bought by other banks.
111 An argument against the inclusion of medium and small banks in the SSM is that
these banks are not able to produce systemic effect in the case of default. However,
the recent case of Spain shows that to stop the contagion effect from medium and
small banks’ default it has been necessary to provide support of around €100 billion
coming from the Spanish government, which was borrowed from the European Sta-
bility Mechanism (ESM).
112 Moreover, another example in the history of systemic bank default is given by the cri-
sis of Savings and Loan (S&L) banks in the United States in the ‘80s. These banks were
around 4,000 at the beginning of 1980, they mainly operated in mortgage market
and they were very small (total asset of $150 million dollar per bank). The crisis in the
(26) Brown M, S. Trautmann and R. Vlahu, 2012, “Contagious Bank Runs: Experimental Evidence”, De
Nederlandsche Bank Working Paper, No. 363.
N. 1 - 2 0 1 4
96
US housing market generated around 120 defaults and mergers of 500 S&L in just
three years. After ten years the defaults exceeded 560 units. The overall fiscal cost of
the S&L crisis is estimated between $130 and $ 500 billion, which correspond, respec-
tively, to around 3 and 10 per cent of US GDP. Even under the most conservative es-
timation, the S&L crisis is considered by Laeven and Valencia (27) as a systemic bank-
ing crisis.
113 The lessons from S&L would have called for a different approach to the European
Banking Union, also because the size criteria for bank participation under the SSM are
excluding segmented banking markets, and these are not known for their efficiency
and stability. In particular, a comprehensive cross-country study of Beck, Demirgüç-
Kunt and Levine (28) show that crises are less likely to happen in banking systems with
higher concentration. Furthermore, Agarwal et al. (29) find that the US dual banking
system, i.e. the mechanism that implies a supervision alternately by state and federal
regulators, is not efficient. State regulators are less strict than federal ones. Under fed-
eral regulators, banks report higher nonperforming loans, more delinquent loans,
higher regulatory capital ratios, and lower ROA, while state regulators are captured
by industry.
114 Another critical aspect is related to the credibility of the AQR and stress test. To be ef-
fective on the market confidence, these tests should underline all banking weak-
nesses and ask for strong actions, such as recapitalization. However, Acharya and
Steffen (2014) show that stress test could require additional capital needs, for all par-
ticipating banks, between a minimum of € 80 billion to a maximum of € 800 billion
depending on the scenario considered. These are amounts which will necessitate
the intervention of national government. In particular, the capital needs for the main
European countries is reported in figure 40. France is in the worst position, with a max-
imum capital deficit equal to the 14 per cent of GDP, followed by Spain (9), Germa-
ny (7.5), and Italy (6.8). Nevertheless, taking into account public financial position of
some European countries, like Italy and Spain, national backstop will not be afforda-
ble at the national level, and in absence of an EU backstop (see next Section) finan-
cial stability could be damaged. As a consequence, supervisors are in front of a di-
lemma: apply rigorous AQR and stress test, increasing thereby balance sheet trans-
parence, or avoid potential financial turbulence, permitting bank forbearance?
Figure 40. Potential impact of stress test on main European banking system
(27) Laeven L. and F. Valencia, 2012, “Systemic Banking Crises Database: An Update”, IMF Working
Papers 12/163.
(28) Beck T., A. Demirgüç-Kunt and R. Levine, 2006, “Bank Concentration, Competition, and Crises: First
Results”, Journal of Banking and Finance 30: 1581-1603.
(29) Agarwal S., D. Lucca, A. Seru and F. Trebbi, 2012, “Inconsistent Regulators: Evidence from Bank-
ing”, NBER Working Paper No. 17736.
102R A P P O R T O C E R
97
97 97
Bank capital in % of GDP
0%
2%
4%
6%
8%
10%
12%
14%
16%
Italy Germany Spain France
min mean max
Note: In the graph are represented minimum, average and maximum level of the four scenarios
and the different hypotheses considered by Acharya and Steffen (2014).
Source: CER’s elaborations on Acharya and Steffen’s (2014) data.
N. 1 - 2 0 1 4
98
sINGLE RESOLUTION MECHANISM
115 The aim of the second pillar is to create instruments to save banks in critical situations,
or resolving them when they are insolvent, with the burden paid mainly by stake-
holders (bail-in) and not by taxpayers (bail-out).
The Bank Recovery and Resolution Directive (BRRD) is the first step to create tools
used in the case of a bank resolution. The problem of the absence of harmonized
tools useful for bank resolutions clearly appeared during the Cyprus banking crisis at
the beginning of 2013, as well as in the different stability financial plans that European
countries launched during the 2007-08 crisis.
The BRRD allows the following actions to be implemented in the case of bank distress:
- sale of (part of a) business;
- bridge company to manage in bonis assets;
- bad bank to manage non-performing loans and other impaired assets;
- bail-in measures.
