Professional Documents
Culture Documents
Titles include:
FINANCIAL LIBERALIZATION
Beyond Orthodox Concerns
You can receive future titles in this series as they are published by placing a
standing order. Please contact your bookseller or, in case of difculty, write to us
at the address below with your name and address, the title of the series and one
of the ISBNs quoted above.
Customer Services Department, Macmillan Distribution Ltd, Houndmills,
Basingstoke, Hampshire RG21 6XS, England
The Euro Crisis
Edited by
Philip Arestis
Director of Research, Cambridge Centre for Economic and Public Policy, Department of
Land Economy, University of Cambridge, UK; and Professor of Economics, University
of the Basque Country, Spain
and
Malcolm Sawyer
Professor of Economics, University of Leeds, UK
Selection and Editorial Matter Philip Arestis and Malcolm Sawyer 2012
Individual Chapters Contributors 2012
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
permitting limited copying issued by the Copyright Licensing Agency,
Saffron House, 610 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
The authors have asserted their rights to be identified as the authors of
this work in accordance with the Copyright, Designs and Patents Act 1988.
First published 2012 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martins Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave and Macmillan are registered trademarks in the United States,
the United Kingdom, Europe and other countries.
ISBN 978-1-349-34965-4 ISBN 978-0-230-39354-7 (eBook)
DOI 10.1057/9780230393547
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin.
A catalogue record for this book is available from the British Library.
A catalog record for this book is available from the Library of Congress.
10 9 8 7 6 5 4 3 2 1
21 20 19 18 17 16 15 14 13 12
Contents
List of Tables vi
List of Figures viii
Preface x
Notes on Contributors xi
Index 269
v
List of Tables
vi
List of Tables vii
viii
List of Figures ix
x
Notes on Contributors
xi
xii Notes on Contributors
ACHIM TRUGER is Senior Researcher for Public Economics and Tax Policy
at the Macroeconomic Policy Institute (IMK), Hans Boeckler Foundation,
Dsseldorf, Germany. He is a member of the coordination committee of
the Research Network Macroeconomics and Macroeconomic Policies
(FMM) and a managing co-editor of Intervention. European Journal
of Economics and Economic Policies. He has taught Public Economics
and Macroeconomics at the Universities of Cologne and Oldenburg,
Germany. His research interests include Macroeconomic Policy, Fiscal
Policy and Tax Reform. He is currently very actively researching on eco-
nomic forecasting and on the German economic policy and tax reform
debate. He has co-authored five books and co-edited more than 20. He
has published a number of papers in refereed journals and more than
100 articles in economic policy-oriented journals and books.
1
2 The Euro Crisis
1 Introduction
The euro has been operating since 2002 (and since 1999 if the period as
a virtual currency is included). Its introduction was technically accom-
plished and the switch over was perceived to have met few problems,
though there were some perceptions that prices rose when the euro
was introduced (a perception which does not show up in the statistics).
Although there have been occasional rumblings against it, there has not
until very recently been any concerted effort for a country to withdraw
from the euro and revert to a national currency, but the financial and
budgetary crises in a number of countries have brought withdrawal of
some from the euro as a seriously considered option.
The European Central Bank (ECB) launched the single currency (euro)
in 1999 alongside with the foundation of the Economic and Monetary
Union (EMU). The euro replaced the national currencies for all trans-
actions at the beginning of 2002 for 12 countries, namely Austria,
Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,
Netherlands, Portugal and Spain. This meant that three countries,
namely Denmark, Sweden and the United Kingdom, of the then 15
members of the European Union did not join the euro. The European
Union (hereafter EU) expanded in May 2004 with ten new member
countries, eight from Central and Eastern Europe countries (CEEC)
(Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovenia,
Slovakia) plus Cyprus and Malta. There was a subsequent expansion
with Bulgaria and Romania joining in January 2007. Of the new (2004)
member states, five have since adopted the euro, namely Slovenia
(2007), Cyprus and Malta (2008), Slovakia (2009) and Estonia (2011).
The economic performance of the euro area countries during the
decade or more of the euros existence, as briefly surveyed below, has
been rather lack-lustre even before the financial crisis struck economic
growth has been sluggish, inflation has remained low though often
breaking the 2 per cent target, and unemployment has remained high,
as indicated below. There have been continuing disparities in economic
performance in terms of unemployment and standards of living, which
Philip Arestis and Malcolm Sawyer 3
the policy faults, which lie at the heart of the euro. Section 4 highlights
key features of the economic performance of the EMU members since
the formation of the euro by concentrating on the 12 initial members
of the union. Section 5 deals with adjustment processes and optimal
currency area considerations before section 6 turns to the question of
whether the euro can be saved, where it is argued that the constraints
of the Treaty of Lisbon and the neo-liberal framework, within which
most of the countries of the EU operate, are likely to preclude relevant
policy changes initiated let alone implemented. This is likely to consign
many countries with a choice between remaining members of the euro
and economic prosperity. We also review a number of policy considera-
tions, sections 710, leading to suggestions for major policy changes,
which could enable the euro to function effectively. The latter possibil-
ity is discussed further in section 11, before concluding comments are
provided in section 12.
The Maastricht Treaty laid down criteria that should be met by those
seeking to join the euro, and indeed all the countries that met the crite-
ria were obliged to join, though Denmark and the UK secured opt-outs
from that obligation.3 The convergence criteria were set in nominal
terms (relating to inflation and interest rates for example) with no
mention of real convergence (in terms of, for example, output per head
or unemployment rates) or even of the convergence of business cycles
across countries. These convergence criteria are now largely of historic
interest, though they are still relevant for those EU countries which
may seek to join the euro in the future. But the convergence criteria
do provide some insights into the nature of the euro project and to
which elements were deemed significant and important; and by omis-
sion those which were not so deemed.
The criteria include a budget deficit and a government debt criterion
designed to establish fiscal responsibility in the eyes of the financial mar-
kets and had no underlying rationale. The independence of the national
central banks on an operational and political level was also on the list of
these criteria. In terms of countries meeting the criteria, it must be said
that with the exception of the inflation rate and the interest rate, they
were not met as comfortably as it might have appeared initially. In fact a
great deal of fudging took place (see, for example, Arestis et al. 2001).
The adoption of a national independent Central Bank, as a forerun-
ner for inclusion into the European System of Central Banks with the
Philip Arestis and Malcolm Sawyer 5
The key features of the Stability and Growth Pact (SGP) are as follows:
the first is the idea that national governments should aim for their
budgets to be in balance or small surplus over the course of a business
cycle and not to exceed 3 per cent of GDP in any given year; and the
second is that the ECB acting independently uses interest rate policy to
achieve price stability. National fiscal policy is subject to the requirements
of the SGP (with no fiscal policy at the level of the EU with a balanced
budget requirement and EU expenditure set at somewhat over 1 per cent
of EU GDP). The official rationale for the SGP is twofold. The first is that
a medium-term balanced budget rule secures the scope for automatic
stabilizers without breaching the limits set by the SGP. Second, since
a balanced budget explicitly sets the debt ratio on a declining trend,
it reduces the interest burden and improves the overall position of the
government budget. Underlying the approach to SGP, though, is the
notion of sound public finances. The European Commission (2000) is
emphatic on this issue: Achieving and sustaining sound positions in
public finances is essential to raise output and employment in Europe.
Low public debt and deficits help maintain low interest rates, facilitate
the task of monetary authorities in keeping inflation under control and
create a stable environment which fosters investment and growth ...
The Maastricht Treaty clearly recognises the need for enhanced fiscal
discipline in EMU to avoid overburdening the single monetary author-
ity and prevent fiscal crises, which would have negative consequences
6 The Euro Crisis
real growth and 2 per cent inflation) then the debt ratio would be 20
times the deficit ratio. In that example a 60 per cent debt ratio would
be consistent with a persistent 3 per cent deficit ratio indeed that pre-
cise calculation was given as a justification for the 3 per cent deficit, 60
per cent debt target in the convergence criteria.
The ECB and the national central banks of the EMU countries
comprise the European System of Central Banks (ESCB), and the ECB
was endowed with the responsibility for the single monetary policy
that is independent from political influence (ECB 2004, p. 12). The
ESCB Treaty, Article 105 (1), states that the primary objective of the
ESCB shall be to maintain price stability and that without prejudice
to the objective of price stability, the ESCB shall support the general
economic policies in the Community with a view to contributing to
the achievement of the objectives of the Community as laid down in
Article 2. Table 1.2 shows that inflation in the euro area has generally
been above the 2 per cent level, with the exception of 2009, albeit by
a relatively small amount, and averaged 2.6 per cent over the period
20028. Only Finland and Germany managed an inflation rate of less
than 2 per cent during that period; the 12 euro area average of inflation
rose to 2.9 per cent in 2010. Furthermore, it is the differences in infla-
tion between countries that have plagued the euro area. This has meant
that a country with a relatively low (high) inflation rate has a relatively
high (low) real interest rate since there is a common nominal interest
rate anchor as set by the ECB applying across the EMU. Thus, monetary
policy has operated in a perverse manner with low real rates applying
where inflation is relatively high, running counter to the presumptions
of inflation targeting that high inflation is met by high real rates of
interest to dampen demand.
The ECB may appear to have been rigid, especially when compared
with the Bank of England and the US Federal Reserve System (Fed). If
we take the period of the great recession since August 2007, the US
Fed has aggressively reduced interest rates over the period; the Bank of
England has behaved in a similar, if less aggressive, manner. The ECB
has not behaved in such a fashion. There has been great reluctance to
reduce interest rates even in obvious circumstances. It is true that the
ECB adopted a wait and see approach, at the beginning of the great
recession, before following the other two central banks. Focusing more
closely in terms of the period near but after August 2007, the reaction
of the ECB was relatively modest. Initially, the upsurge in inflation
convinced the ECB to keep interest rates relatively high for a long time,
and this was especially so in July 2008 when there were already signs of
Philip Arestis and Malcolm Sawyer 9
The growth performance of the euro area during the 2000s was some-
what below the growth of the 1990s (as indicated in Table 1.4) although
the global economy was growing rather faster. The growth figures in that
time run through to 2007, whereas, of course, if 2008, 2009 and 2011
were included the comparison between the 2000s and 1990s would be
even less favourable to the euro project. Unemployment did fall dur-
ing the mid-part of the 2000s but the great recession wiped out those
gains. The figures in Table 1.3 indicate that current account positions
vary substantially between countries with most Southern European
countries having substantial deficits whereas Northern European coun-
tries (with the exception of France) have surpluses.
11
The ideas on the Optimal Currency Area (OCA) had rather little influence
on the formation of the euro.9 Baldwin and Wyplosz (2009), for example,
argue that The negotiators who prepared the Maastricht Treaty did not
pay attention to the OCA theory (p. 345). The same source also poses the
question of whether Europe is an optimum currency area with the answer
that most European countries do well on openness and diversification,
two of the three classic economic OCA criteria, and fail on the third one,
labour mobility. Europe also fails on fiscal transfers, with an unclear ver-
dict on the remaining two political criteria (p. 340). It is clear that EMU
is not fiscally integrated. Taxpayers in one country do not pick up, for
example, any of the costs of a bank bailout of another country. It is also
true that while citizens of the EMU have the legal right to move freely in
any of the member countries in search for employment, in practice citi-
zens are much less geographically mobile than in countries like the US, for
example. A currency union that works coincides with a nation that has a
central government and a common language; EMU has neither.
The OCA literature clearly points out that a monetary union means
that the exchange rate between constituent members cannot be
changed in nominal terms. Hence, the possibility of using changes
in the exchange rate as a means of adjusting to economic shocks or
indeed to continuing difficulties is ruled out. There can, though, be
changes in the real exchange rate through a change in the relative prices
of constituent members. The OCA literature points to the possibility of
price flexibility as a device through which a country could adjust to an
economic shock. But the expectation would be that a negative shock
would be compensated by a fall in relative prices (of a country). In the
euro area it appears that there have been substantial changes in the real
exchange rate of countries, as relative prices of countries have changed
reflecting differential inflation between countries. But it is rather
unlikely that these changes in relative prices have been responses to
differential shocks and that those changes are an adjustment process. If
anything the changes in relative competitiveness have worsened rather
than lessened the disparities in current account positions.
The emphasis of the OCA approach was on the ability (or otherwise) of
an economy to adjust to shocks, where the adjustments were viewed in
14 The Euro Crisis
terms of market ones of price and factor mobility. What was little consid-
ered in the OCA, or other literature, was the consequence for an economy,
which joined the currency union with an economy that was unbalanced.
