Fiscal Challenges to Euro Zone

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Fiscal Challenges in the Euro Zone

Jos Manuel CAMPA

IESE Business School

Fiscal challenges in the Euro zone have been at the center of global economic concern in the last 2

years. Despite lower debt burdens, and higher fiscal efforts taken by Euro countries, a perception of

high fiscal risk remains. This paper reviews the fiscal challenges facing the Euro area countries and

the measures taken at the Euro area level to manage short-term pressures and to enhance long-

term functioning of the area, as well as the main lines of national specific reforms. The paper

shows the unique characteristics of the Euro area that still raise concerns to foster stability and the

challenges to address them.

Key words: economic integration, Euro, debt sustainability, Sovereign debt

JEL codes: F36, H63

1. Fiscal Performance and Challenges in the Euro Area

The fiscal performance of the Euro area had not been exceptionally expansionary over

the period of the large economic expansion leading up to the economic crisis. In fact, the

evidence shows that it had been quite good, at least relative to other developed econo-

mies. According to the International Monetary Fund [IMF] (2011b), the debt to gross

domestic product (GDP) ratio of the 12 original Euro area members decreased from

71.9% in 1999 to 66.8% in 2007. This amounts to a decrease of 5.1 percentage points in

the debt to GDP burden for the Euro area in this period. This compares to increases in

the same ratio of 1.5% increase in the USA, 53.9% in Japan, and 0.3% in the UK. There-

fore, the Euro area was the only large developed economy, jointly with Canada, to

decrease its public debt burden and make it significantly lower than that of other devel-

oped countries.

The buildup to the economic crisis increased the potential vulnerability of all devel-

oped countries to their fiscal situation going forward. However, the increase in the debt

burdens of the Euro area countries resulting from the crisis was again not particularly

different from that of other non-Euro area developed countries. Between 2007 and 2011,

the debt to GDP ratio of the 12 original members of the Euro area increased by an esti-

mated 22.4% of GDP, which again compares positively with increases of 36.8% in the

UK, 45.5% in Japan, and 37.7% in the USA (see Table 1).

I am grateful to Takatoshi Ito, Sahoko Kaji, and Kazuo Ueda, the Editors of the Asian Economic

Policy Review(AEPR), and participants in the Fiscal Policy and Sovereign Debt AEPR Conference

for their helpful comments. I also wish to thank Luis Esteve for excellent research assistance.

Correspondence: Jos Manuel Campa, Camino del Cerro de Aguila 3, 28023 Madrid, Spain.

Email: [email protected]

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doi: 10.1111/j.1748-3131.2012.01231.x Asian Economic Policy Review (2012) 7, 180197

2012 The AuthorAsian Economic Policy Review 2012 Japan Center for Economic Research180


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It is also true that European countries, and Euro area countries, in particular, have

been much more aggressive than other developed countries in taking measures to tackletheir fiscal challenges from the crisis. This applies not only to countries under an IMF/

Euro financial support program (Greece, Portugal, and Ireland) or under clear market

pressure (Spain and Italy), but also to the core of the area. According to estimates by the

IMF (2011b) in September of last year, none of the four large Euro area countries

required a fiscal adjustment to bring down their debt to GDP ratio to 60% by 2030 that

is larger than the adjustment required by the USA, the UK, or Japan (see Table 2). In

addition, by 2011, the Euro area countries had already taken much larger measures to

achieve such a target (60% debt to GDP ratio in 2030) than those of the non-Euro area

Table 1 Fiscal deficits, debt, and interest burden to GDP

2009 2010 2011 2012 2013

Overall fiscal balance (%GDP)

Spain -11.2 -9.3 -8.0 -6.8 -6.3France -7.6 -7.1 -5.7 -4.8 -4.4

Italy -5.3 -4.5 -3.9 -2.8 -2.3

Germany -3.2 -4.3 -1.1 -0.7 -0.1

UK -10.4 -9.9 -8.6 -7.8 -6.5

USA -13.0 -10.5 -9.5 -8.0 -6.4

Canada -4.9 -5.6 -4.9 -4.4 -3.6

Japan -10.8 -9.3 -10.1 -10.2 -8.8

General government gross debt (%GDP)

Spain 53.6 60.8 70.1 78.1 84.0

France 79.0 82.4 87.0 90.7 93.1

Italy 115.5 118.4 121.4 125.3 126.6

Germany 74.4 83.2 81.5 81.6 79.8

UK 68.4 75.1 80.8 86.6 90.3

USA 89.9 98.5 102.0 107.6 112.0

Canada 83.6 85.1 85.5 86.7 84.7

Japan 216.3 219.0 233.4 241.0 246.8

Interest expenditure, general government (%GDP)

Spain 1.8 1.9 2.2 2.4 2.6

France 2.4 2.4 2.6 2.8 3.0

Italy 4.6 4.5 4.9 5.4 5.6

Germany 2.7 2.5 2.4 2.3 2.3UK 1.9 2.9 3.1 3.2 3.2

USA 2.5 2.6 3.0 3.1 3.3

Canada

Japan 2.6 2.7 2.7 2.7 2.7

Shaded areas indicate IMF estimates.

Source: IMF (2012) and European Commission (2011a).

Jos Manuel Campa Fiscal Challenges in the Euro Zone

2012 The AuthorAsian Economic Policy Review 2012 Japan Center for Economic Research 181


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countries. Furthermore, the Euro area countries had also committed to take further mea-

sures until 2015 to close the majority of the gap to reach this target.