116 Starting from 2016, the bail-in mechanism establishes the order and sequence by
which creditors will have to contribute to cover potential banking losses. The first
stakeholders to be asked to participate will be shareholders, followed by subordinat-
ed creditors, senior unsecured bond-holders and certain groups of depositors not
covered by deposit guarantee scheme (DGS), and then by other depositors not
covered by DGS, using first of all resources of large firms and then those of small-
medium enterprises and households. Covered bonds, liabilities to the European In-
vestment Bank (EIB), liabilities to employees and interbank deposits of less than 7 days
original maturity will not be included in the bail-in procedure.
117 Moreover, the BRRD has established the creation of national resolution funds (if these
do not yet exist), one for each MS. Starting from 2015, these funds will have to collect
ex-ante levies from banks, with a target level of at least 0.8 per cent of covered de-
posits by 2025.
If a national resolution fund is involved in the bank recovery, MS could derogate the
general principles of BRRD, allowing the national fund to cover losses that should be
paid by other creditors. However, national resolution funds could participate only af-
ter the contribution of at least 8 per cent in terms of total liabilities of creditors and
would in principle be limited to a maximum of 5% of the bank’s liabilities.
118 Another important element of SRM is the Single Bank Resolution Fund (SBRF). The SBRF
will centralize financial resources from each country, reaching a level of 1 per cent of
covered deposits, equal to around € 55 billion, in 8 years starting from 2015. The SBRF
will be alimented through national resolution funds. During this transitional period, the
SBRF would comprise national compartments corresponding to each participating
MS. In the first year only 40 per cent of resource will be mutualised (another 20 per
102R A P P O R T O C E R
99
99 99
cent in second year, the rest equally over a further 6 years); in other words, the SBRF
could intervene to bank recovery using up to 40 per cent of the overall disposable
resource in the first year.
With respect to the decision making process, the SBRF board will be composed by
permanent members as well as the Commission, the Council, the ECB and the na-
tional resolution authorities. The Board would then assess whether there is a systemic
threat and any private sector solution. If not, it would adopt a resolution scheme in-
cluding the relevant resolution tools and any use of the Fund (30). In its plenary ses-
sion, the SBRF board would take all decisions of a general nature and the individual
resolution decisions which involve the use of the SBRF above € 5 billion. In its execu-
tive session, the Board would take decisions with respect to individual entities or
banking groups where the use of the Single Resolution Fund remains below this
threshold.
CRITICAL ASPECTS ON THE SRM
119 The main critique of the BRRD is the possibility to derogate the general principle of
the directive and avoid the bailing-in of sub-groups of creditors. If not well managed,
this possibility could create uncertainty and unequal treatment between countries,
with the risk to generate panic and capital flight when market expectations are de-
stabilised.
120 With respect to the SBRF, the main fault is its size. In 2023, when the SBRF will reach its
target level, its resource will equal around 0.2 per cent of the current bank total as-
sets of the Euro Area banking system. On this basis Acharya and Steffen (31) have
calculated that the target level of the SBRF will not be enough to deal with relevant
resolutions, even after the application of the bail-in mechanism.
Moreover, taking the resolution fund available during the S&L crisis as a benchmark,
we find that it was equal to 1 per cent of S&L total assets, 5 times the SBRF amount,
but ex-post it was not sufficient to stop contagion effects. The US National Commis-
sion on Financial Institution Reform, Recovery and Enforcement estimates that with a
reserve amount of 4 per cent of S&L total assets, far less than the ultimate cost of the
savings and loan crisis, it would have been possible to stop the disruptive impact of
S&L crisis (32).
121 Applying the same share to the current Eurozone bank total assets means to require
(30) European Commission, 2014, “European Parliament and Council back Commission's proposal for
a Single Resolution Mechanism: a major step towards completing the banking union”, Statement
14/77.
(31) Acharya V. and S. Steffen, 2014, “Falling short of expectations? Stress-testing the European bank-
ing system”, VoxEu.org.
(32) FDIC, 1997, “The Savings and Loan Crisis and Its Relationship to Banking”, in “An Examination of
the Banking Crises of the 1980s and Early 1990s”.
N. 1 - 2 0 1 4
100
a target level for the SBRF of €1 trillion. As a consequence, it is clear that the resolu-
tion mechanism needs a backstop in analogy with the FDCI that is able to ask for fi-
nancial help from the US Treasury in case of necessity.
Moreover, some doubts about the efficiency of the decision making process in case
of bank resolution ought to be recognized, and in particular with respect to the over-
lap of the different authorities involved in the SBRF board that could slow down quick
decision-making and early interventions.
122 Furthermore, the current structure of the SRM does not seem to be able to stop the
interconnection between banks and national governments. Without a backstop, the
amount of capital that will be required after the AQR and the stress test will impact
public finances with high probability for the 75 of international investors interviewed
by Berenberg (33). Financial markets are aware of this situation, and, as a conse-
quence, the correlation between Credit Default Swap (CDS) for sovereign bonds
and banks has increased once it was recognized that the European agreement on
SRM will not include backstop or ESM involvement (figure 41).