By the latter we mean an economy (or parts thereof ) that had high levels
of unemployment or one that had a large current account deficit. It is
then not a matter of asking how an economy could adjust to a shock (par-
ticularly a negative one) to restore full employment but rather whether
there is any prospect of an economy in a currency union escaping from
high levels of unemployment. In order to reach a lower level of unem-
ployment, the demand for the output of that economy has to be increased
faster than output increases in other EMU countries. This would generally
require that the productive capacity on which workers could be employed
would also have to be created. While there may be spontaneous increases
in investment, there are clear limits on the policy instruments available to
promote such investment. Further, those countries have to find additional
markets for their exports without the benefits of devaluation.
In a similar vein, an economy that enters into a currency area with a
current account imbalance lacks the ability to correct that imbalance.
When that economy is able to borrow to meet any deficit, and similarly
is willing to lend when there is a surplus, then the position would be
sustainable, though its debts would mount, which serves to undermine
that sustainability. But such an economy has to rely on borrowing from
overseas and being able to continue to do so. In our interpretation it
is difficulties arising from such borrowing that underlie many of the
problems of the EMU at present. Table 1.3, the column under Current
account /GDP (%), clearly demonstrates the problem to which we have
just referred. In 1999, the start year of the euro area, and also subse-
quently that is data for 2002 to 2010, all this data shows that current
account imbalances did prevail and are relevant even now.
The development of a substantial EU budget, which operates to make
fiscal transfers between the relatively rich and the relatively poor coun-
tries and to act as some form of stabilizer, that is, a country experiencing
a downturn receiving a greater inflow of funds, is a major policy way in
which concerns of OCA literature could be addressed. But the current
account imbalances would remain, which would seem to require mech-
anisms by which a country with a current account deficit can in effect
devalue in real terms, and hence a country with a surplus revalue. This
is not possible, of course, within the EMU area, while the experience of
the past decade in the EU area does not suggest that such adjustments
would readily occur; indeed, it appears that on the whole prices have
adjusted in a manner opposite to that.
Philip Arestis and Malcolm Sawyer 15
There are two key features of the euro project that are highly relevant
when thinking about its future and whether the euro can continue in any-
thing like its present form and be associated with economic prosperity.
The first is an essentially neo-liberal policy framework (which has been
briefly outlined above; see also Arestis and Sawyer 2006c for extensive
discussion). This framework has been enshrined in law (most recently
in the Treaty of Lisbon) and the neo-liberal ideology has become deeply
embedded in the European political elite and the institutions of the
European Union (and nowhere more evident than in the European
Union). The second is that the single currency has been widely viewed
as the crowning pinnacle of economic integration in removing what
could be seen as the final barrier to free trade (different currencies and
the associated costs) after the removal of non-tariff barriers under the
Single European Act.
The major question here is how these two features of the euro project
interact with the operations of the euro and its problems, and more
how those two features may prevent the EMU project being changed in
order for the EMU to operate to provide economic prosperity across all
its member countries. In our view the policy framework within which
the EMU operates needs to be drastically changed, but to do so runs into
the major obstacles, political and ideological, to changing the policy
framework. Further, the euro has been a key element of the drive to
economic integration that any withdrawal of a country from the euro
would be a major defeat for the integration process.
The first feature was embedded in the Treaty of European Union
in its various forms and now cemented in the Treaty of Lisbon (The
Treaty on the Functioning of the European Union). Changes to the
Treaty of Lisbon require the unanimous agreement of the 27 member
countries, and since the changes required to support the euro involve
policies, which could be seen as moves towards political integration,
the possibilities of making those changes is close to zero. This indicates
not only the serious weakness of the policy framework, but also that
of embedding economic policies into a constitution, which is virtu-
ally impossible to change. It would also have to be recognized that the
dominant macroeconomic institutions in the EMU, notably the ECB
and the Directorate-General of Economics and Finance, appear to be
fully signed up to the neo-liberal agenda.10
With regard to the second feature, it was recognized by some advo-
cates of the euro, that there were many ways in which there was
16 The Euro Crisis
7 Fiscal policy
Two basic changes in the fiscal policy arrangements in EMU are required.
The first is the need for an EMU-level fiscal policy under which the scale
of the EMU budget would be greatly increased and the EMU would be
able to run budget deficits (or surpluses) to support the level of eco-
nomic activity within the EMU. The particular concern here is with
Philip Arestis and Malcolm Sawyer 17
the euro area, and as such fiscal policy would be limited to EMU mem-
bers. The scale of such a policy has been variously put at 7 per cent
of GDP (Commission of the European Communities 1977), 5 per cent
(Huffschmid 2005, Chapter 16), 2 to 3 per cent of GDP (Currie 1997;
Goodhart and Smith 1993). An EMU fiscal policy would, in general,
only be able to address EMU-wide shocks. The present crisis could be
considered such an EMU-wide shock (though perhaps one on a scale
only experienced every several decades), but figures such as those sug-
gested above would not be on a scale to cope with such a shock, unless
combined with substantial deficits at the national level. The second is,
in effect, to permit each member country to set its fiscal stance in what
it judges to be its own best interests. There have always been concerns
of spill-over effects, whereby one countrys deficit affects the credit rat-
ings and interest rates faced by others. These concerns have been very
much overstated. In the absence of a substantial EU-wide fiscal policy
designed to achieve high levels of economic activity, each country has
to be free to pursue that objective (if it wishes to do so).
The proposition of functional finance (starting from Lerner 1943) is
that the budget deficit should be set with a view to ensure a high level
of economic activity and not tied to any notion of a balanced budget
(whether in current budget or total budget terms, whether on an annual
basis or over the business cycle). There is the well-known account-
ing relationship of (G T) = (Q X) + (S I) (where G is government
expenditure, T tax revenues, Q imports, X exports plus net income
from abroad, S private savings and I private investment). The scale of
the budget deficit (or indeed budget surplus) then depends on the size
of the current account deficit, private savings and investment at a high
level of economic activity. It then follows that the appropriate budget
deficit depends on the conditions surrounding the current account
(propensities to import, exports) and the net savings position (savings
minus investment). For a country with a current account deficit and a
tendency for savings to exceed investment would require a large budget
deficit, while in contrast for a country with a current account surplus,
and investment tending to exceed savings, a budget surplus would be
appropriate. This is the basis of the one size fits all problem, which
comes with the SGP. The shortcomings of the present SGP is that it
seeks to impose the same conditions on all countries regardless of their
broader economic circumstances and that it is a balanced budget (over
the cycle), which is imposed on all. The latter will inevitably lead to
deflationary tendencies in many countries without any compensating
stimulatory tendencies in other countries.
18 The Euro Crisis
It should be noted in the context of SGP rules and fiscal rules in more
general terms that they are very difficult if not impossible to enforce.
Yet they do exist, and as noted in the Economistt (14 May, 2011, p. 88),
there are 80 countries in 2011 that have fiscal rules, with only 7 in 1990.
Experience clearly shows that enforcement is difficult, if not impossible
see above for relevant SGP enforcement difficulties and failures. In any
case, SGP rules never prevented the debt crisis in the EMU. Fiscal rules
also entail the serious distributional effects for such rules that normally
reduce benefits, which severely hurt low-income groups.
The great recession has raised a host of issues regarding the merits
of fiscal policy and worries in certain quarters of debt-financed budget
deficits. In the EU/EMU it has raised another issue, which is con-
cerned with fiscal policy in the environment of a monetary union. We
have argued that monetary unions need an active fiscal policy that is
accompanied by fiscal transfers. The reason is simple enough. Regions
within the EU/EMU are hit by asymmetric shocks, which can only be
contained by inter-regional transfers, which substitute potentially for
capital and labour mobility. The EU/EMU lacks such a system, which is
desperately needed. In its absence it is conceivable that some member
countries may be compelled to exit the euro area.
9 Inflation
The data in Tables 1.2 and 1.3 indicate something of the scale by which
relative prices and relative unit labour costs have changed. A country
in a fixed exchange rate system, which is in the nature of a currency
union for participating countries, in dealing with cumulative dif-
ferential inflation and current account deficits can endure domestic
deflation (to reduce imports and perhaps lower domestic costs) or can
devalue its currency. The latter is ruled out by membership of EMU. So
it would appear that deflation is the only answer. Before dealing with
this proposition it is important to note that current account imbalances
among the EMU member countries were not considered in the proc-
ess of setting up the euro area (see Arestis and Pal 2009, for further
22 The Euro Crisis
11 Political integration
at least in terms of the bailout part of the clause. Still the agreed funds
mentioned above should not be used to purchase government debt in
the open market. They should be used to buy the debt from struggling
governments. But there is a condition attached. This is that the strug-
gling governments should agree to implement significant austerity
measures. Yet it all amounts to increase the level of debt in the countries
concerned. This is justified on the premise that the new mechanism
helps the countries involved in that the loan conditions are much bet-
ter than the ones replaced. But the debt of the countries involved piles
up thereby creating another serious danger, the possibility of default.
This, however, entails a further danger in view of the high exposure of
a number of European banks to weak countries debt (see footnote 15).
This may very well explain that despite the alleged seriousness of the
European debt crisis, default has not been seriously considered yet.
Indeed, it might not happen to the extent that support continues to be
forthcoming. The weak country debt would continue to grow so long as
support is forthcoming until the debt is all accumulated in, and held, by
the official sector. Under these conditions the official sector will be the
last holder of the assets that take the full loss. The taxpayer will carry
the burden yet again, not the original bondholder. The ECB is trying
very hard to avoid this problem. While helping the troubled countries,
at the same time it attempts to sell debt to avoid excess liquidity in the
market the ECB does not undertake quantitative easing. This is not
always possible, though. It is not infrequent to find that since May 2010
when this operation started that the ECB failed in its attempt to neutral-
ize fully the effect on liquidity of purchasing government bonds.
Further relevant developments that will come into effect in 2013
include common fiscal and economic policies. One dimension of these
policies may very well be dubbed as a reformed Stability and Growth
Pact. This includes close monitoring on government spending, pension
schemes, and limits on wage increases in the public sector. There is also
a further commitment for country-members to close the gap between
their current debt levels and the EUs debt limit of 60 per cent of GDP.
This is of course in addition to the financial penalties of countries that
do not conform with the budget deficit of 3 per cent. The debt to GDP
limit should be achieved by member countries initiating a 5 per cent per
year reduction until the 60 per cent target is met. If a member country
fails to close the gap between its debt level and the 60 per cent limit
of GDP, by 5 percentage points per year, it will be subject to a fine of
0.2 per cent of its GDP. The fine would be automatic, unless a majority of
the Council opposed it. The agreement does also allow pension reforms
Philip Arestis and Malcolm Sawyer 27
12 Concluding comments
We would argue that the policy framework within which the euro is
placed is not fit for purpose. Three aspects of this argument stand out.
First, the independence of the ECB precludes the ECB from devoting
its attention to financial stability and to coordinating and cooperating
with other macroeconomic institutions in pursuit of other objectives,
such as high levels of economic activity. Second, it does not have ways
of developing fiscal policy, which would be supportive of high levels
of economic activity, recognizing that budget deficits are generally
required. Third, there are no mechanisms for resolving the pattern of
current account deficits and surpluses, which we argue are unsustainable
in their present form. Without the ability to vary the exchange rate,
countries with current account deficits will be thrown back into defla-
tion. For it is the case that the EMU completely lacks any mechanisms
by which countries can resolve their deficit problems.
30 The Euro Crisis
Notes
1. The split referred to in the text relates to a sharp division of views between
the ECB and the EMU political leaders. This dispute is over how to solve the
Greek sovereign debt crisis, which is a very serious one and as such it threat-
ens the euro existence seriously.
2. The situation in Greece since mid-May 2010, when the Greek rescue was
launched, is even worse. The austerity measures introduced at the time have
resulted so far and according to the 2010 figures to a debt to GDP ratio of
Philip Arestis and Malcolm Sawyer 31
142.80 per cent and to a deficit to GDP ratio of 10.5 per cent. Both figures
are above the equivalent ratio of 2009, when the Greek Tragedy emerged.
In the case of debt to GDP it is clearly higher (it was 127 per cent in 2009).
In the case of the deficit to GDP although it was admittedly 15.4 per cent in
2009, it was nonetheless targeted to achieve an 8.1 per cent by 2010. Figures
are available at: http://en.wikipedia.org/wiki/Economy_of_Greece.
