Posted by Andrea Schaechter
On June 23, 2009, the European Commission published its . Now in its tenth year the report focuses on the challenges that the financial and economic crisis has brought about for EU member states’ public finances as well as the EU’s fiscal surveillance process (notably the Stability and Growth Pact). In particular, budgetary prospects are assessed as well as policy needs identified to contain the fiscal costs of the crisis.
The European Economic Recovery Programme (EERP): The report reviews the discretionary fiscal stimulus measures that EU member states have launched under the EERP which called for discretionary fiscal support of at least 1.5% of GDP. Overall EU member states have adopted or announced fiscal stimulus measures totaling 1.1% of GDP in 2009 and 0.7% in 2010 (by the cut-off date of the report in mid-June) with slightly more measures (1.0% of GDP) taken on the revenue side than on the expenditure side (0.8% of GDP). The European Commission estimates that those measures would contribute to about ¾ % of real GDP growth in 2009 and ⅓ % in 2010. With an even larger support coming from automatic stabilizers the budgetary position in the EU is expected to deteriorate to a deficit of 7.3% of GDP in 2010 (compared to 2.3% in 2008). The report includes detailed data and information on the discretionary measures for each member state (Part I.1 and Part V).
The Stability and Growth Pact (SGP): With the revision of the SGP in 2005, the European Commission reports that it has been applied during the current crisis in a flexible manner, namely by basing the recommendations on how quickly member states should adjust their excessive fiscal deficits on their different rooms for fiscal manoeuvre. The adjustment deadlines range from 2010 to 2013 for currently ten countries in excessive deficit procedure (France, Greece, Hungary, Ireland, Latvia, Malta, Poland, Romania, Spain and the United Kingdom) (Part I.3). The report, however, also identifies shortcomings of the EU fiscal framework. In particular, during the strong economic pre-crisis times member states did not sufficiently strengthen their state of public finances, often in contradiction with their medium-term plans. Moreover, budgetary surveillance in the past was not holistic enough in accounting for the role of fiscal policy in allowing the build-up of internal and external balances. The report therefore recommends strengthening fiscal frameworks (in particular fiscal rules and institutions) and broadening fiscal surveillance.
Fiscal costs of the crisis: To assess the potential direct fiscal costs (from banking sector rehabilitation measures) and indirect fiscal costs (from revenue shortfalls, automatic stabilizers and discretionary measures) of the current crisis for the EU, the report analyzes the fiscal implications that 49 past crisis episodes have had (Part III). The data are drawn from an IMF database (Laeven and Valencia, 2008) 1/ which comprises in total 122 systemic financial crises that occurred between 1970 and 2007 around the world.
The report finds that net direct fiscal outlays to rehabilitate the banking system averaged 13% of GDP in the past with recovery rates of fiscal outlays of 20%. Experience and econometric work undertaken by the Commission shows that lower direct fiscal costs and higher recovery rates were achieved in the past (taking into account the severity of the crisis) when the banking crisis resolution strategy was (i) implemented swiftly, and transparent and received broad political support; (ii) backed by strong public institutions and legal frameworks; (iii) consistent in terms of fair and uniform treatment of market participants; and (iv) was part of a clear exit strategy, including restructuring of the banking sector. In particular, the report runs regressions on recovery rates and finds that the use of asset management companies has significantly increased recovery rates only when they were operated in an environment of strong public institutions.
For today’s crisis, the report tallies up bank support measures so far taken/announced by EU member states and puts the potential direct fiscal costs that they could imply in a range of 2¾ to 16½% of GDP for the EU on average. The upper estimate assumes that capital injections beyond the currently approved ones would materialize and loss rates on guarantees be higher than in the past due to the global and more complicated nature of the crisis. The report however cautions about the high uncertainty of such a scenario and makes the point that the costs could be contained by swifter and more resolute bank resolution policies.
Increases in public debt ratios in past crises went far beyond the direct fiscal costs and such a surge is also expected for the EU today. During past crises, debt ratios jumped on average by 20% of GDP with most of the ratcheting up occurring in the first two crisis years and rooted in the expenditure side. The process of rising debt ratios proved difficult to reverse. Even a decade after the start of the crisis, most governments ran public debt-to-GDP ratios above pre-crisis levels. The EU is currently on the same trajectory, but starting from even higher debt levels, with the public debt-to-GDP ratio projected to rise by 21 percentage points to 79.4% of GDP in 2010. Given also the age-related spending pressures in the EU, this is another reason why the report calls for stronger fiscal institutions and the use of the SGP to anchor medium-term adjustments.
Public finances in booms and busts: The report analyzes the impact that the boom had and the bust could have on public finances and simulates how fiscal policy could respond to avoid the implications of booms and busts (Part IV). In response to the question what has driven fiscal balances in the boom it finds, based on regression analysis, that revenue and, with a lag, expenditure were driven by surges in house prices and positive growth surprises. For the current bust, large revenue shortfalls are predicted which would lead to large output drops for countries which do not have sufficient fiscal space for an active fiscal policy. Simulations with the European Commission’s QUEST III model show how in countries with limited fiscal space the benefits of a fiscal stimulus are nullified by higher risk premiums. The simulations also show that this would not be the case in case of more prudent fiscal policy during booms.
Fiscal space: Somewhat hidden in the report a preliminary measurement of fiscal space is developed (Part IV.3.1 and Annex IV.1), following the definition by Heller (2005) 2/ that fiscal space is the"room in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy." A composite indicator is created including five elements: (i) the general government gross debt-to-GDP ratio, (ii) potential government contingent liabilities to the financial sector, (iii) estimates of foreseeable revenue shortfalls in the medium run, (iv) the current account balance as an indicator of external imbalances, and (v) the share of nondiscretionary expenses as a proxy for the vulnerability of public expenses to meet short-run obligations.
Other topics: The report also summarizes recent developments in EU member states’ fiscal frameworks (fiscal rules, medium-term budgetary institutions, and fiscal institutions), including an updated fiscal rules index (Part II.4). It presents a methodology to assess the quality of public finances through a set of composite indicators (Part II.3). It reports on progress by Eurostat on the provision of first and second-level government expenditure data (COFOG II) (Part II.3). And it reviews the development of tax elasticities in the EU accounting for newly available information on discretionary revenue measures (Part II.2).
1/ Laeven, L. and F. Valencia (2008), 'Systemic Banking Crises: a New Database', IMF Working Paper 08/224 (Washington, D.C.: International Monetary Fund).
2/ Heller, P.S. (2005), 'Understanding Fiscal Space', IMF Policy Discussion Paper 05/4 (Washington, D.C.: International Monetary Fund).
