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OccasiOnal PaPer series

nO

109 / aPril 2010

e U rO area Fiscal PO licies anD THe crisis

Editor

Ad van Riet

OccasiOnal PaPer series

nO 109 / aPril 2010

Editor Ad van Riet

eUrO area Fiscal POlicies anD THe crisis In 2010 all ECB publications feature a motif taken from the €500 banknote. This paper can be downloaded without charge from http://www.ecb.europa.e u or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1325250. NOTE: This Occasional Paper should not be reported as representing the views of the European Central Bank (ECB).

The views expressed are those of the authors

and do not necessarily reflect those of the ECB.

© European Central Bank, 2010

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Any reproduction, publication and

reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the authors.

Information on all of the papers published

in the ECB Occasional Paper Series can be found on the ECBís website, http://www.ecb.europa.eu/pub/scientifi c/ ops/date/html/index.en.html

ISSN 1607-1484 (print)

ISSN 1725-6534 (online)

3 ecB

Occasional Paper no 109

april 2010

CONTENTS

ECB FISCAL POLICIES TEAM 5

ABSTRACT 6

PREFACE 7

by Jürgen Stark

SUMMARY

8 by Ad van Riet

1 INTRODUCTION 10

by Ad van Riet

2 EURO AREA FISCAL POLICIES:

RESPONSE TO THE FINANCIAL CRISIS 12

by Maria Grazia Attinasi

2.1 Introduction

12

2.2 Public interventions to support

the fi nancial sector 13

2.3 The net fi scal costs of bank

support 17

2.4 Conclusions 21

3 EURO AREA FISCAL POLICIES:

RESPONSE TO THE ECONOMIC CRISIS 22

by António Afonso,

Cristina Checherita, Mathias Trabandt

and Thomas Warmedinger

3.1 Introduction

22

3.2 The fi scal impulse for the euro

area economy 22

3.3 Effectiveness of a fi scal impulse 29

3.4 Conclusions 34

4 EURO AREA FISCAL POLICIES

AND THE CRISIS: THE REACTION

OF FINANCIAL MARKETS 35

by Maria Grazia Attinasi,

Cristina Checherita and Christiane Nickel

4.1 Introduction

35

4.2 The fi nancial market

reaction from July 2007 until September 2009 35

4.3 The determinants

of government bond yield spreads in the euro area 39

4.4 Conclusions 425 THE CRISIS AND THE SUSTAINABILITY

OF EURO AREA PUBLIC FINANCES

44
by Maria Grazia Attinasi,

Nadine Leiner-Killinger and Michal Slavik

5.1 Introduction

44

5.2 Risks to fi scal sustainability 46

5.3 Government debt scenarios 49

5.4 Conclusions 53

6 EURO AREA FISCAL POLICIES:

EXIT FROM THE CRISIS MODE 56

by Philipp Rother and Vilém Valenta

6.1 Introduction

56

6.2 Fiscal exit and

consolidation strategies 56

6.3 Crisis-related challenges

for the EU fi scal framework 60

6.4 Conclusions 67

7 EARLY LESSONS FROM THE CRISIS 68

by Ad van Riet

REFERENCES 70

EUROPEAN CENTRAL BANK OCCASIONAL

PAPER SERIES SINCE 2008 78

LIST OF BOXES:

Box 1 The statistical recording

of public interventions to support the fi nancial sector 16 by Julia Catz and Henri Maurer

Box 2 The

fi scal costs of selected past banking crises 19 by Maria Grazia Attinasi

Box 3 Fiscal developments in past

systemic fi nancial crises 26
by Vilém Valenta

Box 4 The determinants of sovereign

bond yield spreads in the euro area: an empirical investigation 40
by Maria Grazia Attinasi,