3. The convergence criteria applied to each country for membership of the
EMU under the Maastricht Treaty are: (1) average exchange rate not to devi-
ate by more than 2.25 per cent from its central rate for the two years prior
to membership; (2) inflation rate should not exceed the average rate of infla-
tion of the three community nations with the lowest inflation rate by 1.5 per
cent; (3) long-term interest rates not to exceed the average interest rate by 2
per cent of the three countries with the lowest inflation rate; (4) government
budget deficit not to exceed 3 per cent of its GDP; (5) overall government
debt not to exceed 60 per cent of its GDP.
4. For extensive discussion on fiscal and monetary policy in the EMU see
Arestis and Sawyer (2006a, 2006b, 2006c).
d B 1 dB B dY 1 B 1 dY
5. The change in the debt ratio is given by = = D
dt Y Y dt Y 2 dt Y Y Y dt
where Y is the level of income since the change in debt is equal to the deficit
(including interest payments) and the debt ratio is stable when the change
in this ratio is zero. This would imply d bgg = 0 and hence b = d/g
/ .
6. It should be noted that a current account deficit can interact with a budget
deficit in the following sense. A current account deficit and a budget deficit
will be related for a given net savings position. Other things being equal
(that is, net savings) then a larger current account deficit would be associated
with a larger budget deficit (there is no causal link implied).
7. The percentages mentioned in the text are from the OECD Economic Outlook
data (various issues).
8. According to IMF (2011) estimates, Germanys banking sector exposure to
EMU distressed periphery (Greece, Ireland, Portugal, Spain) debt is over 150
per cent of their equity capital; Frances banking sector exposure is just under
100 per cent, and the rest of the EMU is about 50 per cent. Interestingly
enough, and following the bailout of Greece in May 2010, the ECB exposure
to the Greek state and Greek banks is 190bn euros. Clearly, the ECB exposure
to Greek debt is very high so that restructuring of this debt would produce
huge losses to it. It clearly follows that restructuring of the Greek sovereign
debt would produce huge losses to the ECB. It is for this reason that the
Governor of the ECB is so much against restructuring of the Greek debt (see,
for example, Trichet 2011a).
9. The OCA literature starts from Mundell (1961), McKinnon (1963) and Kenen
(1969): for reviews see, for example, Baldwin and Wyplosz (2009, chapter 11).
10. D-G ECFIN stands for The Directorate-General for Economic and Financial
Affairs, which reports to the EU Commissioner for Economic and Monetary
Affairs. The D-G ECFIN strives to improve the economic wellbeing of
the citizens of the EU through policies designed to promote sustainable
economic growth, a high level of employment, stable public finances and
financial stability. At the present juncture, this means working to ensure that
the European economy emerges quickly and strongly from the present deep
32 The Euro Crisis
References
Angeriz, A. and Arestis, P. (2007), Monetary Policy in the UK, Cambridge Journal
of Economics, Vol. 31, No. 6, pp. 86384.
Angeriz, A. and Arestis, P. (2008), Assessing Inflation Targeting through
Intervention Analysis, Oxford Economic Papers, Vol. 60, No. 2, pp. 293317.
Arestis, P. (2010), Interview with Philip Arestis, Intervention. European Journal of
Economics and Economic Policies, Vol. 7, No. 2, 2316.
Arestis, P. and Pal, J. (2009), Dficits en cuenta Corriente en la Unin
Econmica y Monetaria europea y crisis Financiera Internacional, Ola
Financiera, SeptemberOctober.
Arestis, P. and Sawyer, M. (2004), Can Monetary Policy Affect the
Real Economy?, European Review of Economics and Finance, Vol. 3, No. 3,
pp. 932.
Arestis, P. and Sawyer, M. (2006a), Alternatives for the Policy Framework of the
Euro, in W. Mitchell, J. Muysken and T.V. Veen (eds), Growth and Cohesion in
the European Union: The Impact of Macroeconomic Policy, Cheltenham: Edward
Elgar Publishing Ltd.
Arestis, P. and Sawyer, M. (2006b), Reflections on the Experience of the Euro:
Lessons for the Americas in M. Vernengo (ed.), Monetary Integration and
Dollarization: No Panacea, Cheltenham: Edward Elgar Publishing Ltd.
Arestis, P. and Sawyer, M. (2006c), Macroeconomic Policy and the European
Constitution, in P. Arestis and M. Sawyer (eds), Alternative Perspectives on
Economic Policies in the European Union, Basingstoke: Palgrave Macmillan.
Arestis, P. and Sawyer, M. (2008), A Critical Reconsideration of the Foundations
of Monetary Policy in the New Consensus Macroeconomics Framework,
Cambridge Journal of Economics, Vol. 32, No. 5, pp. 76179.
Arestis, P. and Sawyer, M. (2011), Eurobonds Will Need a Form of Political
Union: Letter to the Editor, Financial Times, 18 August.
Arestis, P. and Sawyer, M. (2012), Economic Policies of New Economics,
International Review of Applied Economics, Vol. 26, forthcoming.
Arestis, P., Brown, A. and Sawyer, M. (2001), The Euro: Evolution and Prospects,
Cheltenham: Edward Elgar Publishing Limited.
Arestis, P., Ferrari, F. Fernando de Paula, L.F. and Sawyer, M. (2003), The Euro and
the EMU: Lessons for Mercusor, in P. Arestis and L. Fernando de Paula (eds),
Monetary Union in South America: Lessons from EMU, U Cheltenham: Edward Elgar
Publishing Ltd.
34 The Euro Crisis
Abstract: The financial and economic crisis in the euro area has revealed
a number of important flaws in the economic policy framework in
Europe. On the one hand, the imbalances, which have dominated
European development since the introduction of the euro, are not sus-
tainable; and this is more serious in a period of crisis in particular. On the
other hand, it has become clear that the euro area suffers from a serious
lack of institutions and policy concepts, which will not allow coping
with deep financial and economic crises unless a deep restructuring takes
place. The policy reactions of European governments, the European
Commission and the European Central Bank in cooperation with the
IMF will, therefore, hardly be able to initiate recovery. On the one hand,
some important steps towards financial stabilization have been made.
On the other hand, however, these are combined with restrictive fiscal
and wage policies, which will impose deflationary pressure on major
parts of the euro area and thus prevent stabilization (or reduction) of
public debtGDP ratios. In the paper we will first analyse the imbalances,
which have been built up in the euro area, before we briefly review the
policy responses towards the crisis. Since the prescribed fiscal and wage
policies are still dominated by the New Consensus Macroeconomics
theoretical framework, we will then develop an alternative macroeco-
nomic policy model based on Keynesian and Post-Keynesian principles.
It will be shown that stabilizing wage and active fiscal policies will have
35
36 The Euro Crisis
major roles to play in order to cope with the imbalances and to initiate
recovery for the EU as a whole. Furthermore, current account targets will
have to be included into intra-euro area policy coordination.
1 Introduction1
The European Union and the euro area are presently facing the most
serious crisis since the introduction of the euro in 1999. As a conse-
quence of the world-wide financial and economic crisis, which started
in 2007 in the US and rapidly spread over major parts of the world
economy, Greece in early 2010, Ireland in late 2010 and Portugal in early
2011 were the first three euro area economies with serious public debt
problems. These problems triggered massive increases in interest rates on
public debt of these economies and finally public debt crises with rescue
measures introduced by the European Union member countries together
with the IMF. The financial and economic crisis in the euro area has
revealed a number of important flaws in the economic policy framework
in Europe. It has become clear that the European Union and the euro
area suffer from a serious lack of appropriate institutions and policy con-
cepts. In particular, there are no efficient mechanisms designed to pre-
vent the building up of external macroeconomic imbalances across the
euro area countries. The current debate over a reform of the Stability and
Growth Pact, and the economic policy framework more broadly, is still
dominated by the paradigm that has led to the crisis. Despite the rec-
ognition that current account imbalances contributed to the crisis, the
policy reactions of European governments, the European Commission
and the European Central Bank are still characterized by a narrow focus
on budget deficits and public debt. At the same time, there is a contin-
ued call for intensified deregulation of labour and product markets, in an
attempt to raise the competitiveness of the euro area as a whole. These
measures are conceptually flawed and will, therefore, hardly be able to
initiate recovery. Some important urgency measures have been taken to
stabilize financial markets and prevent government defaults, in particu-
lar the introduction of the European Financial Stability Facility (EFSF)
as well as the European Financial Stabilization Mechanism (EFSM), the
Eckhard Hein, Achim Truger and Till van Treeck 37
and debt.3 And a first casual look at the developments might even seem
to confirm this view. Since the start of the global financial crisis in 2007
the up to that point in time almost negligible spreads of government
bonds of euro area member states relative to the benchmark German
bonds materialized, most notably for Greece, Ireland, Portugal, and Spain
(GIPS) (see Figure 2.1). The situation continued, especially for Ireland
and Greece and especially so in mid-2009. However, in spring 2010 the
development escalated dramatically again in the Greek case. Dramatic
emergency measures had to be taken in order to prevent a Greek govern-
ment default and possibly government defaults in the aforementioned
other member states as well, and therefore to prevent an end to the euro
as a currency. The relief provided by the Greek rescue package and the
euro rescue fund set up to prevent further problems for other govern-
ments proved to be very short-lived. In October 2010 spreads for Irish
government bonds increased dramatically again so that, in November of
the same year, finally the Irish government decided to request assistance
16
14
12
10
0
20 Jan
20 pr
07 l
20 Oct
20 Jan
20 pr
08 l
20 Oct
20 Jan
20 pr
09 l
20 Oct
20 Jan
20 pr
10 l
20 Oct
20 Jan
r
20 Ju
20 Ju
20 Ju
20 Ju
Ap
A
A
07
08
09
10
07
08
09
10
11
07
08
09
10
11
20
Figure 2.1 10-year government bond yields, selected countries, January 2007
May 2011
Source: ECB long term interest rate statistics, June 2011 (http://www.ecb.int/stats/money/
long/html/index.en.html); authors representation.
Eckhard Hein, Achim Truger and Till van Treeck 39
by the EFSM, the EFSF and the IMF. In spring 2011, the Portuguese gov-
ernment had to do the same and many expect that its much larger neigh-
bour Spain could soon become the next victim of the euro debt crisis.
Mainstream economics and economic policy debates see the high and
rising government debts, and the failure of the Stability and Growth
Pact (SGP) to contain government deficits and debt, as the main rea-
son for the crisis and therefore the most important problem to be
tackled in the euro area. From that point of view the main threat for
the euro is caused by governments, which have run irresponsibly high
deficits leading public finances to the brink of default. However, even a
casual look at the data raises many doubts regarding that point of view
(see Figures 2.2 and 2.3). For Greece, of course, the picture seems clear,
as the budget deficit was outstandingly large over the whole period
since the mid-1990s. For Portugal, however, the picture is less clear, as
the budget deficit was not larger than in Germany for a long period of
time. And most strikingly, both Ireland and Spain looked perfectly well
8
6
4
2
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
160
140
120
100
80
60
40
20
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
before the crisis as they seemed to follow the SGP in an almost ideal
manner. Ireland ran a budget surplus of 3 per cent of GDP in 2006 and
Spain had a surplus of 1.9 per cent in 2007. Turning to gross govern-
ment debt in relation to GDP, which many regard as a better indicator
for the sustainability of public finances, the evidence for the purely
fiscal view of the crisis becomes even weaker: Portugal used to have
a considerably smaller debt burden than Germany. And in 2007 gross
government debt in relation to GDP was only 25 per cent in Ireland and
36 per cent in Spain, far below the 60 per cent threshold of the SGP.
From this perspective, nobody would have suspected any risk of govern-
ment default in Portugal, let alone in Ireland or Spain.
The fact that the aforementioned countries nevertheless ran into
trouble must thus be due to other imbalances: And, of course, for both
Spain and Ireland it is well known that it was the private sector that
had gone deeply into debt before the crisis unfolded, partly as a con-
sequence of a housing price bubble and construction boom. Once the
Eckhard Hein, Achim Truger and Till van Treeck 41
crisis struck it was the government that had to step in and go into debt.
The interconnection of public, private and foreign debt can be more
systematically explored if one recalls that the following accounting
identity holds for any economy:
This simply means that any particular sector in the economy cannot
run a surplus, without the remaining two sectors of the economy run-
ning a joint deficit of exactly the same magnitude. If one country runs
a current account surplus, then at least in one other country the govern-
ment or the private sector has to run a financing deficit, and so on.
