European Economy Recovery
Plan: An Evaluation
Paul De Grauwe
University of Leuven and CEPS
Introduction
• European Commission launched a
Recovery Plan in November 2008
• Four principles
– Timely, Temporary, Targeted, Co-ordinated
– Mix of revenue and expenditure instruments
– Within framework of SGP
– Accompanied by structural reforms
• How well has this worked?
Preliminary remark
• The European Stimulus Program had very
little European dimension
• It was a summing up of national stimulus
programs
• that were mostly uncoordinated.
• The discretionary stimulus content was
very small
• Approximately two-thirds of the stimulus
came from automatic stabilizers.
EC-estimates of different components of
budget deficit in euro area
• The question is: how well has Europe
done?
• Given that so little discretionary stimulus
was applied
• Surprisingly well
• I say surprisingly because virtually all
economists predicted that Europe would
suffer more than the US
• Here is the evidence from Daniel Gros
How well has Europe done?
Better performance than US
Misery index for the euro ara
(consumption growth and change in unemployment rate)
6.0
4.0
Misery index
2.0
0.0
1996
1997
1998
1999
2000
-2.0
Euro area (16 countries)
US
United Kingdom
-4.0
-6.0
Source: Daniel Gros, CEPS
2001
2002
2003
2004
2005
2006
2007
2008
2009
But large differences between EU-countries
Misery index (consumption growth and change in unemployment rate)
10.0
8.0
6.0
4.0
Misery index
2.0
0.0
1996
1997
1998
1999
2000
-2.0
-4.0
-6.0
-8.0
-10.0
Source: Daniel Gros, CEPS
2001
2002
2003
2004
2005
2006
2007
2008
2009
Germany
Spain
France
Italy
• Among the big euro area countries Spain
is the exception
• It did not so well
• Spain compares well with UK
• Why these differences?
• Two factors
– Initial conditions: US, UK, Spain had gone
through more intense boom and bubble
• Much of the growth experienced in these countries
prior to crisis was artificial
• Based on exessive debt creation
• Many economists were fooled by the high growth
rates of these countries
• And saw mysterious productivity miracles in these
countries (especially in US but also in UK)
• And lectured everybody that continental Europe
had to emulate the US
• By introducing structural reforms
• This was all fiction
– Flexibility turned out to be a disadvantage
• Debt deflation dynamics is intensified in flexible
countries
• where social security is weak
– This being said the crisis is far from over
– Also in the more succesful continental EUcountries
Where do we go from here?
Exit strategies
• Resurgence of growth has led to calls for
an exit strategy, i.e. reduction in spending
and increases in taxes
• Is this a good idea
• Growth alone is not sufficient to decide
about timing of exit strategy.
• We have to look at origin of crisis
• Which is a debt deflation dynamics
Private and public debt prior to crisis.
Private and government liabilities in eurozone
(percent GDP)
300
250
percent
200
Bank liabilities
150
Government debt
Household debt
Corporate debt
100
50
0
1999
2000
2001
2002
2003
Source: CEPS and European Commission
2004
2005
2006
2007
2008
A little blowup of previous figure
Household and government debt in eurozone
(percent GDP)
80
70
percent
60
50
Government debt
Household debt
40
30
20
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Provisional conclusion
• In period prior to crisis, the problem was
excessive and fast increasing PRIVATE debt,
rather than public debt
• Yet, Eurozone had set up elaborate mechanism
watching and controlling public debt and deficits
• No such mechanism existed to contain private
debt,
• despite the fact that governments were implicity
guaranteeing significant parts of private debt,
especially debt of financial institutions
Role of the ECB during boom years
• The ECB has set up its two-pillar strategy
that should have warned about excessive
growth of bank credit and liabilities
• It did not
• True ECB was successful in keeping
inflation low
• But why did this two-pillar strategy fail to
detect the credit boom?