The case of Italy is particularly interesting. According to the IMF, by September 2011,

Italy had already taken more than enough measures to reach the 60% debt target in 2030.

In fact, it was the only developed country to have done so. Nevertheless, at that exact

moment, Italy was the subject of a major confidence crisis in financial markets on the

sustainability of its public accounts. A crisis that led to a large political crisis and to the

resignation, 2 months later, of its long-standing Prime Minister.

Nevertheless, the challenges facing the Euro area countries appear to be much larger

than those of other developed countries. Certainly, Europe, and the Euro area, in par-

ticular, has been perceived as the main downside risk to the global economy in the last 2

years. One of the crucial questions faced by analysts is why did the current sovereign

crisis focus on the Euro area rather than on other developed countries with apparently

just as challenging, if not more challenging, fiscal difficulties going forward? Can thesecountries learn something from the current Euro tensions to avoid similar tensions in

the near future?

It is true that the evolution of the aggregate of the Euro area debt burden reflects

only part of the story, and probably not the most interesting part. In a partially inte-

grated economic union with very limited mutualization of the fiscal burden, it is not

only the aggregate that matters, but also the components. Therefore, the breakdown of

the evolution of these debt burdens across member countries within the Euro area is

most interesting.

Table 2 Fiscal adjustment: required and performed

Fiscal adjustment (% of GDP) required to achieve debt target (60% GDP) in 2030

20102020

Estimated performed

in 2011

Estimated performed

in 2015

Remainder

perform

Spain 8.3 3.1 5.1 3.2

France 6.3 1.2 4.8 1.5

Italy 3.1 0.5 3.4 -0.3

Greece 15.5 2.4 7.6 7.9

Ireland 12.0 2.4 9.6 2.4

Portugal 9.2 3.2 7.2 2.0

Germany 2.3 1.6 3.5 -

United Kingdom 9.1 0.9 7.6 1.2

USA 10.8 0.7 4.7 6.1

Canada 4.3 1.3 5.4 -

Japan 13.6 -1.1 1.8 11.8

Shaded areas indicate IMF estimates.

The target of Japan is a net debt of 80% of GDP.

Source: IMF (2011c) p. 30 and p. 64.

Fiscal Challenges in the Euro Zone Jos Manuel Campa



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Three unique characteristics of the Euro area made the region more vulnerable to a

sustainability analysis of the aggregate debt burden of the area and of each individual

member state. These characteristics were the uneven distribution of the debt burden

across the Euro area; the ability to finance that debt burden in the short run; and con-

cerns regarding future growth as a mechanism to dilute the debt burden in the future.

These three challenges have confronted the debate among policymakers and financial

analysts during the last 2 years on how to best deal with the crisis in Europe.

This paper shows that the Euro area has been struggling to provide convincing

answers to the following three related questions to address those challenges. How is the

Euro area going to deal with the excessive debt burden in some countries (mainly

Greece)? Will countries that are, in principle, solvent but facing increasing financing

costs, be able to finance their debt in the short run (mainly Italy and Spain)? How are

some countries facing competitive challenges in the Euro area going to be able to grow in

the future (mainly southern Europe)?

The rest of this paper is structured as follows. The next section provides a description

of the measures that Europe, and, in particular, the Euro area, has been taking to try to

address the concerns raised by the previously stated three questions. Section 3 provides

an analysis on the relative merits of the progress made and the challenges ahead. Section

4 provides some concluding remarks on the remaining challenges going forward.

2. Measures on Fiscal Discipline Coordination

At the time of the creation of the euro, considerable concerns existed on the incentives to

pursue cautious fiscal policies by member states within the currency area. These con-

cerns resulted in the imposition of a number of criteria to enter the union, and of two

criteria within the Stability and Growth Pact (SGP) that participant countries needed to

comply with in the future.1 These well-known criteria within the SGP were to limit the

size of budget deficits to less than 3% of GDP, and to put a threshold to the level of

public debt of 60% to GDP. Countries made a significant commitment (a legal commit-

ment at the level of an international treaty) to stick to the rules according to this new

arrangement. At face value, the experience with compliance from the first years of the

Euro area was not promising. During the first 5 years of the Euro area, 8 out of 12 origi-

nal members did not comply with either the deficit criteria and/or had an increase in

their debt to GDP ratio despite being already beyond the 60% threshold (see Table 3).However, it would be unfair to say that the rules had no impact at all. The debt to

GDP ratio decreased in almost all of the 12 original Euro area countries in the period up

to 2007 (see Table 3). In general, the fiscal behavior of Euro area countries during this

period was much more conservative than that of other developed countries. The debt to

GDP ratio increased in only four Euro countries: France, Germany, Portugal, and Greece.

Only the latter two are currently perceived as being vulnerable. Ironically, the ratio

decreased most, by close to 20% points of GDP, in three other countries currently per-

ceived as being fiscally vulnerable (Ireland, Belgium, and Spain).