Figures 2.4 and 2.5 show the financial balances of the private sector,
the public sector and the external sector for Spain and Ireland respec-
tively. Although the figures are more striking for Spain, in both coun-
tries huge deficits of the private sector (more than 5 per cent of GDP in
Ireland for some years and more than 10 per cent of GDP in Spain) were
associated with (relatively small) surpluses in the government balance
and to a much larger extent with current account deficits against the
rest of the world. When the bubble growth models came to a sudden
15
10
5
10
15
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
40
30
20
10
10
20
30
40
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
Figure 2.5 Sectoral financial balances relative to GDP, Ireland, 19952010
Source: AMECO Database of European Commission, May 2011 (http://ec.europa.eu/
economy_finance/db_indicators/ameco/index_en.htm); authors calculations.
end as the result of the crisis, the private sector balance quickly turned
into surplus and governments stabilizing the economy had to accept a
dramatic rise in government deficits. Therefore, the unsustainable gov-
ernment deficit turns out to be a consequence of unsustainable private
and external sector balances in the first place.
In fact, if one takes a look at two other economies currently in trou-
ble with their public debt, it turns out that the picture is very similar
for them. In Greece (Figure 2.6), as well as in Portugal, both the private
sector and the government sector continuously ran deficits after the
inauguration of the euro. Those deficits had to be financed by capital
inflows and hence current account deficits of about 12 per cent of
GDP in the case of Greece, and about 10 per cent of GDP in the case
of Portugal, before the crisis. After the crisis, in both countries the gov-
ernment stepped in to prevent the economy from collapsing when the
private sector reduced deficits or turned into surplus again, leading to
rising public deficits and the problems of government debt currently
in the focus of public attention.
Therefore, it seems that the current euro crisis can better be interpreted
as the consequence of earlier private debt and current account imbal-
ances and not as a result of excessive public deficits. In the four countries
Eckhard Hein, Achim Truger and Till van Treeck 43
20
15
10
5
10
15
20
95
06
07
96
97
98
99
00
01
02
03
04
05
08
09
10
19
19
19
19
20
20
19
20
20
20
20
20
20
20
20
20
Figure 2.6 Sectoral financial balances relative to GDP, Greece, 19952010
Source: AMECO Database of European Commission, May 2011 (http://ec.europa.eu/
economy_finance/db_indicators/ameco/index_en.htm); authors calculations.
outlined above, the private sector obviously tended to spend more than
its income. This was associated with government surpluses (Ireland,
Spain) or amplified by government deficits (Portugal, Greece), which led
to very high and rising current account deficits in the four countries.
For Italy, which is sometimes considered part of the GI(I)PS coun-
tries, the picture is less clear. In this country the private sector balance
was consistently positive. Therefore the government deficit could be
financed partly by the private sector surplus and partly by the capital
inflows associated with the moderate, but continuously rising, current
account deficit. When the crisis hit, the improvement in the private
sector balance was compensated mostly by a rather modest increase in
the government deficit.
Obviously, there must be a counterpart to the rising current account
deficits of the GIPS countries. Since the current account of the euro area
as a whole has been roughly balanced, there must have been other coun-
tries in which the private sector has consistently spent much less than
it earns. If in such cases the government is not willing (or is prevented
by the SGP) to run a correspondingly high deficit, then this will imply
a deficit of the foreign sector, i.e., a current account surplus taking
GDP as given. Within the euro area there are at least four countries for
44 The Euro Crisis
10
8
6
4
2
0
2
4
6
8
10
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
Figure 2.8 Current account in billions ECU/euro, selected Euro area countries,
19952010
Source: AMECO Database of European Commission, May 2011 (http://ec.europa.eu/
economy_finance/db_indicators/ameco/index_en.htm); authors calculations.
46
Consumption boom Slow growth Surplus economies
deficit economies deficit economies
Greece Ireland Spain Italy Portugal EU 12 France Austria Belgium Germany Netherlands
Financial balances of 11.5 1.4 5.7 0.6 9.5 0.4 0.1 1.5 4.5 2.9 6.8
external sector as a
share of nominal
GDP, %
Financial balances 5.3 1.6 0.1 2.8 3.6 1.8 2.6 1.8 0.5 2.1 0.5
of public sector as
share of nominal
GDP, %
Financial balance 6.2 3.0 5.8 2.2 5.8 2.2 2.6 3.3 4.9 5.0 7.3
of private sector as a share
of nominal
GDP, %
Financial balance of 9.3 1.0 4.3 0.3 4.0 4.4 4.3 5.1 0.1
private household
sector as a share of
nominal GDP, %**
Financial balance of 3.1 4.8 2.1 6.1 1.5 1.3 0.5 0.1 7.0
the corporate sector
as a share of nominal
GDP, %
Annual real GDP 4.2 6.5 3.8 1.5 1.8 2.2 2.2 2.5 2.3 1.6 2.0
growth, %*
Annual growth 4.7 5.7 4.8 0.8 1.9 2.1 2.7 1.6 1.9 0.7 2.0
contribution of
domestic demand
including stocks,
percentage points
of which private 2.7 2.9 2.3 0.7 1.5 1.1 1.5 0.9 0.8 0.5 0.8
consumption,
percentage points
of which public 0.8 0.9 0.9 0.4 0.4 0.4 0.4 0.3 0.4 0.2 0.8
consumption,
percentage points
of which gross 1.3 1.4 1.6 0.2 0.0 0.6 0.8 0.3 0.6 0.2 0.4
fixed capital
formation,
percentage points
Annual growth 0.6 1.4 1.0 0.2 0.1 0.1 0.4 0.8 0.4 0.9 0.5
contribution of the
balance of goods and
services, percentage points
Net exports of goods and 11.3 13.5 3.8 0.6 9.0 1.6 0.3 3.6 4.3 3.9 6.7
services as a share
of nominal GDP, %
Annual growth rate of 3.1 3.1 3.0 2.5 2.7 1.6 1.7 0.6 1.6 0.0 2.2
nominal unit labour
costs, %
Annual inflation 3.2 3.7 3.2 2.3 3.0 2.1 1.7 1.9 2.0 1.5 2.3
(HCPI growth rate), %
Annual growth rate of 0.8 0.9 0.7 0.9 0.4 0.7 0.6 0.6 0.9 0.5
nominal effective
exchange rates (relative to
23 countries), %
Annual growth rate of 1.5 2.2 1.6 1.5 1.2 0.6 0.4 0.5 1.2 1.1
real effective exchange
rates (relative to 23
countries), %
Notes: * Growth contributions for some countries may not add up to GDP growth rates even for individual years in the AMECO data,
47
** Balance adjusted such that the sum of household and corporation sub-sectors equals the private sector balance as a whole.
Source: AMECO Database of European Commission, May 2011 (http://ec.europa.eu/economy_finance/db_indicators/ameco/index_en.htm); authors
calculations.
48 The Euro Crisis
although this is almost entirely due to a rather steep increase in the first
years of the euro; since 2003 there has been a remarkable deceleration.
Taking a look at the current account deficit countries, the picture is
very clear for all of them: their unit labour cost growth has been much
faster than that of the EU-12 average. In particular, it has exceeded the
2 per cent rate consistent with the ECB inflation target (2.5 per cent in
the case of Italy, 2.7 per cent for Portugal and 3 per cent in the case of
Spain), whereas the EU-12 average rate (1.6 per cent) is below this target
rate. The relative inflation rates mostly reflect the differences in unit
labour cost growth: the current account surplus countries mostly have
inflation rates below EU-12 average, whereas in the current account
deficit countries inflation exceeds EU-12 average.
So far we have argued that instead of the financial balance of the gov-
ernment the financial balances of all three sectors should be taken into
account and that this will automatically lead to focus on the imbalances
in the current accounts of euro area member states as the major object
of concern. In the analysis we have shown that international competi-
tiveness and differences in domestic demand growth are the main fac-
tors driving the development of the balance of goods and services and
correspondingly the current account. What we have not done is to pro-
vide an analysis on whether the current account deficits/surpluses are
sustainable, or how sustainable let alone optimal levels could be deter-
mined. We also did not provide causal reasons for the development of
the factors driving the current account. Both these tasks are well beyond
the scope of this paper. However, in Section 3 we shall show that the
existing economic policy framework, and the theoretical paradigm on
which it relies, have either largely ignored the threat posed by the exter-
nal imbalances or proposed completely inadequate remedies.
From a descriptive perspective, with respect to the question of sus-
tainability, we simply note that the net foreign asset position of the
four economies currently under pressure from the financial markets has
deteriorated tremendously over the past five years (see Figure 2.9). It is
highly improbable that such a development could go on for a longer
period of time without a major debt crisis be it a crisis of government
or private debt.
With respect to the economic reasons for the current account deficits/
surpluses we refer to our analysis of the neo-mercantilist strategy of
Germany (Hein and Truger 2009) for the most important surplus case.
As is well known, Germany combined a strategy of wage restraint
and welfare state reforms, which led to a dramatic increase in income
inequality and a stagnation of private consumer demand, with a
Eckhard Hein, Achim Truger and Till van Treeck 49
100
50
50
100
150
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Figure 2.9 Net foreign asset position relative to GDP, selected Euro countries,
19952010
Source: Ecowin-Reuters (IMF World Economic Outlook, April 2011 and IMF International
Financial Statistics, June 2011); authors calculations.
retrenchment of the state and highly restrictive fiscal policies (see also
Horn et al. 2010). For the deficit economies the following distinction
has to be made. On the one hand, there are the economies with very
high pre-crisis growth rates, Greece, Ireland and Spain. Although part
of their current account deficits may well be explained by catching up
to the higher GDP levels of the other EU economies, there is much evi-
dence for a debt driven consumption boom that was doomed to fail (see
Hein 2011a, 2011b, for a more detailed analysis): Growth contributions
from private consumption were very high and the private (household)
sector was driven into substantial deficits (see Table 2.1). Furthermore,
except for Greece, a substantial part of the observed investment dynam-
ics must be attributed to a construction boom, much of it in residential
investment, which is evidence for a housing boom.
In this section, we shall briefly review the three pillars of the eco-
nomic policy framework in the euro area in turn. We shall explain
why we see their theoretical underpinnings as theoretically flawed and
empirically inappropriate in view of the macroeconomic developments
during the first decade after the introduction of the single currency, as
sketched in the previous section. We will conclude that the current crisis
of the euro area, far from indicating that individual member states have
lacked discipline in terms of fiscal consolidation and structural reforms,
clearly reveals the conceptual limits of the so-called New Consensus
Macroeconomics (NCM), on which much of the existing economic
policy framework in the euro area is based.4
In line with its position that the financial integration process should
be market-led, the Eurosystem considers that the role of public policy
in fostering financial integration should be limited. In particular,
policy measures should not promote a specific level or type of cross-
border activity, as only market participants themselves are in a posi-
tion to develop the underlying business strategies, take the respective
investment decisions and assume responsibility for the economic
consequences. (p. 101)
Asset price and credit bubbles are of concern to the central bank only
insofar as they pose a risk to price stability. As Woodford (2003), one
of the most prominent advocates of inflation targeting and financial
deregulation, puts it:
Not only expectations about policy matter, but, at least under cur-
rent conditions, very little else matters. Few central banks of major
industrial nations still make much use of credit controls or other
attempts to directly regulate the flow of funds through financial mar-
kets and institutions. Increases in the sophistication of the financial
system have made it more difficult for such controls to be effective,
and in any event the goal of improvement of the efficiency of the
sectoral allocation of resources stressed previously would hardly be
served by such controls, which (if successful) would inevitably create
inefficient distortions in the relative cost of funds to different parts
of the economy. Instead, banks restrict themselves to interventions
that seek to control the overnight interest rate in an interbank mar-
ket for central-bank balances. (p. 15, italics in the original)
Eckhard Hein, Achim Truger and Till van Treeck 53
All member states adopting the euro are obliged by the Treaty on
the European Union to avoid excessive government deficits above
3 per cent of GDP and they must keep the public debt-to-GDP ratio
below 60 per cent of GDP. The SGP, adopted in 1997 and revised in
2005, furthermore obliges EU member states, as a medium-term objec-
tive (MTO), to keep the government budget close to balance or in
surplus. While the need to react to adverse country-specific shocks is
recognized, all member states should aim at fiscal positions that leave
enough room to allow the operation of automatic fiscal stabilizers
without violating the deficit and debt criteria.