Growth rate of total bank loans (left) and
Stock price index(right) in euro area
14%
200
180
12%
160
140
index
% change
10%
8%
120
6%
100
Loans
4%
Stock price
2%
2003Jan
Source: ECB
80
60
2004Jan
2005Jan
2006Jan
2007Jan
2008Jan
• Two-pillar strategy was used exclusively to
target CPI-inflation
• Information about M3-growth was not used
to temper asset prices and bank credit
• As a result the euro area experienced
similar boom and bust cycle as the US
• Different two-pillar strategy is necessary
• Using additional instruments
After the bailout: hangover in eurozone
…and even bigger hangover in US
Government debt in Eurozone and US
(2009, 2010 forecasts)
100
percent of GDP
90
80
70
60
EA-12
50
USA
40
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: European Commission
• Explosion of government debt is direct
result of explosion of private debt
• It came about as result of debt deflation
dynamics discussed earlier
Debt deflation dynamics
• The simultaneous action of individuals to
reduce their debt is self-defeating:
•
•
•
•
They all sell assets at the same time, thereby reducing
the value of these assets.
This leads to a deterioration of the solvency of
everybody else,
forcing everybody to increase their attempts at
reducing their debt by selling assets.
This can only be solved by government willing to
increase its debt, thereby allowing private sector
to reduce its own debt without a meltdown in
economic activity.
• A refusal of government to increase its debt so
as to allow the private sector to reduce its own
could have led to
• intense depression in economic activity
• leading to large losses of government revenues
• which would equally have led to an explosion of
government debt.
• Thus refusal to increase government debt would
have led to both a depression and an explosion
of government debt
• In other words it would not have prevented a
deterioration of government budgets
• Previous discussion suggests that exit strategies
are premature
• Private debt is still too high in many countries
(US, UK, Ireland, Spain)
• Exit strategy would start debt deflation dynamics
again
• Note that this problem is more acute for US, UK,
Ireland, Spain
• Than for the “rigid” continental EU-countries
• Paradoxically, those with the highest
budget deficits (US, UK, Ireland, Spain)
can least afford to start a process of
budgetary restrictions.
Academic note
• Previous analysis is based on idea that
macroeconomy can experience potential for
instability
• This feature is absent from mainstream
macroeconomic models (DSGE)
• which are stable equilibrium models
• assuming Ricardian equivalence
• That is also why these models will always tell us
that fiscal stimulus have few beneficial effects
• and should not be undertaken
Impact of permanent increase in US government spending
of 1% of US-GDP
1,8
1,6
%increase in real US-GDP
1,4
Keynesian camp
Ricardian camp
1,2
1
0,8
0,6
0,4
0,2
0
2009Q1
2009Q4
Source: Volker Wieland, et al.
2010Q4
2011Q4
2012Q4
Are present debt levels in euroarea sustainable?
• Let’s first get some perspective
• Forecast of budget deficits (European
Commission:
EA-12
US
2009
5.3%
12.1%
2010
6.5%
14.2%
If euro area deficit and debt level are unsustainable,
US debt level appears even more unsustainable
Interest payments as % GDP
EA-12
US
2009
3.1%
2.6%
2010
3.2%
2.6%
“Exorbitant privilege” of the US?
Common eurobond issue?
Are Government deficits
sustainable?
• Clearly if deficit levels are maintained
indefinetely
• and if nominal growth rate remains low
• these deficits are not sustainable
• This can easily be seen from fact that
stability condition :
– Primary surplus > interest rate – Nominal growth
– Is not satisfied today
• In euro-area (2009):
• interest rate - nominal growth = 6%
• However, primary surplus is - 3% So there
is shortfall of 9% to guarantee stability
• But this is only a temporary snapshot
• Forecasts for 2010 (EC): 2% and - 4%
• Thus shortfall is 6% due to forecasted
pickup of economic activity
Conclusion
• Present government debt levels are
unsustainable
• but necessary
• An exit strategy is premature especially in
countries with highest deficits
• Government debt will be easier to deal with
when nominal growth increases
• I also believe that modern democracies are
sufficiently mature to deal with this problem
• By adjusting primary surplus (i.e. spending and
taxation)
• The fear that government debt levels will
lead to defaults is excessive
• And so is the fear that it may lead to a
disintegration of the euro area, when some
countries default and others refuse to bailout
• There will be problems and strains
• But they can be managed