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Table3

Compliancewiththe

StabilityandGrowthPact:Euroarea

YearswhenafiscalMaastrichtcriteriawasnotaccomplishedbyeachcou

ntry

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

N

operforming

M

aastrichtcriteria

(def-3%;debt60%)

CountriesintheEuroareaDecember2000

Finland

DeficitEDP

6.9

5.1

4.1

2.6

2.5

2.8

4.1

5.3

4.3

-2.5

-2.5

-0.5

0

DebtEDP

43.8

42.5

41.5

44.5

44.4

41.7

39.6

35.2

33.9

43.5

48.4

48.6

Luxembourg

DeficitEDP

6.0

6.1

2.1

0.5

-1.1

0.0

1.4

3.7

3.0

-0.8

-0.9

-0.6

0

DebtEDP

6.2

6.3

6.3

6.1

6.3

6.1

6.7

6.7

13.7

14.8

19.1

18.2

Spain

DeficitEDP

-0.9

-0.5

-0.2

-0.3

-0.1

1.3

2.4

1.9

-4.5

-11.2

-9.3

-8.5

6

DebtEDP

59.4

55.6

52.6

48.8

46.3

43.1

39.6

36.2

40.1

53.9

61.2

68.5

Ireland

DeficitEDP

4.7

0.9

-0.4

0.4

1.4

1.7

2.9

0.1

-7.3

-14.0

-31.2

-13.1

7

DebtEDP

37.5

35.2

31.9

30.7

29.4

27.2

24.7

24.9

44.3

65.1

92.5

108.2

Netherlands

DeficitEDP

2.0

-0.2

-2.1

-3.1

-1.7

-0.3

0.5

0.2

0.5

-5.6

-5.1

-4.7

7

DebtEDP

53.8

50.7

50.5

52.0

52.4

51.8

47.4

45.3

58.5

60.8

62.9

65.2

Belgium

DeficitEDP

0.0

0.4

-0.1

-0.1

-0.3

-2.7

0.1

-0.3

-1.3

-5.6

-3.8

-3.7

15

DebtEDP

107.8

106.5

103.4

98.4

94.0

92.0

88.0

84.1

89.3

95.8

96.0

98.0

Euroarea

(17countries)

DeficitEDP

-0.1

-1.9

-2.6

-3.1

-2.9

-2.5

-1.3

-0.7

-2.1

-6.4

-6.2

-4.1

16

DebtEDP

69.2

68.1

67.9

69.1

69.5

70.1

68.5

66.3

70.1

79.9

85.3

87.2

France

DeficitEDP

-1.5

-1.5

-3.1

-4.1

-3.6

-2.9

-2.3

-2.7

-3.3

-7.5

-7.1

-5.2

16

DebtEDP

57.3

56.9

58.8

62.9

64.9

66.4

63.7

64.2

68.2

79.2

82.3

85.8

Austria

DeficitEDP

-1.7

0.0

-0.7

-1.5

-4.4

-1.7

-1.5

-0.9

-0.9

-4.1

-4.5

-2.6

15

DebtEDP

66.2

66.8

66.2

65.3

64.7

64.2

62.3

60.2

63.8

69.5

71.9

72.2

Portugal

DeficitEDP

-2.9

-4.3

-2.9

-3.0

-3.4

-5.9

-4.1

-3.1

-3.6

-10.2

-9.8

-4.2

16

DebtEDP

48.5

51.2

53.8

55.9

57.6

62.8

63.9

68.3

71.6

83.1

93.3

107.8

Germany

DeficitEDP

1.1

-3.1

-3.8

-4.2

-3.8

-3.3

-1.6

0.2

-0.1

-3.2

-4.3

-1.0

18

DebtEDP

60.2

59.1

60.7

64.4

66.3

68.6

68.1

65.2

66.7

74.4

83.0

81.2

Italy

DeficitEDP

-0.8

-3.1

-3.1

-3.6

-3.5

-4.4

-3.4

-1.6

-2.7

-5.4

-4.6

-3.9

21

DebtEDP

108.5

108.2

105.1

103.9

103.4

105.4

106.1

103.1

105.8

116.0

118.6

120.1

Greece

DeficitEDP

-3.7

-4.5

-4.8

-5.6

-7.5

-5.2

-5.7

-6.5

-9.8

-15.6

-10.3

-9.1

24

DebtEDP

103.4

103.7

101.7

97.4

98.6

100.0

106.1

107.4

113.0

129.4

145.0

165.3

Shadedareasindicatetheyearsinwhichthecountrydidnotcomplywit

htheStabilityandGrowthPact.

Source:EUROSTAT.




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But it is also true that complying with the rules did not put countries in any signifi-

cant better position to confront the fiscal challenges arising from the crisis. Portugal and

Greece, currently under a program, did not comply with the requirements of the SGP.

But, Germany, Austria, and France were in the same league of persistent violators of the

rules. On the other side, Ireland and Spain were the only countries, jointly with Luxem-

bourg and Finland, that had fulfilled the commitments of the SGP since its creation. This

compliance, however, did not prevent them from being at the center of concerns about

their fiscal sustainability in the last 2 years. So, committing to the rules did not put coun-

tries in a more sound position to confront the crises and violations of the rules were not

a good predictor of problems ahead.

Over the last 2 years, Europe has taken a large number of reforms that try to respond

at least indirectly to the three questions posed at the beginning of this paper. These

reforms, particularly in the area of economic governance, are substantial and have sig-

nificantly shaped the way in which economic coordination will take place within the

member states relative to the original provisions of the SGP. These measures can be clas-

sified in three broad areas: mechanisms designed to provide support to member states in

the short run; Euro- and/or European-wide measures to strengthen the fiscal framework

and the coordination of economic policies within the area; and country specific mea-

sures to enhance the fiscal framework and growth.

2.1 Mechanisms designed to provide financial support to member countries

These mechanisms are the main tool that the European Union (EU), and the Euro area,

in particular, have developed to manage the short-term pressures from the crisis. These

mechanisms arose from the need to deal with the implications from the tensions

observed by individual member states, particularly Greece, to finance their sovereign

debt. These mechanisms have evolved and continue to adjust their capabilities as the

crisis has shown some of the main weaknesses in their original design.