Clearly, one peculiar ingredient of the economic policy framework in
the EU is that one-size fits all recommendations for fiscal discipline are
expected to contribute to the avoidance of imbalances across countries.
As shown in the previous section, external imbalances in terms of trade
and current accounts emerged soon after the introduction of the euro
and intensified around 2004/5. However, the link between the fiscal pol-
icy stance and those imbalances was hardly recognized by the European
authorities. In its opinionon the Stability Programme of Spain, 2005
2008, ECOFIN (Council of the EU 2006a) was of the opinion that, over-
all, the budgetary position is sound and the budgetary strategy provides
a good example of fiscal policies in compliance with the Stability and
Growth Pact (p. 3). In the spring of 2007, just before the outbreak of the
financial crisis, while recognizing that (m)aintaining a strong budgetary
position, thus avoiding an expansionary fiscal stance, is important in the
light of large and rising external imbalances and the existing inflation dif-
ferential with the euro area, the ECOFIN (Council of the EU 2007a) still
considered that the medium term budgetary position is sound and the
budgetary strategy provides a good example of fiscal policies conducted
in compliance with the Stability and Growth Pact (p. 3). Moreover, it
was judged that it provides a sufficient safety margin against breaching
the 3 per cent of GDP deficit threshold with normal macroeconomic
fluctuations in every year (ibid., p. 2). Similarly, in its assessment of the
Stability Programme of Ireland, 20062009, the ECOFIN considered that
the medium-term budgetary position is sound and, the budgetary strat-
egy provides a good example of fiscal policies conducted in compliance
Eckhard Hein, Achim Truger and Till van Treeck 55
The call for wage and price flexibility and deregulated financial mar-
kets can be traced back to the so-called theories of optimum currency
area (OCA). However, the array of competing and largely contradictory
OCA theories is very confusing, and hence (t)here is no robust, widely
accepted theory of optimum currency areas which can be used as a com-
pass for policy-makers (Priewe 2007, p. 47).7 The current stage of the
debate is that the optimality of a currency area can be assessed against
a catalogue of various properties, including the mobility of labour and
other factors of production, price and wage flexibility, economic open-
ness, and diversification in production and consumption, similarity in
inflation rates, fiscal integration and political integration (see Mongelli
2002). However, there is no consensus whatsoever as to how far the
lack of one ingredient of the aforementioned list could be compensated
by the existence of others, or which degree of, say, price and wage flex-
ibility would be required for a currency area to be optimal, given the
various other factors. While in some OCA theories, a high degree of
wage and price flexibility is an indispensable prerequisite for an optimal
currency union, in others labour mobility may, to some degree, be a
substitute for wage and price flexibility.8 While a thorough assessment
of OCA theories would be beyond the scope of this paper, it suffices
here to note that within the framework of economic policy in the euro
area the main focus has been on the deregulation of labour, product and
financial markets, while the importance of fiscal federalism and politi-
cal union have been downplayed.
As a consequence, in practice, the presence of large current account
balances has been interpreted as reflecting in part equilibrium phenom-
ena linked to catching-up processes,9 demographic differences, national
consumption preferences, etc. For the other part, they were seen as the
result of wage and price rigidities; and as ECB (2007) puts it:
Hence, even after the outbreak of the current crisis, the ECB (2008)
recommends further deregulation of labour and product markets and
moreover relies on capital mobility as an adjustment mechanism to
external imbalances, arguing that a deepening of financial integration
in the years to come will allow investors to diversify their portfolios
more efficiently and thereby provide a cushion against localised macro-
economic risks (p. 71). Clearly, until the sudden panic of the financial
crisis, the financial markets seemed to consider current account imbal-
ances as equilibrium phenomena not giving rise to any particular con-
cerns about the sustainability of private and public indebtedness in the
deficit countries. This was reflected in very low risk premia for private
and public debt in the deficit countries (see Figure 2.1).
The global financial and economic crisis and the crisis of the euro area
have shown that the policy package combining monetary and fiscal pol-
icy abstinence and the deregulation of labour and financial markets has
failed. While recent official proposals for reform of the economic policy
framework in EMU recognize the importance of addressing excessive
macroeconomic imbalances, including current account imbalances
(European Commission 2010; van Rompuy 2010), the monetary policy
strategy is not called into question. The flawed emphasis on the pub-
lic deficit and debt criteria of the Stability and Growth Pact is even to
be strengthened (Council of the European Union 2011a, 2011b). And
the emphasis on structural reforms and deregulation is maintained,
as the conclusions from the March meeting of the European Council
(2011) mentioned above underline. In the next section, we present the
main principles of an alternative macroeconomic policy framework
for the euro area which should be more appropriate when it comes to
tackling the present crisis.
The outline of a Post-Keynesian policy mix for the euro area targeted
at overcoming the present crisis takes place in three steps.10 In the first
step we will recall the Post-Keynesian macroeconomic policy assign-
ment as compared to the still dominating mainstream NCM approach
outlined in the previous section. In the second step we will apply this
approach to the euro area assuming that in the long run each country
should grow at a rate consistent with a balanced current account. In
the third step we will then lift this restriction and consider that long-
run growth dynamics may persistently tend to violate balanced current
accounts, in particular due to productivity catch-up processes.
60 The Euro Crisis
b = (1 ) ( pd pf ) + Yf , , < 0, , > 0,
+ +
Yd (1)
b = Yf = X .
Y (2)
d
Note that with balanced current accounts within the currency area, and
with equal rates of inflation, GDP growth rates of member countries
may nonetheless differ, depending on the relative income elasticities of
demand for exports and imports. Also note that the improvement of the
balance of payments constrained growth rate of a single country within
a currency area, by means of increasing the income elasticity of exports
or by reducing the income elasticity of imports, has the adverse effect
on the balance of payments constrained growth rate of the rest of the
currency area, because it will mean increasing its income elasticity of
imports and decreasing the income elasticity for its exports assuming
a roughly balanced current account of the currency area with the rest of
the world. One might, therefore, wish to argue that in an ideal currency
union, income elasticities of intra-union exports and imports should be
equal, and the balance of payments constrained growth rate for each
member country should therefore be given by the growth rate for the
64 The Euro Crisis
b = Y
Y . (3)
d f
In order to improve the growth rate of the euro area as a whole, and
thus the balance of payments constrained growth rate for each mem-
ber country, and to provide the conditions and incentives for each
country to grow at a rate consistent with balanced current accounts,
major institutional reforms in the European Union and the euro area
are required.
First, the institutional setting of the ECB and its monetary policy
strategy have to be modified such that the ECB is forced to take into
account the long-run distribution, employment and growth effects of
its policies, and to pursue a monetary policy targeting low real interest
rates. In a first step, an adjustment towards the objectives of the US
Federal Reserve might be helpful, which include stable prices, maxi-
mum employment and moderate long-term interest rates on an equal
footing (Meyer 2001). In its monetary policy strategy the ECB should
refrain from fine tuning the economy in real or nominal terms and
should target low interest rates, such that long-term real interest rates
remain below euro area average productivity growth in the medium
run. This should be conducive to real investment and growth in the
euro area. The ECB should focus on financial market stability. Instead
of the blunt instrument of the interest rate it should introduce those
instruments, which are appropriate to contain bubbles in specific asset
markets in specific countries or regions, i.e., credit controls or asset-
based reserve requirements (Palley 2004, 2010).
Second, the orientation of labour market and social policies towards
deregulation and flexibilization still prevalent in the European Union
and the euro area will have to be abandoned in favour of re-organizing
labour markets, stabilizing labour unions and employer associations, and
euro area-wide minimum wage legislation. This could provide the insti-
tutional requirements for the effective implementation of nominal stabi-
lizing wage policies. Nominal wages should rise according to the sum of
long-run average growth of labour productivity in the national economy
plus the target rate of inflation for the euro area as a whole.17 This would
contribute to equal inflation rates across the euro area, it would prevent
improving the balance of payments constrained growth rate of a single
country at the expense of the rest of the euro area, and it would prevent
mercantilist strategies based on nominal wage moderation in general.
Eckhard Hein, Achim Truger and Till van Treeck 65
Third, the SGP at the European level has to be abandoned and needs
to be replaced by a means of coordination of national fiscal policies at
the euro area level which allows for the short- and long-run stabiliz-
ing role of fiscal policies. Hein and Truger (2007) have suggested the
coordination of long-run expenditure paths for non-cyclical govern-
ment spending, i.e., those components of spending, which are under
control of the government. Such expenditure paths could be geared
towards stabilizing aggregate demand in the euro area at full employ-
ment levels, and automatic stabilizers plus discretionary counter-cyclical
fiscal policies could be applied to fight demand shocks. In order to avoid
the current account imbalances within the euro area, which have con-
tributed to the present euro crisis, these expenditure paths would have
to make sure of the following: On average over the cycle and the aver-
age tax rate in each member country given, as a first approximation, the
government deficits in each of the countries would have to be roughly
equal to the excess of private saving over private investment in the
respective country; such that the current accounts are roughly balanced
at a high level of aggregate demand and employment (S I = G T), and
GDP growth is close to the balance of payments constrained growth rate
of the individual country. All government debt issued in line with this
principle should be guaranteed by all member states (either in the form
of Eurobonds or by guarantees provided by a European Monetary Fund)
and it should be monetized by the ECB in its refinancing procedures:
The avoidance of external balances is beneficial to the euro area as a
whole; and as long as euro area governments are not indebted in foreign
currency, there is no solvency issue for sovereign debt.
Fourth, attempts at effective macroeconomic ex ante policy coordi-
nation among monetary, fiscal and wage policies at the euro area level
will have to be made in order to contribute to an improvement of euro
area average growth rate with positive feedbacks on the balance of
payments constrained growth rates for each of the member countries.
For this the Macroeconomic Dialogue (Cologne-Process) provides an
institutional basis.18
Fifth, on the global level, the European Union should push for a
return to a world financial order with fixed but adjustable exchange
rates, symmetric adjustment obligations for current account deficit and
surplus countries, and regulated international capital markets in order
to avoid the imbalances that have contributed to the severity of the
present crisis. Keyness (1942) proposal for an International Clearing
Union can be seen as a blueprint for this. As is well known, Keynes
suggested an International Clearing Union in a fixed but adjustable
66 The Euro Crisis
The major task for the current account deficit countries, with the
exception of Ireland,20 will be to improve their balance of payments
constrained growth rates. This means, on the one hand, to contribute
to a reduction of the inflation differentials with respect to the surplus
countries, by means of unit labour cost growth below the sum of
national productivity growth plus the inflation target. In order to pre-
vent the risk of deflation in these countries during the process of adjust-
ment, the euro area inflation target should be increased above the rather
ambitious present target of below, but close to 2 per cent for the HICP.
On the other hand, current account deficit countries have to increase
the income elasticity of demand for their exports and to reduce the
income elasticity of demand for imports by means of industrial, struc-
tural and regional policies; this means they have to improve their non-
price competitiveness.21 In fact, export growth in Greece (6.1 per cent
average annual growth in 19992007) and Spain (5.3 per cent) has been
rather dynamic, but imports have grown even more. These countries
would therefore have to reduce their income elasticities of demand
for imports. Italy and also France have had the weakest export growth
(2.8 per cent and 3.8 per cent respectively) among the countries consid-
ered in our study, with import growth exceeding export growth. These
countries would have to focus on increasing the income elasticity of
demand for their export goods. Due to the still considerable negative
balance of goods and services, Portugal should aim at both increasing
the income elasticity of demand for its exports and reducing the income
elasticity of its imports, although export growth has already exceeded
import growth in the past.
Even if these adjustment processes of actual and balance of payments
constrained growth rates in each of the euro area member countries
takes place, we would not expect complete adjustment in the short
or medium run. Growth rates of member countries will differ due to
productivity catch-up processes and it is hard to imagine that these
differences in growth rates will be matched by reverse differentials
in inflation rates or by inverse relative income elasticities of demand
for exports and imports. In other words, it is not very likely that the
more rapidly-growing catching-up countries will have lower inflation,
higher income elasticities of demand for their exports, and lower
income elasticities of demand for imports than the slowly growing
more advanced economies, so that actual growth differentials will be
matched exactly by balance of payments constrained growth differen-
tials. Therefore, current account surpluses and deficits will arise due to
these differentials.
