Euro area fiscal policies and the crisis

1. Euro area fiscal policiesand the crisis Vilém Valenta Fiscal Policies Division Czech public finances in a global context Smilovice, 4 May 2010

2. Outline • ECB Occasional Paper • Past economic cycles and systemic crises • EA fiscal policies: exit from the crisis mode • Challenges for the SGP • Ways forward?

3. ECB Occasional paper Ad van Riet (editor): “Euro area fiscal policies and the crisis”, ECB Occasional Paper No. 109. • Introduction • EA fiscal policies: response to the financial crisis • EA fiscal policies: response to the economic crisis • EA fiscal policies: the reaction of financial markets • The crisis and the long-term sustainability of EA public finances • EA fiscal policies: exit from the crisis mode • Early lessons from the crisis

4. Past economic cycles and systemic crises Objectives: • provide stylised facts on fiscal developments during past recession periods • compare past systemic financial crises with ‘normal’ cyclical fluctuations • compare the past experience with the current developments in the euro area and the US

5. Past economic cycles and systemic crises Overview of the approach: • ‘normal cycles’ – around 80 recession periods in_20_advanced economies since 1960 • ‘crisis cycles’ – 5 systemic financial crises in_Spain_(growth trough in 1979), Finland (1991), Sweden (1992), Norway (1988), and Japan (1993) • for the current crisis a common real GDP growth trough in 2009 is assumed • data sources: a mix of Eurostat, Ameco, OECD and IMF data, EC’s Spring 2009 Economic Forecast

6. linked to the economic activity – roughly stable ratio to GDP drop in growth dynamics more pronounced in ‘crisis’ cycles current developments in line with past systemic crises Total government revenue(y-o-y growth relative to avg. over cycle, %) Total government revenue(annual change in ratio to GDP, % points)

7. nominal rigidity (wages, pensions) and fiscal activism lead to increases in expenditure-to-GDP ratios currently a large increase expected – in line with the past experience during systemic crises Total government expenditure(y-o-y growth relative to avg. over cycle, %) Total government expenditure(annual change in ratio to GDP, % points)

8. a flat pattern in ‘normal’ cycles systemic crises seem to have a stronger negative impact currently a peak in investment activity due to fiscal stimuli – much more pronounced and protracted in the US Nominal government investment(year-on-year growth, %) Real government consumption(year-on-year growth, %)

9. deterioration in fiscal balances, larger in ‘crisis’ cycles a strong adverse structural impact in ‘crisis’ cycles the EA and the US started from much less favourable fiscal position than the countries hit by systemic crises in the past Cyclically adjusted balance(% of GDP) Government budget balance(% of GDP)

10. steep increase in debt-to-GDP ratios during systemic crises, stemming from more pronounced and protracted deterioration in public finances + fiscal costs of bank bailouts (excluding guarantees) Government debt(annual change in ratio to GDP, % points) Government debt(annual change in ratio to GDP, % points)

11. Past cycles and crises – concluding remarks Past cycles and crises • Some features of fiscal developments during the past systemic crisis episodes differ from the other cycles. • Deeper and more protracted contractions in_economic activity during banking crises led to more pronounced deterioration of public finances. • In distinction to normal cycles, crisis cycles are characterised by a considerable worsening of structural fiscal balances.

12. Past cycles and crises – concluding remarks Current situation • Current fiscal developments broadly similar to the past crisis cycles – a considerable deterioration of structural balances and a rapid accumulation of government debt. • Current fiscal stimuli promise to accelerate government investment, while past crises observed steep declines. • Both the euro area and the US start from less favourable structural fiscal positions.

13. Exit from the crisis mode – objectives Three objectives of fiscal exit strategies: • Phasing out of the financial assistance to the banking sector • Unwinding fiscal stimuli and restoring fiscal sustainability • Growth-enhancing structural reforms

14. Exit from the crisis mode – need for exit • Sound fiscal positions represent a prerequisite for the smooth functioning of EMU. • Fiscal policies bolstered confidence through stimuli in the entry phase, in the exit phase, confidence needs to be preserved by timely fiscal consolidation. • Large fiscal imbalances may undermine economic growth via higher interest rates crowding out private and public investment and fuelling other economic imbalances. • As recent signs of contagion from the Greek fiscal crisis show, there is also a risk for financial stability. • Market principle remains the most efficient system and government involvement in the economy should be scaled down again.

15. Exit from the crisis mode – general principles • The SGP represents an appropriate framework for ensuring sound fiscal positions in the EU/EA. • Structural fiscal adjustment should start no later than the economic recovery and be significantly higher than minimum annual fiscal effort of 0.5% of GDP. • Strong and frontloaded fiscal adjustment is needed in particular for countries with the most vulnerable fiscal positions in order to maintain/restore confidence. • The consolidation plans should be based on realistic and cautious macroeconomic assumptions with a strong focus on expenditure reforms. • The fiscal consolidation strategies need to go well beyond the correction of excessive deficits.

16. Exit from the crisis mode – additional criteria • The level and expected dynamics of government deficit/debt (affecting market sentiment). • Expected duration of the recession. • Past fiscal performance. • Extent of contingent liabilities. • Existence of other macroeconomic and financial sector vulnerabilities.

17. Challenges for the SGP – weak surveillance? • Quantitative cornerstones 3% of GDP for deficit and 60% of GDP for debt. • MTOs for structural government balance. • Measurement problems (output gap, tax elasticities). • Did not become a nominal anchor – implementation failed in most countries. • Qualitative information in the SCPs. • Only a formality for many countries.

18. Challenges for the SGP – ways to strengthen fiscal surveillance • Quantitative assessment. • Prudent and forward-looking approach. • Detailed analysis of expenditure policies. • Strengthened focus on debt and financing needs. • Stability and convergence programmes. • Presentation of no-policy-change and programme scenarios, identifying policy gap to be filled. • Improve quality of government statistics.

19. Challenges for the SGP – weak incentives? • The crisis exposed deficiencies of past policies and demonstrated need for establishing sound fiscal positions in good times. • The 2005 reform of the SGP a mixed success – corrective arm improved, but applied with delays, enforcement of preventive arm remains weak. • Large fiscal imbalances in most EA countries weaken the peer pressure mechanism on which the SGP is resting. • Activist fiscal response to the crisis (EERP) in conflict with the SGP, potentially undermining its credibility. • Fiscal stimulus measures did not foresee credible exit strategies (TTT not met), which would have helped to anchor expectations of fiscal sustainability

20. Challenges for the SGP – ways to strengthen fiscal incentives • Market incentives – investors started to discriminate between sovereigns; efficiency and accuracy however uncertain (also due to contagion effects). • Within current legislation, scope for strengthening fiscal incentives at the EU level is limited. • New Van Rompuy Task Force of the European Council will look for ways to strengthen the EU fiscal framework. • Much can be done at the national level. • Numerical fiscal rules in line with the SGP. • Independent fiscal councils.

21. Thank you for your attention! vilem.valenta@ecb.int