Figure 41. Correlation between CDS of sovereign bond and principal banks
75%
80%
85%
90%
95%
100%
sept-11 dec-11 mar-12 jun-12 sep-12 dec-12 mar-13 jun-13 sep-13 dec-13 mar-14
Italy Spain
Note: for each country we have considered the first two banks.
Source: CER’s elaborations on Thomson-Reuters Datastream data.
123 Finally, the timetable for the implementation of the SRM could generate problems for
the financial stability of the banking sector. In fact, at the end of 2014 the results of
the AQR and the stress tests will be released, but the SBRF will be available only in
2015 and with only €2.75 billion of mutualized resources, while the bail-in mechanism
will only be available in 2016. As a consequence, in autumn 2014 there is the risk that
European banks will be exposed to market turbulence. Policy makers should be
aware of this risk and include in the SRM at least a temporary mechanism which con-
(33) Chappell J. and N. Anderson, 2013, “The ABC of making banks investable”, Berenberg Equity Re-
search.
102R A P P O R T O C E R
101
101 101
templates that the ESM will have the power to recapitalize directly Eurozone banks.
US experience shows that the stress test of 2009 has been able to stabilize the bank-
ing market thanks to the fact that by that time the Trouble Asset Relief Program
(TARP) was available to recapitalize banks.
SINGLE DEPOSIT GUARANTEE SCHEME
124 The last pillar of the EBU is the SDGS and has the aim to guarantee deposits against
bank runs. At the moment, the debate at the European level is still about a draft pro-
posal presented in 2010; each country has its own scheme, with substantial differ-
ences in terms of coverage, mandate and modality of provision. The harmonization
of these schemes represents an important step in order to reduce fragmentation of
banking market, and in particular with respect to one of the main liability instruments,
i.e. households’ bank deposits. In the major European countries, bank deposits have
increased their relevance after the financial crisis because of their higher stability in
comparison with other liabilities, e.g. bonds and interbank deposits (figure 42).
Figure 42. Households’ bank deposits
In % of total assets
0%
5%
10%
15%
20%
25%
30%
2006 2007 2008 2009 2010 2011 2012 2013
Italy Germany France Spain
Source: CER’s elaborations on Thomson-Reuters Datastream data.
CRITICAL ASPECTS REGARDING THE SDGS
125
As there is no advanced proposal on the SDGS, it is impossible to analyze the third pil-
lar. However, it is important that SDGS will have to take into account the interactions
with the SRM, and in particular with the bail-in mechanism. In fact, as shown before,
the bail-in mechanism excludes deposits covered by DGS.
Furthermore, bank deposits are a funding instrument that can contribute to higher
N. 1 - 2 0 1 4
102
stability of banking systems, as seen in the case of Canada and Italy (34). The SDGS
could be a way to increase the role of deposit funding also in European markets,
and thereby improving the overall banking stability.
126
However, it is also important that the SDGS will minimize the negative effects of this
kind of protection of bank managers’ behaviour, which became less sensitive to the
risks banks undertake (35). In particular, one should take into account the results of
Demirgüç-Kunt, Kane and Laeven (36), who find that when deposit protection is
adopted during a financial crisis, government tend to design their system very poorly,
thereby increasing moral hazard problems.
CONCLUSIONS
127 In order to fully restore international investors’ confidence into the Euro Area’s econ-
omy and its banking industry, which is the primary credit channel for European firms, it
is important that the EBU will be rapidly accomplished.
However, market confidence is not only based on formalities; substance is crucial.
The actual decisions in the structure of the EBU seem more connected with the nar-
row national interest of Northern European creditors, and in particular with the target
not to expose their taxpayers to the risk of paying for the mistakes of other MS, but
they disregard the risks a major financial crisis has for Europeans in North and South.
These partial national egoisms are a hurdle for creating a stable and durable eco-
nomic and financial union. The crises observed in the US, such as the S&L and sub-
prime crises, show that the federal actions may have to play a fundamental role in
order to prevent more disruptive effects.
(34) Collignon S., 2013, “The various roles of the ECB in the new EMU architecture”, Directorate Gen-
eral for Internal Policies, Policy Department A: Economic and Scientific Policy.
(35) Demirgüç-Kunt A. and H. Huizinga, 2004, “Market Discipline and Deposit Insurance”, Journal of
Monetary Economics 51: 375-399.
(36) Demirgüç-Kunt A., E.J. Kane and L. Laeven, 2008, “Adoption and Design of Deposit Insurance”, in
Deposit Insurance around the World: Issues of Design and Implementation, eds. Demirgüç-Kunt A., E.J.
Kane and L. Laeven, 29-80. Cambridge, MA: MIT Press.