There are primarily four mechanisms: the package of financial assistance to Greece;

the European Financial Stability Facility and the European Financial Stability Mecha-

nism, which have always been conceived as temporary financial assistance mechanisms;

and the European Stability Mechanism (ESM), which was conceived as a permanent

mechanism.

The package of financial assistance to Greece was initially established as an ad hoc

mechanism on May 2, 2010 to provide, together with the IMF,

110 billion of financialassistance to Greece in the form of bilateral loans. The program provided official financ-

ing for the next 3 years, with partial access to markets by Greece starting in 2012, an

aggressive privatization plan to be executed by the Greek government, and a very large

macroeconomic adjustment program. It quickly became clear that this program was

insufficient and that Greece was not going to have access to financial markets in 2012

as expected. In the fall of 2011, a new program was agreed to that provided additional

official financing of up to 130 billion (including the IMF contribution) and a volun-

tary contribution from the private sector. The private sector would have to agree to a




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reduction of at least 50% in the face value of the Greek debt held by the private sector,

extension of maturities, and the lowering of lending rates on new private sector bonds.

Temporary financial backstop mechanisms

In May 2011, the Finance Ministers of the European Union (ECOFIN) agreed on the cre-

ation of the European Financial Stabilization Mechanism (EFSM) and the European

Financial Stability Facility (EFSF). The EFSM is based on guarantees from the Commu-

nity budget of up to 60 billion and is regulated according to European Union Legisla-

tion. In contrast, the EFSF is an intergovernmental body providing up to 440 billion in

guarantees from the Euro area member states. The IMF decided at the same time to

complement these mechanisms with a potential financial support to Euro area countries

of up to 250 billion.

The launch of the EFSF quickly faced some important difficulties that needed to be

confronted. First, there was the unwillingness of the member countries to enter in joint

and several guarantees of the amounts issued by the EFSF. This limitation in the joint

guarantees implied that, given the different credit quality of the Euro sovereigns, the

effective borrowing capacity of the EFSF was substantially lower than the initial 440

billion. Furthermore, the range of activities for which the EFSF had been originally

designed, mainly providing lending to a member state with a full range of macroeco-

nomic conditionality, was too narrow to deal with the needs arising from the crisis. In

particular, in July 2011, the EFSF was reformed to enhance the amount guaranteed by

each member state to guarantee an overall borrowing capacity of 440 billion; provide

lending for primary and secondary purchases of sovereign debt; and allow the facility to

enhance its leverage capabilities. Ireland and Portugal have been granted 85 billion and

78 billion in assistance, respectively, by these funding mechanisms. It has also been

agreed that the additional Euro area contribution for the new financial package for

Greece explained earlier will be provided by the EFSF.

Permanent financial mechanism

The ESM agreed to by the members of the Euro area is meant to be a permanent mecha-

nism that will supersede the existing EFSF and the EFSM, and will provide a permanent

solid basis for emergency lending to member states confronted with financial needs. The

ESM became operational on July 1, 2012. It will have an effective lending capacity of

500 billion with a paid-in capital contribution of80 billion.

Despite the institutional differences among these mechanisms, and the changes overtime in their operational capabilities, three fundamental principles have guided their

design and usage during the crisis. These guiding principles are (i) all these mechanisms

have always been used jointly with IMF involvement; (ii) the use of financial resources

provided to a member state has always come with strong and broad conditionality; and

(iii) the mechanisms are used exclusively as a means to provide financing directly to a

member state, originally on nonpreferential terms. A fourth principle has been also fun-

damental for the establishment of most of these mechanisms: the intergovernmental

approach. An intergovernmental approach in the EU applies when the implementation




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of the agreed policy decisions is done via international agreements established in parallel

but outside of existing European legislation by a subset of the member countries. With

the exception of the EFSM which is engrained in the existing legal framework of the EU,

the other three mechanisms have been developed in parallel to the existing European leg-

islation via a new international agreement among the signatory member states. This

approach leads to large institutional complexity and confusion. Furthermore, it also

leads to the opportunity by member states to pick and choose which specific proposal

they are going to participate in.2

2.2 Euro- and/or European-wide measures to strengthen the fiscal framework and the

coordination of economic policies within the area

In the last 2 years, the EU has also been aggressively reforming its institutional frame-

work so as to enhance its economic governance, the integration of its institutional capa-

bilities, and the coordination of major economic policies across member states. Again, a

large part of this effort has focused on Euro area countries, but parts of these changes

also affect all 27 EU member states. As with the design of the mechanisms for financial

assistance, the legal framework used for these reforms differs across the reforms. This

implies that some reforms apply to all EU member states, others just to the Euro area,

and some others to different subsets of both groups. This pick-and-choose approach

again adds to the complexity in the design and implementation of the reforms

approved.

These reforms started at the beginning of the crisis with a strong push to reform the

institutional setting of the working of the financial markets within the EU. The initial

impetus came from the response to the financial crisis in the fall of 2008 that resulted in

an agreement on the coordination of deposit guarantee schemes across all European

member states so as to avoid unfair competition among different national regimes in

moments of panic.3 This was followed by the Larosire Report issued in February of

2009 by a high-level group on financial supervision in the EU, headed by Jacques de

Larosire (Larosire, 2009), on reforms of financial supervision in the EU. The main

changes proposed in this report implied the creation of four new pan-European bodies:

the European Systemic Risk-Board for assessing macro-prudential risk assessment, and

three industry-specific European supervisory bodies: one for banking, one for insurance,

and one for securities. A quick agreement was reached on the creation of these supervi-

sory bodies, and all four started their operations in January 2011. Although the jury isstill out on the overall effectiveness of this institutional structure in the financial indus-

try, the momentum for reform in this area on the part of the European countries was

admirable. These reforms have been followed in June 2012 with a move toward suprana-

tional supervision by the ECB of Euro area banks.