68 The Euro Crisis
L d L d
= L = L Y Ld Y
Yd d
d
= d = d . (4)
Ld Ld Yd
Y d
Yd
Provided that nominal GDP growth exceeds the nominal interest rate,
also the foreign debt service-GDP-ratio will not rise. Furthermore, the
higher the (sustainable!) growth trend of the catching up economy, the
higher will be the tolerable current account deficitGDP ratio for a given
maximum foreign-liabilitiesGDP ratio.22 As derived in Appendix B, in
a currency union with a balanced current account with the rest of the
world and therefore with a zero net foreign assets/liabilities position, a
constant net foreign liabilitiesGDP ratio of the current account deficit
member countries will be associated with a rising net foreign assetsGDP
ratio of the current account surplus member countries, provided that
GDP growth in the deficit countries exceeds growth in the surplus coun-
tries. Alternatively, a constant net foreign assetsGDP ratio of the surplus
countries will be accompanied by falling net foreign liabilitiesGDP
ratios of the deficit countries, or net foreign assetsGDP ratios of surplus
countries will be rising and net foreign liabilitiesGDP ratios of deficit
countries will be falling. In other words, provided that current account
deficit countries have a higher growth rate than the surplus countries, it
is impossible for their net foreign liabilitiesGDP ratio to rise.
Sustainably higher growth than the surplus countries on euro area
average should therefore be the ultimate criterion for tolerable current
account deficits in the coordination process of fiscal policies within the
euro area. Current account deficits of countries with a below surplus
country average GDP growth rate, and the related current account sur-
pluses, should not be tolerated and should be tackled symmetrically, i.e.,
by deficit and surplus countries, with the measures discussed above.
Current account deficits will have to be financed by capital imports.
Appropriate financial regulations, avoiding excessive asset price infla-
tion and credit bubbles, are a key prerequisite for sustainable growth,
Eckhard Hein, Achim Truger and Till van Treeck 69
In this paper we have analysed the imbalances, which have been built
up in the euro area and which are at the roots of the present crisis,
i.e., the Greek, the Irish and the Portuguese public debt crises and
the related euro crisis which started in 2010. Since the current reform
debate in Europe and the macroeconomic policy measures applied are
still grounded in the theoretical framework of the NCM, the reforms
are likely to fail and create either further deflationary pressure and/
or a resurgence of macroeconomic imbalances. We have, therefore,
described some key ingredients of an alternative macroeconomic policy
model based on Keynesian and Post-Keynesian principles. Having out-
lined the basic principles of a Post-Keynesian macroeconomic policy
approach, we have applied this approach to the euro area. We have
derived that stabilizing wage and expansionary fiscal policies will have
major roles to play in order to cope with the imbalances and to initiate
recovery for the euro area as a whole. Furthermore we have argued that
current account targets will have to play a major role in intra-euro area
70 The Euro Crisis
Notes
1. For most helpful research assistance we would like to thank Nina Dodig and
Gregor Semieniuk. Earlier versions of the paper were presented at a work-
shop at the University of the Basque Country, Bilbao, in December 2010, and
at the 8th International Conference Developments in Economic Theory and
Policy at the University of the Basque Country, Bilbao, in July 2011. We are
most grateful for the comments by the participants. Remaining errors are,
however, exclusively ours.
2. See the agreements of the meeting of the Economic and Financial Affairs
Council (ECOFIN) on 15 March 2011 (Council of the EU 2011a), the conclu-
sions of the meeting of the European Council (2011) on 24/25 March 2011,
and the statement by the heads of state or government of the euro area and
EU institutions on 21 July 2011 (Council of the EU 2011b).
3. See for example the argument of the German Federal Ministry of Finance
(2011) in the German Stability Programme submitted to the European
Commission and the European Council (2011) in its proposal for the Euro
Plus Pact (see also section 3.2. of this article).
4. For NCM see Goodfriend and King (1997) and Clarida et al. (1999), and for
detailed critiques of the NCM, see Arestis (2009), Arestis and Sawyer (2004a),
and Hein and Stockhammer (2010).
5. See also the agreement of the ECOFIN regarding the reform of the SGP and
the surveillances of economic policies (Council of the European Union,
2011a).
6. The euro Plus Pact also briefly mentions the reinforcement of financial
stability and tax policy coordination.
7. As Priewe (2007) summarises his survey of OCA theories, there are numer-
ous approaches with strong contrasts and contradictions, both among the
early theorists (Mundell, McKinnon, Kenen) and the second generation
theories summarised in the criteria-approach put forward by Tavlas and oth-
ers. The latter is a hybrid approach, paving the way for large and heterogene-
ous unions, albeit with strong shortcomings (pp. 478).
8. For instance, it seems that in the United States, generally considered an
optimal currency union, wage and price flexibility is not much higher than
in Europe, but labour mobility is much higher. Hence, when a particular
region is affected by an adverse shock to output and employment, work-
ers migrate to more dynamic regions with higher growth and employment
(see Blanchard and Katz, 1992; Goodhart, 2007). Another scenario is that
Eckhard Hein, Achim Truger and Till van Treeck 71
capital mobility may take the place of labour mobility (which for obvious
reasons is limited in the euro area), hence avoiding prolonged external
imbalances across countries: There is no question that a single currency
enhances capital mobility. The hope is that a rise in labour availability
(i.e., unemployment) and constrained wages may make capital flow into
such, previously uncompetitive, regions and thereby restore their pro-
ductivity and growth (ibid., pp. 923); Goodhart (ibid.) also adds: This
prospect seems (to me) unconvincing as the deflationary pressure is likely
to raise political and exchange rate risks, while the unemployed are quite
likely to be less skilled and demotivated (p. 93).
9. We will address the catching-up issue in our Post-Keynesian alternative
policy framework in Section 4 of this paper.
10. For the integration of the macroeconomic policy mix for the euro area
outlined here into a broader Keynesian New Deal in order to tackle and
overcome the world-wide financial and economic crisis see Hein and Truger
(2011). Such a Keynesian New Deal at the European and the Global Level
should include the following pillars: the re-regulation of the financial sec-
tor, the re-orientation of macroeconomic policies and the re-construction
of international macroeconomic policy co-ordination, in particular at the
European level, as well as the introduction of a new world financial order.
11. See Rochon and Setterfield (2007) for a review of Post-Keynesian suggestions
regarding the parking it approach towards interest rate policies of central
banks and the rate of interest central banks should target.
12. See Hein (2002) for a review of the related theoretical and empirical literature.
13. This is, of course, the functional finance view, pioneered by Lerner (1943).
See also Arestis and Sawyer (2004b).
14. A constant government debtGDP ratio (B/Y) requires that government debt
and GDP grow at the same rate g = B/B = Y/Y. Since the government deficit
D = G T = B, if follows that B/Y = (D/Y)/g.
15. See Appendix A for the derivation of the balance of payments constrained
growth rate.
16. McCombie (2002) nicely summarizes the balance of payments constrained
growth model as follow: The central tenet of the balance-of-payments-
constrained growth model is that a country cannot run a balance-of-
payments deficit for any length of time that has to be financed by short-term
capital flows and which results in an increasing net foreign-debt-to-GDP
ratio. If a country attempts to do this, the operation of the international
financial markets will lead to increasing downward pressure on the currency,
with the danger of a collapse in the exchange rate and the risk of a resulting
depreciation/inflation spiral. There is also the possibility that the countrys
international credit rating will be downgraded. Consequently, in the long
run, the basic balance (current account plus long-term capital flows) has to
be in equilibrium. An implication of this approach is that there is nothing
that guarantees that this rate will be the one consistent with the full employ-
ment of resources or the growth of productive potential (p. 15).
17. Quite remarkably, the president of the ECB recently acknowledged the
importance of this wage rule: Thus a medium-term inflation rate of some-
what below 2 per cent over the medium term is the appropriate benchmark
also at the national level. Unit labour costs, and therefore developments in
72 The Euro Crisis
References
Arestis, P. (2009), New Consensus Macroeconomics and Keynesian Critique, in
E. Hein, T. Niechoj and E. Stockhammer (eds) Macroeconomic Policies on Shaky
Foundations. Whither Mainstream Economics? (Marburg: Metropolis).
Arestis, P. and Sawyer, M. (2004a), Re-examining Monetary and Fiscal Policy for the
21st Centuryy (Cheltenham: Edward Elgar).
Arestis, P. and Sawyer, M. (2004b), On Fiscal Policy and Budget Deficits,
Intervention. Journal of Economics, 1(2), 6174.
Blanchard, O. and Gal, J. (2007), Real wage rigidities and the New Keynesian
model, Journal of Money, Credit, and Bankingg 39 (supplement 1), 3565.
Blanchard, O. and Katz, L. (1992), Regional Evolutions, Brookings Papers on
European Activityy 1, 175.
Eckhard Hein, Achim Truger and Till van Treeck 73
Clarida, R., Gali, J. and Gertler, M. (1999), The Science of Monetary Policy:
A New Keynesian Perspective, in Journal of Economic Literature 37, 1661707.
Council of the EU (2006a), Council Opinion of 14 March 2006 on the updated
stability programme of Spain, 20052008.
Council of the EU (2006b), Council Opinion of 14 March 2006 on the updated
stability programme of Germany, 20052009.
Council of the EU (2007a), Council Opinion of 27 March 2007 on the updated
stability programme of Spain, 20062009.
Council of the EU (2007b), Council Opinion of 27 February 2007 on the updated
stability programme of Ireland, 20062009.
Council of the EU (2011a), Council Reaches Agreement on Measures to Strengthen
Economic Governance, Brussels, 15 March 2011, 7681/11, PRESSE 63.
Council of the EU (2011b), Statement by the Heads of State or Government of
the Euro Area and EU Institutions, Brussels, 21 July 2011.
Davidson, P. (2009), The Keynes Solution. The Path to Global Economic Prosperity
(Basingstoke: Palgrave Macmillan).
Domar, E.D. (1944), The Burden of the Debt and National Income, American
Economic Review w 34, 794828.
Dullien, S. (2010), Towards a Sustainable Growth Model for Europe: Institutional
Framework, Internationale Politik und Gesellschaftt 1/2010, 3644.
Dullien, S. and Schwarzer, D. (2009), The Euro Zone Needs an External Stability
Pact, SWP Comments 2009/C09, Berlin: German Institute for International
and Security Affairs.
ECB (European Central Bank) (2005): Monetary Policy and Inflation Differentials
in a Heterogeneous Currency Area, Monthly Bulletin May, 6177.
ECB (European Central Bank) (2007): Output Growth Differentials in the Euro
Area: Sources and Implications, Monthly Bulletin April, 7386.
ECB (European Central Bank) (2008), Monthly Bulletin 10th anniversary of the
ECB, Special Edition, May.
European Commission (2010), Press Release. EU Economic Governance: The
Commission Delivers a Comprehensive Package of Legislative Measures,
IP/10/1199.
European Council (2011), Conclusions, 24/25 March 2011, EUCO 10/11.
Gal, J. (2008), Monetary Policy, Inflation, and the Business Cycle. An Introduction to the
New Keynesian Framework (Princeton and Oxford: Princeton University Press).
German Federal Ministry of Finance (2011), German Stability Programme 2011
Update, Berlin.
Goodfriend, M. and King, R.G., (1997), The New Neoclassical Synthesis and
the Role of Monetary Policy, in B.S. Bernanke and J.J. Rotemberg (eds), NBER
Macroeconomics Annual: 1997 7 (Cambridge, MA, MIT Press).
Goodhart, C. (2007), Currency Unions: Some Lessons from the Euro Zone:
Reconsidering the Theories of Optimum Currency Areas A Critique, in
E. Hein, J. Priewe and A. Truger (eds), European Integration in Crisis (Marburg:
Metropolis).
Guttmann, R. (2009), Asset Bubbles, Debt Deflation, and Global Imbalances,
International Journal of Political Economyy 38 (2), 4669.
Hein, E. (2002), Monetary Policy and Wage Bargaining in the EMU: Restrictive
ECB Policies, High Unemployment, Nominal Wage Restraint and Inflation
above the Target, Banca Nazionale del Lavoro Quarterly Review w 55, 299337.
74 The Euro Crisis
Mongelli, F.P. (2002), New Views on the Optimum Currency Area Theory:
What is EMU Telling Us?, ECB Working Paper No. 138.
Palley, T. (2004), Asset-based Reserve Requirements: Reasserting Domestic
Monetary Control in an Era of Financial Innovation and Instability, Review of
Political Economyy 16, 4358.
Palley, T. (2010), Asset Price Bubbles and Counter-cyclical Monetary Policy: Why
Central Banks Have Been Wrong and What Should Be Done, Intervention.