Cristina Checherita and

Christiane Nickel

CONTENTS

4 ecB

Occasional Paper no 109

april 2010

Box 5 Measuring

fi scal sustainability 45 by Maria Grazia Attinasi,

Nadine Leiner-Killinger

and Michal Slavik

Box 6 Ageing costs and risks

to fi scal sustainability 54
by Nadine Leiner-Killinger

Box 7 Fiscal consolidation

and economic growth 58
by AntÛnio Afonso

Box 8 The

fl exibility provisions of the Stability and Growth

Pact in times of crisis

63
by Philipp Rother 5 ecB

Occasional Paper no 109

april 2010

ECB FISCAL

POLICIES TEAMECB FISCAL POLICIES TEAM

This Occasional Paper was prepared by an

ECB Fiscal Policies Team under the lead

management of Ad van Riet, Head of the Fiscal

Policies Division of the ECB. The study brings

together ECB staff analyses undertaken between

September 2008 and December 2009 on the

consequences of the crisis for the sustainability of public fi nances in the euro area, including in its member countries. The authors are staff members of the Fiscal Policies Division and the

Euro Area & Public Finance Accounts Section

of the ECB.

Editor Ad van Riet

Preface Jürgen Stark

Authors António Afonso

Maria Grazia Attinasi

Julia Catz

Cristina Checherita

Christiane Nickel

Nadine Leiner-Killinger

Henri Maurer

Philipp Rother

Michal Slavik

Mathias Trabandt

Vilém Valenta

Ad van Riet

Thomas Warmedinger

Research assistance Krzysztof Bankowski

Alexandru Isar

Management assistance Elizabeth Morton

Editing assistance Mike Moss

A valuable contribution by Sebastian Hauptmeier,

as well as comments and suggestions from

Philippe Moutot, Francesco Mongelli, Ludger

Schuknecht and an anonymous referee, are

gratefully acknowledged. 6 ecB

Occasional Paper no 109

april 2010

ABSTRACT

In mid-September 2008, a global fi nancial

crisis erupted which was followed by the most serious worldwide economic recession for decades. As in many other regions of the world, governments in the euro area stepped in with a wide range of emergency measures to stabilise the fi nancial sector and to cushion the negative consequences for their economies.

This paper examines how and to what extent

these crisis-related interventions, as well as the fall-out from the recession, have had an impact on fi scal positions and endangered the longer- term sustainability of public fi nances in the euro area and its member countries. The paper also discusses the appropriate design of fi scal exit and consolidation strategies in the context of the Stability and Growth Pact to ensure a rapid return to sound and sustainable budget positions.

Finally, it reviews some early lessons from the

crisis for the future conduct of fi scal policies in the euro area.

JEL Classi

fi cation: E10, E62, G15, H30, H62

Key words:

fi scal policies, fi nancial crisis, fi scal stimulus, fi nancial markets, sustainability,

Stability and Growth Pact.

7 ecB

Occasional Paper no 109

april 2010

PREFACE

PREFACE

The fi nancial and economic crisis has had a very

profound impact on public fi nances in the euro area. Projections suggest that the government de fi cit in the euro area will climb to almost 7% of

GDP in 2010 and that all euro area countries will

then exceed the 3% of GDP limit. The euro area government debt-to-GDP ratio could increase to

100% in the next years - and in some euro area

countries well above that level - if governments do not take strong corrective action. These fi scal developments are all the more worrying in view of the projected ageing-related spending increases, which constitute a medium to long-term fi scal burden.

There is no doubt that the exceptional fi scal

policy measures and monetary policy reaction to the crisis have helped to stabilise confi dence and the euro area economy. Following the substantial budgetary loosening, however, the fi scal exit from the crisis must be initiated in a timely manner and is to be followed by ambitious multi-year fi scal consolidation. This is necessary to underpin the public's trust in the sustainability of public fi nances. The Stability and Growth

Pact constitutes the mechanism to coordinate

fi scal policies in Europe. The necessary fi scal adjustment to return to sound and sustainable fi scal positions is substantial and will take considerable efforts. Without doubt, this situation poses the biggest challenge so far for the rules- based EU fi scal framework.

Sound and sustainable public fi nances are a

prerequisite for sustainable economic growth and a smooth functioning of Economic and Monetary

Union. Therefore, it is important not to miss the

right moment to correct the unsustainable defi cit and debt levels. A continuation of high public sector borrowing without the credible prospect of a return to sustainable public fi nances could

have severe consequences for long-term interest rates, for economic growth, for the stability of the euro area and, therefore, not least for the monetary policy of the European Central Bank.

Jürgen Stark

Member of the Executive Board

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