To give further impetus to the governance reforms, several proposals were sequen-

tially approved in line with the development of the crisis starting in May 2010. These

proposals can be grouped in three different areas: reforms of European legislation to

enhance the working of the SGP and the coordination of macroeconomic policies;




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reforms to national legislation particularly in the area of fiscal discipline and coordina-

tion; and country-specific commitments to enhance economic coordination, competi-

tiveness, and convergence.

The reforms of European legislation have been directed to address some of the fail-

ures observed in the application of the SGP, mainly, the tendency for the recommenda-

tions arising out of the Pact to arrive too late and not be sufficiently binding on affected

member states. The reforms implied a more automatic application of recommendations

and sanctions for noncompliant countries, put a larger emphasis on the preventive

stage, and a more strict application of the correction of excessive debt ratios in member

countries.

Additionally, the legislation also tried to complement some of the gaps left in the

original SGP that had proven crucial. Mainly, a new procedure to address the appearance

of macroeconomic imbalances in the Euro area was put in place so as to enhance recom-

mendations to those countries with policies that may result in imbalances affecting the

stability of the overall Euro area. The third area of reform is a significant increase in the

coordination of short-term fiscal policies and long-term more structural policies at

the national level in what has been termed the European Semester.

Preventing and correcting macroeconomic and competitiveness imbalances is a

crucial aspect of this set of reforms as the Euro area moves beyond the crisis. Over the

past decade, member states had made economic choices which have lead to competitive-

ness divergences and macroeconomic imbalances within the EU. This new surveillance

mechanism should aim to prevent and correct such divergences in the future and help

correct those that have accumulated. The procedure will rely on an alert system that uses

a scoreboard of indicators followed by more detailed country studies.

The second area of reform has been the establishment of new binding commitments

by member countries in the functioning of their national fiscal policies. The main part of

this reform has been articulated around a new international agreement, named the Fiscal

Pact, that has been recently negotiated. This Fiscal Pact is expected to be ratified during

2012 by all countries of the EU, including, of course, Euro area members, with the

notable exception of the UK, and a reservation by the Czech Republic. This agreement

commits member countries to impose in their national legislation a set of rules on the

functioning of their fiscal policies. Most visible among these commitments is the agree-

ment to insert in each countrys constitution, or a similar ranking legal instrument, the

so-called golden rule, that is, the commitment to a structural fiscal balance in the

operation of fiscal policies at the national level.The third area of reforms has been an increase in the number of national commit-

ments to even stronger economic coordination for competitiveness and convergence in

areas of national competence by member countries. The objective of these commitments

is mainly to increase growth and the stability of future growth patterns within Europe.

The challenges in this area are great because the required policies in many ways affect

issues (labor markets, regulated industries, nontraded sectors in the economy, and parts

of the so-called social state) that have long been difficult to include in any meaningful

agenda of coordination and integration at the European level. The recent experience is




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also disappointing on this front. The previous attempt to pursue these types of reforms,

the so-called Lisbon Agenda, proved to be a big failure. The Lisbon Agenda was supposed

to be a program for reforms at the European level introduced a decade ago with the

laudable objective of making the EU one of the most competitive areas in the world by

2010. Europe has decided to try again, and within the new set of reforms expected to be

put in place, it has created the Europe 2020 agenda. This is mainly the continuation of

the Lisbon agenda, and will face the same difficulties for success faced by the former

attempt. Finally, an attempt to make these reforms easier to monitor led to another set of

commitments in the same area: the Euro Plus Pact. This Pact is an agreement by 23

member states, including six outside the Euro area (Bulgaria, Denmark, Latvia, Lithua-

nia, Poland, and Romania), signed in March 2011. This Pact is expected to make these

reforms more operational by committing its signatories to the concrete goals agreed on

and reviewed on a yearly basis by the Heads of State or Government. The annual review

process should make these commitments more operational. However, both the areas of

commitment and the specific commitments are the decision of each member state.

Therefore, the space for coordination remains weak.

2.3 Country-specific measures to enhance fiscal credibility, sustainability, and growth

The third area of active reforms has been the country-specific measures taken by indi-

vidual countries in response to the challenges facing each one of them. Despite the mea-

sures described in the previous two sections both for short-term financial support and

medium-term fiscal sustainability and economic coordination, the reality of European

economic policy is that national decision making remains at the core of the process of

reforms. Countries have been engaging in active measures to deal with the challenges of

the crisis primarily according to their perceptions of what was needed and feasible. Let

me here focus on three areas which I find particularly illustrative: fiscal consolidation,

financial sector, and growth adjustment.