European Journal of Economics and Economic Policies 7 (1), 91108.
Priewe, J. (2007), Reconsidering the Theories of Optimum Currency Areas
A Critique, in E. Hein, J. Priewe and A. Truger (eds), European Integration in
Crisis (Marburg: Metropolis).
Rochon, L.-P. and Setterfield, M. (2007), Interest Rates, Income Distribution and
Monetary Policy Dominance: Post-Keynesians and the Fair Rate of Interest,
Journal of Post Keynesian Economics 30, 1342.
Thirlwall, A.P. (1979), The Balance of Payments Constraint as an Explanation of
International Growth Differences, Banca Nazionale del Lavoro Quarterly Review
128, 4553.
Thirlwall. A.P. (2002), The Nature of Economic Growth (Cheltenham: Edward
Elgar).
Tobin, J. (1993), Price Flexibility and Output Stability: An Old Keynesian View,
Journal of Economic Perspectives 7, 4565.
Trichet J.-C. (2011), Competitiveness and the Smooth Functioning of EMU,
Lecture at the University of Lige, Lige, 23 February (http://www.ecb.int/
press/key/date/2011/html/sp110223.en.html).
UNCTAD (2009), The Global Economic Crisis: Systemic Failures and Multilateral
Remedies (New York and Geneva: UNCTAD).
Van Rompuy, H. (2010), Report of the Task Force to the European Council, 15302/10,
21.10.2010.
Woodford, M. (2003), Interest and Prices: Foundations of a Theory of Monetary Policy
Princeton (NJ: Princeton University Press).
76 The Euro Crisis
pdXpfeM, (A1)
p dXpfeM. (A2)
p
X = Q d Yf , < 0, > 0, (A3)
pf e
p e
M = R f Yd , < 0, > 0, (A5)
pd
Substituting equations (A6) and (A4) into equation (A2) yields the domestic rate
of growth which is consistent with a current account equilibrium.
b = (1 + + ) ( pd pf e ) + Yf .
Yd
(A7)
Since in a currency union the exchange rate among member countries is fixed,
they all use the same currency, the balance of payments constrained growth rate
for the individual member country becomes:
b = (1 + + ) ( pd pf ) + Yf .
Yd (A8)
Eckhard Hein, Achim Truger and Till van Treeck 77
LdAf. (B1)
LdAf. (B2)
Dividing equation (B2) by equation (B1), it follows that the growth rate of net
foreign liabilities of the domestic economy has to be equal to the growth rate of
net foreign assets of the foreign economy:
L d A f .
L d = = Af = (B3)
Ld Af
Ld
constant, if LdY
Yd, (B4.a)
Yd
Af
constant, if AfY
Yf. (B4.b)
Yf
Taking into account equation (B3) this means that the constancy of both, the
net foreign liabilitiesGDP ratio of the domestic economy and the net foreign
assetsGDP ratio of the foreign economy requires that the two economies have
to grow at the same rate:
Ld L
and d constant, if LdY
YdAfY
Yf. (B5)
Yd Yd
liabilitiesGDP ratio of the domestic economy. Of course, one may also obtain
both, falling foreign liabilitiesGDP ratios of the domestic economy and rising
foreign-assetsGDP ratios of the foreign economy.
From equations (B3), and (B4.a) and (B4.b) we obtain that the net foreign
liabilitiesGDP ratio for the domestic country and the net foreign assetsGDP
ratio of the foreign economy are given as:
L d L d
L d Y Ld Y
Ld = = d = d , (B6.a)
Ld Ld Yd
Y d
Yd
A f A f
= A Y Af Y
A f
f
= f = f . (B6.b)
Af Af Yf
Y f
Yf
Abstract: After a decades experience for the EMU and based on ongoing
fiscal consolidation plans, a comparative evaluation exercise was con-
ducted for the sustainability of public debt dynamics and that of fiscal
policies pursued in Germany, the Netherlands and Finland (fiscally prudent
economies), against those in Greece, Ireland and Portugal (economies in fiscal
distress). Standard debt sustainability analysis (based on the governments
inter-temporal solvency condition) was complemented with a range of
short and medium term sustainability indicators. In addition, a synthetic-
recursive fiscal sustainability indicator, utilized to assess the sustainability
of past fiscal policies, provided corroborative evidence for the fact that
the policies pursued so far, generated unsustainable and divergent fiscal
outcomes for the economies in the second group, in contrast to the econ-
omies in the first group. Overall, the findings suggest that current fiscal
policies are on an unsustainable trajectory for the economies in fiscal dis-
tress. Although all economies considered in this study need to embark on
a course of fiscal adjustment to some extent, this adjustment seems like a
daunting fiscal exercise for the economies which face severe budget imbal-
ances. Furthermore, based on a number of macro-fiscal and indebtedness
indicators, the analysis also reveals pronounced asymmetries in perform-
ance between the two groups. In terms of convergence, the results indicate
that progress in achieving the Maastricht objectives has been slow, partial
and fragmented and observed only in a small number of EMU economies,
which unlike the rest of the economies examined in the study, were not
characterized by asymmetric macroeconomic disequilibria.
79
80 The Euro Crisis
1 Introduction
Over the last decade, explosive debt dynamics in many economies the
world over have become one of the principal sources of policy con-
cern. Many countries with high public debt ratios, mainly as a result of
unsustainable or undisciplined fiscal policies pursued in the past, are
now faced with formidable challenges and need to take decisive and
prompt actions including, but not confined to, sweeping adjustment
policies, stern fiscal austerity measures and deep structural reforms, in
order to regain control of the state budget. Large budget deficits and ris-
ing levels of accumulated public debt constitute direct threats and can
deal a serious blow to short-term macroeconomic stability and longer-
term fiscal sustainability. In the post-2008 era, a gradual shift back to
fiscal prudence, to effectively address downside risks and to rein in
the evolution of state liabilities, is now on the reform agenda of many
economies, especially so in the economies of the Eurozone but also in
the United States.
The effects of high debt and deficits have been explored extensively
in the economics literature and in a growing mass of empirical works
to date. Economic analysis offers many useful insights and advances in
methods are continuously employed to sharpen our understanding of
a changing economic reality. In this respect, frequent re-examination
and reassessment of analyses is warranted, as new developments need to
be taken into account and evaluated accordingly. Moreover, a universe
of satellite issues, such as the institutional framework within which
fiscal policy is conducted, the economys initial conditions, binding
constraints as a result of a participation in a monetary union, etc., have
now been widely recognized as having serious implications for fiscal
performance. These factors offer invaluable insights and thus cannot be
ignored in the overall evaluation of a countrys fiscal performance.
In this connection and in view of the growing debt concerns and
appropriate policies to tackle rising debts and deficits in the EMU, the
objective of the present work is to explore the key issues involved in the
debt sustainability assessment. Specifically, the aim is to conduct a sus-
tainability analysis for a group of selected EMU countries in an effort to
assess whether in the light of recent developments, debt dynamics are on
a sustainable trajectory. Past macro-fiscal performance, indebtedness and
convergence indicators shed additional light in our understanding of the
evolution of key budget variables and thus observed fiscal outcomes.
To this end, we critically review the main approaches developed in the
literature, focusing on the traditional fiscal approach to sustainability
Yannis A. Monogios and Panagiotis G. Korliras 81
provide a compelling justification for the way the numbers evolved the
way they did, but rather merely to depict the main economic develop-
ments by resorting to purely statistical information. For each country
in this study, the effects of the recent economic and financial crisis are
distinctly pronounced in the statistical series from 2008 onwards.
Our taxonomy divides the countries to be examined into two distinct
groups. The first group consists of three fiscally prudent
t EMU econo-
mies, namely Germany (DE), the Netherlands (NL) and Finland (FI). The
second group contains Greece (GR), Ireland (IE) and Portugal (PT) as the
three EMU economies in fiscal distress. The latter economies, currently
under economic surveillance, have recently sought financial support
from the International Monetary Fund, the European Commission and
the European Central Bank due to the insurmountable fiscal challenges
they have accumulated.
Output growth during the last decade has been uneven in the
Eurozone and among the groups under examination, judging from
their relative performance against each other but also against the 16
EMU economies output performance.9 The growth in real GDP has been
smoother albeit lower (on average) in the decade in the first group of
countries than in the second group (with the exception of Portugal).
Both groups experienced a pronounced dip in output growth due to the
impact of the recent financial and economic downturn (2008 onwards).
However, growth has shown signs of rebound in the post-crisis era in
the first group of countries, in contrast to the second group, where the
effects of the crisis have been more pronounced, and thus more difficult
to overcome. Inflation, as depicted by movements in the Harmonized
Index of Consumer Prices (HICP), has been higher (on average) in the
decade in the second group, than in the first and also higher than the
EMU16 average annual rate in the corresponding period.10
Apart from the observed growth imbalances, fiscal progress has been
asymmetric as well, judging from the evolution of the main budget
fundamentals but ultimately from the budget outcomes. Specifically,
regarding total revenues as a per cent of GDP, the average perform-
ance in the decade for the second group of countries has been notably
lower in comparison to that for the first group and against the EMU16
average revenues/GDP of 45 per cent. Revenues underperformance in
the second group of EMU states was matched by lower expenditures/
GDP ratios against the EMU16 average of 47.7 per cent of GDP in the
decade. Government expenditures ratios in the first group of the EMU
countries in our sample, although consistently higher than those in the
second group, were also lower than the EMU16 average expenditure to
Yannis A. Monogios and Panagiotis G. Korliras 89
GDP ratio as well. In overall budget terms the group of the economies
in fiscal distress recorded a deficit to GDP ratio much higher than the
EMU 16 average of 2.7 per cent.
During the period 2000 to 2010, the group of fiscally prudentt econo-
mies on the other hand recorded, on average, a much lower budget
deficit (which in the case of Finland was actually a surplus which
averaged around 2.9 per cent of GDP) than that in the second group.
However, looking at the primary balance as a ratio to GDP instead (i.e.
the overall balance excluding interest payments as per cent of GDP), the
differences among the groups in the sample are more pronounced. All
countries belonging to the first group have produced primary surpluses
well in excess of the EMU16 average record of 0.5 per cent during the
period 20002010. The second group however exhibited primary defi-
cits throughout the corresponding period.11
Developments in indebtedness are an additional testimony of the
diverging paths followed during the last decade in the selected groups
of EMU economies under scrutiny. There is an apparent recession-
fuelled debt/GDP growth due to the global crisis (notably from 2008
onwards), but this is difficult to ascertain by judging the debt dynamics
in the countries belonging to the second group, where the debt/GDP
was already in an upward trajectory since the early years of the mon-
etary union. This trend is more pronounced however, in the group of
the fiscally prudentt economies. In this group, the debt/GDP ratio was
(and still is) well contained to safe (e.g. Finland) or comfortable levels
(e.g. the Netherlands). In Germany although the debt/GDP fluctu-
ated around the 60 per cent Maastricht benchmark until 2002, it then
started to drift apart, reaching levels around 83 per cent of GDP in the
post-crisis period. From the countries in the second EMU group, Greece
has consistently been an outlier having a high debt/GDP ratio (108.8
per cent on average in the decade),12 well above the EMU16 average of
71.2 per cent. In 2010 Greeces debt stood at 142.8 per cent of the coun-
trys output. Portugal and Ireland had both been good performers half
way through the decade. Nonetheless, these countries breached the 60
per cent Maastricht threshold in 2005 and 2009 respectively, and their
debt/GDP ratios continued on a rising path thereafter. All three econo-
mies in the second group are projected to incur debt ratios in excess of
100 per cent of their output from 2011 onwards.
A class of useful criteria against which fiscal performance can be
evaluated, are various measures of interest payments relative to the
economys output, and to the states revenues and expenditures.
The interest payments/GDP is one measure of the claims of the state
90 The Euro Crisis
4 Sustainability indicators
medium-term tax gap indicators, along the same line of reasoning. The
medium tax gap indicator is considered a more appropriate criterion for
signaling the magnitude of the required fiscal corrections further in the
future and thus it is more relevant to policy planning.