On the fiscal front, countries remain primarily responsible for establishing their fiscal

objectives. The degree of coordination at the European level remains very small beyond

setting objectives for fiscal deficits. Coordination on expenditure obligations or tax coor-

dination remains very small. Despite the existence of the valued added tax with a fair

degree of coordination at the European level, the core of direct taxation (personal

income, corporate tax) continues to be a national matter. Recent debates on the coordi-

nation of the establishment of a possible financial tax on banks (either a financial trans-action tax or a tax on other components of the activity of the financial sector) and on

progress in the harmonization of the corporate income taxes show the difficulties in

making progress on any meaningful coordination on this front. On the expenditure side,

coordination may be even harder. The social component of expenditure and the core of

expenses on health, education, pensions, and income subsidies, linked to the situation in

the labor market (unemployment subsidies, training programs, income support pro-

grams), are at the core of the political debate in all countries. A slightly more positive

role for coordination exists in relation to productive expenditures on infrastructure,




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support for innovation activities, and other enterprise-related programs from the public

sector. Nevertheless, issues of nationalism, transfer and risk sharing among countries,

and national bias still remain.

Countries have been active, however, in establishing country-specific measures to

enhance their fiscal sustainability in the long run. Despite the dominance of national pri-

orities in these policies, some common features are beginning to appear. There is a con-

siderable convergence in the functioning and adjustments in pension reforms (increasing

retirement ages toward 67, and rules linking the legal retirement age to the evolution of

life expectancy), and in the management of fiscal policy as discussed earlier (the golden

rule, the use of independent forecasts, and multiyear budgeting). This convergence,

however, is still way short of fostering a strong sense of integration and facilitating the

mobility of the population, and the labor force within the Union.

In the financial sector, despite the establishment of supervisory authorities at the

European level, a highly integrated financial market prior to the crisis, and a single mon-

etary authority, the regulation and resolution of the financial challenges remain a

country-specific issue. Countries had pursued individual strategies that highlight impor-

tant differences in the mechanisms used by member countries to deal with banking

crises. The degree of restructuring involved differs substantially. The lack of mechanisms

at the European level to deal with individual institutions and the resort to the national

sovereigns of the home base whenever financial support is needed have led to an increas-

ing vicious circle between the perceived solvency of the banking industry of vulnerable

countries, and the increase in the cost of financing of the sovereign, which in turn

worsens the growth prospects for the economy and the solvency of the banking system

(Gerlach et al., 2010). Furthermore, this vicious circle between the vulnerability of the

national sovereign and its banking system has also led to a substantial increase in the

fragmentation of the European financial industry.

3. Addressing the Specific Challenges Facing Euro Area Countries

As indicated in the first section, the fiscal challenges facing the euro as a whole were large

but not unique in the context of other developed economies. Furthermore, in aggregate,

the fiscal challenges confronting the euro were substantially lower. Nevertheless, there

have been several questions confronting these challenges in the Euro area: How is the

Euro area going to deal with the excessive debt burden of some countries (mainly

Greece)? Will countries that are, in principle, solvent but facing increasing financingcosts, be able to finance their debt in the short run (mainly Italy and Spain)? How are

some countries facing competitive challenges in the Euro area going to be able to grow in

the future (mainly southern Europe)?

Europe has been addressing these questions over the last 3 years. Probably the domi-

nant perception among the international community on the form and content of the

decisions taken so far is that these have been too little, too late (see, e.g. Pisani-Ferry,

2011). The perception continues today that Europe has not put enough resources into

dealing with the short-term challenges; that there is too much cacophony among




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political leaders on what could be done; and that there is a lack of a clear perspective on

the long-term future for the Euro area.

The most obvious part of the story on the too little, too late actions has been the way

Europe has dealt with an assistance package to deal with Greeces excessive debt burdens.

The Euro area member states set up an ad hoc mechanism on May 2, 2010 to provide,

together with the IMF, 110 billion of financial assistance to Greece in the form of bilat-

eral loans. The original terms of these loans, in terms of the interest rates, maturity, and

the conditionally required, quickly became the subject of across-the-board skepticism on

its likelihood of providing any kind of long-term sustainability to Greece. Additional

measures taken afterward lengthen the maturities of the loans, reducing interest rates,

and most importantly, the agreement reached in March 2012 to decrease the Greek debt

burden with the private sector holders of Greek bonds jointly with an additional official

package of financial support still appear insufficient. The demands for economic reform

and fiscal consolidation to be implemented by the Greek government continue to be

extremely challenging. The sense of weakening political support, and specially citizen

support, for the program is clearly increasing in Greece and in other parts of the Euro

area. As this paper goes to press (August 2012), Greece has formed a new government

after having had to call for a second round of general elections in mid-June that resulted

in sufficient support to form a coalition government among the parties that support the

implementation of the reform measures agreed with its European partners in the context

of the program.

For other Euro area countries confronting high debt burdens and/or a lack of cred-

ibility from financial markets, the crucial questions they need to address continue to be

this: how can they maintain financing at a reasonable cost in the short-run, and how do

they expect to grow to decrease their debt burdens and, in particular, their fiscal burdens?

The answers to these two questions are obviously interrelated. If a country can con-

vincingly show that it has the capability of sustained economic growth in the future, it

will generate the necessary confidence to finance itself at reasonable cost in the financial

markets. This logic configured the essence of the approach taken initially by the Euro

area (and the IMF) in dealing with the crisis. The logic was as follows: the country at

stake should commit to a set of structural reforms and fiscal consolidation that will

provide confidence in both its fiscal sustainability and its economic growth in the long

term. The official sector will complement this program by providing all the necessary

financing for a sufficient time.

Initially, sufficient time was estimated to be in the range of up to 3 years, so that thecountry is taken out of the market and does not rely on financial markets for its financ-

ing needs (at least for maturities beyond a year). This line of reasoning underlines the

structure of all the assistance programs agreed so far.4

This strategy has proven to be of limited success. The strategy basically followed the

long-standing experience of IMF programs. However, several shortcomings quickly arose

when applied to the Euro area context. First, the short-term recovery of output in such a

program is likely to be much slower within the euro than in the traditional program

involving a nominal exchange rate depreciation. The lack of a quick adjustment in




13/18

relative prices in the economy implied that the positive contribution to the recovery

from the tradable sector is likely to be very small in the short term, and the resulting

drop in short-term output substantially larger. As a result, the likelihood of a short-term

recovery that will boost confidence in financial markets is less likely. This made the

underlying assumption of taking a country out of the financial markets for a prespecified

period more risky and did not guarantee in any way the timing when the country would

be capable of returning to the market in any significant manner. This shortcoming

became clear in the Greek case about a year ago, and was the triggering factor for the

design of a new program. Currently, voices are already beginning to raise a similar

concern on the likelihood that Portugal may be able to access the market to finance itself

according to the schedule of its existing program.

A second concern was the negative feedback loop between the sovereign solvency and

the solvency of the banking sector in the country involved. This negative loop made the

necessary adjustments and the estimated financing needs even larger. This became quite

clear in the case of the program for financial support for Ireland. Most of the required

funding in that program was to capitalize the banking sector. It has also become an

important issue currently in the second Greek program.5

Third, the strategy of directly guaranteeing by the official sector all financing needs

for a significant period of time was a strategy that could work only for sufficiently small

countries. Belonging to a monetary union meant that domestic savings had plenty of

alternative opportunities to financing their sovereign. The ability to perform financial

repression in the context of the euro is very limited.6 Once the concerns on the financing

capability of sovereign needs moved to larger countries, such as Spain and Italy, the

shortcomings became more important. The amounts of money necessary to provide

such support from the point of view of the creditors become so large that it made it

politically very difficult to find sufficient support domestically for such packages. Inves-

tors could read through these difficulties and did not have the guarantee that the support

will exist. The rollover risk of these countries become a major source of concern.

A standard response to this concern exists in the policy world, namely, the national

central bank should act as the lender of last resort. In fact, this traditional response has

been applied to a large degree by the developed economies in response to the crisis over

the last 4 years. However, the institutional and public restrictions faced by the European

Central Bank to engage in this type of activity were large. There was an explicit no bail

out clause of any member state by other member states in the treaty of the EU. A crucial

condition for the participation of Germany in the creation of the euro was to eliminatethe possibility of the monetization of debt from a member state by the new European

Central Bank (ECB).

Despite these restrictions, the ECB decided in May 2010 to engage in a program of

purchases of sovereign bonds in the secondary market in those cases in which it felt that

the appropriate transmission of monetary policy was at risk. It started purchases of

bonds from Greece, Portugal, and Ireland, and extended its purchases to Spanish and

Italian bonds in August 2011. The results were temporary at best. Market participants

quickly understood that the determination of the ECB to engage in considerable




14/18

purchasing was limited. At the same time, the decision to engage in purchases of a par-

ticular sovereign implied a negative signal that some participants perceived as increasing

the vulnerability of those sovereign markets. The result was that the ECB held just over

2% of the outstanding sovereign debt from the Euro area countries in October 2011,

while the Bank of England held 22% of the stock of UK sovereign debt, and the US Fed

held over 15% of US sovereign debt.7 Despite the limited amounts of sovereign bonds

purchased as a percentage of all sovereign debt issued by Euro sovereigns, the perception

of nonmarket interest rates in Euro sovereigns relative to those of other countries was

widespread.8

The ECB announced in November 2011 the provision of a new long-term refinanc-

ing operation to provide liquidity to the banking sector in unlimited supply for up to 3

years. This new refinancing operation had the impact to provide much-needed liquidity

to the European banking system and aborting an imminent credit crunch.9 It also

increased the relative attractiveness to certain banking systems in the Euro area of

holding sovereign bonds (particularly of their home country) that were yielding very

appealing rates. As a result, the increase in demand for Euro sovereign bonds was signifi-

cant. Yields adjusted considerably, especially in the short-term part of the yield curve up

to 3 years, and the ECB could scale back in its secondary market purchases of bonds

from Euro sovereigns.

These actions helped address in the short term the concerns to the answer of the

second question on the ability to finance the short-term needs of potentially solvent

countries. Nevertheless, the relief has only been temporary. The main reason has been

the vicious circle in the Euro area between banking sector vulnerability and sovereign

vulnerability (see Standard & Poors, 2012). The actions by the ECB have not led to an

increase in international borrowing and lending within the euro. Rather the opposite has

happened, the additional liquidity has led to an increase in purchases of sovereign bonds

by the national banking systems in the vulnerable countries, while decreasing the

amount of interbank borrowing and lending within the euro. In fact, the interbank

market across Euro area countries has essentially disappeared, and most of the borrow-

ing and lending is being done through the National System of Central Banks (i.e.

through the national central banks). As a result, the national banking system, and in turn

the access to financing in national economies, has become more dependent rather than

not less dependent on the perceived credibility of the sovereign (see Darvas 2011 and

Von Hagen et al., 2011). Private firms and consumers in similar lines of business and

credit quality, but located in different Euro area countries, face significantly differentfinancing costs depending on the perceived risk of their sovereign. Put simply, the single

currency is currently not capable of providing a single reference interest rate for agents

across the Euro area.

This malfunctioning of the monetary policy transmission mechanism imposes an

even higher toll on countries under pressure to trigger growth. All Euro countries under

pressure have engaged in important structural reforms to boost their competitiveness

and productivity. The challenges for growth differ by country, but they all share a need to

recoup part of their price competitiveness lost during the initial 10 years of the creation




15/18

of the euro relative to Germany. Spain, Portugal, and Ireland have approved major over-

hauls of their labor market regulations. Reductions of severance payments, increased

flexibility at the firm level to opt-out from collective bargaining agreements, and mecha-

nisms to enhance wage adjustment are at the core of these reforms. These reforms have

begun to result in some significant progress. Ireland and Spain have adjusted the real

effective exchange rates with a significant depreciation relative to the Euro area average

(see Figure 1). The real exchange rate, measured by unit labor costs, has adjusted in these

two countries since the beginning of the crisis by around 70% of its appreciation relative

to the Euro area since the creation of the euro. These two countries had also been able

since the creation of the euro to enhance their tradable sector. The market share of

exports from these two countries relative to world trade were, jointly with Germany,

among the best performers of all Euro area (and large European) countries. This ability

to continue to perform in world markets despite a persistent real exchange rate apprecia-tion during the boom points to a significant part of the adjustment as having been

driven by BalassaSamuelson convergence effects. Furthermore, the adjustment in unit

labor costs since the crisis in these two countries also points to a relatively more flexible

economy. In contrast, Portugal, Greece, and to a lesser extent Italy, have not been able to

considerably grow their tradable sector since joining the Euro, and their corrections in

terms of real appreciation during the crisis have also been slow (see Figure 1).

Nevertheless, the challenges are still large for all these countries. The most important

challenge is growth. Growth has to be driven by the external sector; however, it is not

Figure 1 Changes in intra-Euro real effective exchange rates (REER) 20072011.

Source: EUROSTAT.

Note: Intra refers to the REER relative to 16 Euro zone trading partners.

CPI, consumer price index; ULCs, unit labor costs.




16/18

clear where the additional demand will be coming from. So far, since the crisis, most of

the adjustment of internal imbalances within the Euro area has taken place in the vulner-

able countries. Euro countries running large current account surplus prior to the crisis

continue to do so. Aggregate demand in the Euro area needs to substantially increase to

absorb the increase in unemployment and to promote growth in the vulnerable coun-

tries. Furthermore, the strength of the euro as an international currency, despite the

apparent concerns on Euro area stability, reduces the contribution to growth from exter-

nal demand. A second challenge is the ability of these countries to engage in the neces-

sary sectoral adjustment of factors of production within their economies. This

adjustment requires flexibility not only in labor markets, but also on other areas of the

economy such as labor mobility, training, entrepreneurship, red tape, and deregulation

in many parts of the service sector. Countries have started to make progress in this direc-

tion. Italy has announced a very ambitious reform of professional services, the elimina-

tion of restrictions on opening hours for retail outlets, and facilitating new business

creation. Nevertheless, both the breadth of reforms and the time needed for them to

filter down into real enhancements of productive capacity raise uncertainty on how

much of it will reflect in increases in growth in the short and medium term.

4. Concluding Remarks

Europe has been confronting serious challenges to the perceived sustainability of its fiscal

situation by financial markets. These challenges have been questioning the viability of

the euro project. This paper shows that the fiscal trajectory of the Euro area over the last

decade was at least as prudent as that of other developed economies. The measures taken

by Euro area countries since the crisis to tackle their fiscal challenges have been more

aggressive than those of many other developed countries.

The paper shows the institutional changes and reforms that Europe has been engag-

ing in to address concerns about its long-run viability. The measures taken point in the

direction of the concerns raised. However, the assertiveness in taking those measures and

the methods used increased the complexity of governing the EU. At the same time, large

challenges remain to provide strong confidence to investors concerns in two particular

areas. The commitment of Euro area countries to support each other in finding a way to

restore fiscal credibility and the determination of all countries to engage in the necessary

macroeconomic adjustment policies to restore growth in the area and decrease internal

macroeconomic divergences.

Notes

1 A vigorous discussion existed among academics that strong institutions and fiscal rules were

necessary for the well functioning of the euro going forward (see, e.g. Alesina & Bayoumi, 1996;

Von Hagen, 2010).

2 For instance, the Slovak Republic did not participate in the original program of support for

Greece, and Finland requested additional guarantees for participating in the second program of

support for Greece.




17/18

3 An agreement was reached to harmonize the provision of deposit guarantees to 100,000 per

customer in an institution.

4 See for instance European Commission (2010; 2011b) or International Monetary Fund

(2010a,b; 2011a) for a description of the first two adjustment programs, that is, for Greece and

Ireland.

5 The official sector provided 23 billion for bank recapitalization, and 35 billion to provideadditional guarantees to the ECB to support the discounting activities of the Greek banks, while

the debt exchange with private sector investors took place and Greek bonds were on special

default status.

6 Reinhart and Rogoff (2009) show that financial repression was the most common way to reduce

the debt burderns of developed countries in the twentieth century.

7 These estimates were published by Credit Suisse, and were in line with broad industry estimates.

8 Given that the ECB only purchased debt from a subset of Euro sovereigns, the percentage of

sovereign bonds purchased by the ECB from specific countries relative to the outstanding debt

of those member countries was significantly higher.

9 The results of the two auctions performed in December 2011 and February 2012 resulted in an

allocation slightly above 1 trillion.

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Fiscal Challenges to Euro Zone