Sustainability indicators are, as a rule, forward looking, in the sense
that they have been applied in a forward-looking manner. However,
an innovation of this paper is that, instead of focusing exclusively on
the necessary budget adjustments dictated by the evolution of the key
variables in the future, it attempts to also evaluate sustainability of past
policies by applying a synthetic-recursive indicator of sustainabilityy (IFS)
proposed by Croce and Juan Ramon (2003). This ex-post indicator of
fiscal sustainability,
y which is based on the standard law of motion of
the debt/GDP (see Ley 2010), where applicable, conveys useful informa-
tion on whether past policies have been conducted in a manner consist-
ent with fiscal policy sustainability objectives. The attractive feature of
this indicator is that it is based on an algorithm that does not require
estimation of future output growth or interest rates. It generates results
based on past, current and target values of the variables involved in its
calculation. However, the IFS is more of a monitoring device rather than
a pure criterion for fiscal sustainability.17
All sustainability indicators signify the need for fiscal policy
readjustment. Their usefulness however, is summarized in their ability
to convey reliable signals of future fiscal imbalances and their impor-
tance rests on the necessity to take corrective policy actions to pre-
vent deterioration of the budget. In practical terms, they indicate the
magnitude of the fiscal correction required to achieving the set policy
targets, but their mechanistic use as a policy prescription tool should be
avoided. Although highly relevant to policy making, these indicators do
not always provide adequate answers as to what kind of adjustments are
fiscally feasible and/or politically or socially desirable. In other words,
they indicate what needs to be done, but not how.
However, any sustainability analysis must adopt some kind of estima-
tion or forecasting regarding the evolution of growth and the interest
rates, or it can rest on plausible assumptions about the course of devel-
opments of the variables employed in the analysis.
5 Assessing sustainability
In this section we follow the standard methodology to test for the sus-
tainability of public finances in the groups of EMU economies discussed
in the previous part. Within the inter-temporal budget constraint
Yannis A. Monogios and Panagiotis G. Korliras 93
take into account other factors such as the impact of regime changes19
and/or the interdependence between fiscal variables, growth and inter-
est rates.20 However, in this kind of budget accounting exercises, it is
important always to keep in mind that future values of key variables
determining debt/GDP sustainability are fundamentally uncertain, thus
implying many sources risk for the validity of outcomes.21
The results of the standard sustainability analysis along with the
results for the corresponding primary gap indicators (Tables 3.2, 3.3
and 3.4) are summarized next (under the heading debt-target analysis).
Table 3.5 presents the results as calculated for the sustainable tax ratios
from 2011 to 2016 and Tables 3.6 and 3.7 document the short and
medium tax gap indicators respectively. Finally, Table 3.8 reports the IFS
indicator for the past five years (20062010).
Turning to Table 3.2, under the base case scenario, the primary surplus
required to sustain the debt/GDP at the 2010 level in the countries in
our sample, ranges from 0.64 to 4.71 percentage points of GDP. This is
a first indication of the varying degrees of fiscal effort required in dif-
ferent EMU economies. The effort is a function of the current debt/GDP
level among other things. The higher the debt/GDP, the higher the fis-
cal effort, i.e. the higher the primary surpluses required to stabilize the
debt/GDP ratio. Countries such as Greece and Ireland have to put in
place ambitious fiscal consolidation plans, in order to maintain a debt/
GDP ratio at current levels.
Comparing the results of the base case scenario with the correspond-
ing ones in the optimistic scenario (Table 3.3), one can observe that the
fiscal effort required for debt sustainability at the 2010 level, is con-
siderably lower (almost one-third in most cases, compared to the base
case scenario), mainly due to the positive impact of higher growth.
However, the situation becomes worrisome, if the conservative scenario
materializes (Table 3.4). In this instance, where growth is lower and
the interest rates are higher, the fiscal effort required almost doubles
in intensity. In this scenario, the second group of economies, needs to
embark in deep and profound consolidation programmes, in order to
control their debt/GDP at the 2010 level, otherwise the debt/GDP ratio
will continue to increase at explosive rates. However, it is evident in all
calculations of this sort (Tables 3.2, 3.3 and 3.4) that all the countries
in our sample need to generate primary surpluses in order to contain
rising debt dynamics.
The primary gap indicator estimated for each scenario provides a more
accurate picture of the fiscal distance needed to be covered when tak-
ing into account the budget outcome of the current year. In all three
Debt target analysis
Table 3.2 Base-case scenario
Base Case Scenario T
Debt as % of Growth/interest pb* = Primary pb** = Primary
GDP rate scenarios Surplus Surplus required
based on required for for the reduction of
projections the Debt/GDP to Target-
for 20102016 stabilization levels
of Debt/GDP
to 2010 levels
Country 2007 2010 Growth Real Int. pre-crisis Maastricht Primary gap
rate, g Rate, r 2007 debt level, indicator
debt b* = 60% as % of
level T=20 GDP
T=10
Germany 0.649 0.832 0.0208 0.042 1.722 3.729 2.130 Germany 2.612
Netherlands 0.453 0.627 0.0165 0.029 0.784 2.685 0.935 Netherlands 4.206
Finland 0.352 0.484 0.0247 0.038 0.645 2.083 in target Finland 2.025
Greece 1.054 1.428 0.0048 0.038 4.718 8.677 7.736 Greece 9.654
Ireland 0.250 0.962 0.0193 0.065 4.274 10.98 5.375 Ireland 33.43
Portugal 0.683 0.930 0.0053 0.032 2.428 5.649 3.757 Portugal 8.564
Notes: T real gdp growth projections are based on the average of the 20102016 available IMF projections. Interest rate projections are based
on calculations of historical data plus one st.dev. of historical average.
Source: Authors calculations.
95
96
Debt target analysis (cont.)
Table 3.3 Optimistic scenario
Optimistic Scenario T
Debt as % Growth/interest pb* = Primary pb** = Primary
of GDP rate scenarios Surplus Surplus required
based on required for for the reduction of
projections for the Debt/GDP to
20102016 stabilization Target-levels
of Debt/GDP
to 2010 levels
Country 2007 2010 Growth Real Int. pre-crisis Maastricht Primary gap
rate, g Rate, r 2007 debt debt level, indicator
level b*= 60% as % of
T=10 T=20 GDP
Germany 0.649 0.832 0.025 0.036 0.966 2.920 2.074 Germany 1.855
Netherlands 0.453 0.627 0.017 0.024 0.402 2.321 0.553 Netherlands 3.824
Finland 0.352 0.484 0.027 0.033 0.270 1.725 in target Finland 1.650
Greece 1.054 1.428 0.020 0.029 1.333 5.434 5.310 Greece 6.268
Ireland 0.250 0.962 0.028 0.046 1.775 9.165 3.370 Ireland 30.93
Portugal 0.683 0.930 0.011 0.026 1.376 4.070 2.890 Portugal 7.512
Notes: T real gdp growth projections are based on the average of the 20102016 available IMF projections plus 1/2 st. dev. Interest rate
projections are based on calculations of historical data plus 0.5 st.dev. of historical average.
Source: Authors calculations.
Debt target analysis (cont.)
Table 3.4 Conservative scenario
Conservative Scenario T
Debt as % Growth/interest pb* = pb** = Primary
of GDP rate scenarios Primary Surplus required
based on Surplus for the reduction of
projections for required Debt/GDP to
20102016 for the Target-levels
stabilization
of Debt/GDP
to 2010 level
Notes: T real gdp growth projections are based on the average of the 20102016 available IMF projections minus 1/5 st. dev. Interest rate
projections are based on calculations of historical data plus 1.5 st.dev. of historical average.
Source: Authors calculations.
97
98 The Euro Crisis
The crux of the above exercise was not to provide precise numerical
results, but rather to put the emphasis on the fiscal effortt necessary for
debt stabilization/reduction, as well as on the disproportional implica-
tions for budgetary policy in the EMU countries under consideration.
The sensitivity of the primary surplus to alternative growth-interest rate
combinations is a key factor determining the outcomes. In all cases,
the numbers point to one direction: that of inevitable and long-lasting
fiscal adjustments. This in turn, implies that severe fiscal retrenchment
(both tax hikes and spending cuts) and prolonged austerity programs
will eventually be needed to ensure sustainability of public finances.
Even though, economic history provides several examples of successful
fiscal consolidation episodes,23 large and long-lasting adjustments tend
to be associated with lower success rates. Apparently, any delays in the
adjustments required can only come at a higher economic and social
cost in the future.
Tables 3.5, 3.6 and 3.7 next, present the results from the calculations
of the sustainable tax ratio (necessary to sustain the debt/GDP in its
current level), the sort run tax gap, as well as the medium term tax gap
indicators.
Given the debt/GDP levels currently prevailing and the projected
trends regarding expenditures/GDP, Table 3.5 provides the estimates
for the sustainable tax ratios from 2011 to 2016 for each EMU economy
in this study. Figures 3.1 and 3.2 provide visual representation of the
results. The sustainable tax ratio depicts more accurately the magnitude
of fiscal adjustment than the sustainable primary surplus, since the
future evolution of public spending is taken into account in the relevant
calculations. A sustainable tax to output ratio offers an indication of
the changes in future tax and spending policies necessary to stabilize
Notes: * Sustainable tax ratio ( *) necessary to stabilize the debt/gdp at the 2010 level.
Source: Authors calculations.
100 The Euro Crisis
55.0
50.0
45.0
40.0
*2011 * 2012 * 2013 * 2014 * 2015 * 2016
Figure 3.1 Sustainable tax ratios for Germany, Netherlands and Finland
Source: Authors calculations.
60.0
50.0
40.0
30.0
*2011 * 2012 * 2013 * 2014 * 2015 * 2016
Figure 3.2 Sustainable tax ratios for Greece, Ireland and Portugal
Source: Authors calculations.
the debt/GDP ratio at current levels. For all countries in our sample
the sustainable tax ratios up to 2016 are higher than the current ratios.
A notable exception is Greece, where the current tax ratio exceeds the
value of the corresponding sustainable ratio in 2016. Strictly speaking
this is not to be perceived as a signal that current tax policy ensures that
no adjustments will be required in the future. This indicator only tells
us, at a given point in time, how far the current tax policies are from
those required for debt sustainability.
Table 3.6 reports the calculations of the corresponding one year short-
term tax gap. Given current (and projected) spending policies, a positive
value for this indictor suggests that the current level of taxes is too
low for debt sustainability. The short term tax gap in the countries
Yannis A. Monogios and Panagiotis G. Korliras 101
tax gap tax gap tax gap tax gap tax gap
2012 2013 2014 2015 2016
Germany 2.06 1.90 1.67 1.72 1.62
Netherlands 3.04 2.78 2.53 2.36 2.05
Finland 3.32 3.38 3.28 3.23 3.19
Greece 7.52 4.91 3.20 1.06 0.26
Ireland 20.24 17.13 14.52 12.73 11.59
Portugal 5.42 3.83 3.52 3.14 2.97
4.0
3.0
2.0
1.0
0.0
Tax gap Tax gap Tax gap Tax gap Tax gap
2012 2013 2014 2015 2016
Figure 3.3 Medium-term tax gap indicator for Germany, Netherlands and
Finland
Source: Authors calculations.
22.0
12.0
2.0
8.0
Tax gap Tax gap Tax gap Tax gap Tax gap
2012 2013 2014 2015 2016
Figure 3.4 Medium-term tax gap indicator for Greece, Ireland, Portugal
Source: Authors calculations.
analysis, an attempt has been made to evaluate those policies for the
past five years (i.e. from 20062010).
Calculations of this indicator require, apart from the baseline assump-
tions on growth and interest rates, corresponding calculations of the
debt-stabilizing primary surplus (estimated previously) and a debt
target, which in the case of the EMU economies is the Maastricht debt
level of 60 per cent of GDP. What is of importance, however when
assessing the IFS, it is not its absolute values but values that depart from
unity, which is the threshold-test level. Values around unity signify that
future debt/GDP levels will, other things being equal, be maintained at
around their current levels. When the IFS takes values over unity, con-
sistently and for many successive periods, this signals that current (past)
policies produce fiscal outcomes that diverge from the target and thus
fiscal policy is deemed unsustainable. Convergence on the other hand,
is attained when the IFS takes negative values.
The usefulness of this indicator is that it complements the previ-
ous analysis on sustainability, while assessing progress in terms of
convergence to the debt target. Table 3.8 and Figure 3.5 report and
graphically illustrate the results from the relevant calculations. All
values of the IFS were positive for the countries examined during the
20062010 period. However, a closer inspection reveals that in the
case of Germany the IFS value has been lower than unity throughout
this period, with the exception of 2009, where the effects of the crisis
were more pronounced. The implication is that fiscal policies in the
past five years in Germany were deemed as consistent with the aims of
104 The Euro Crisis
2.50
2.00
1.50
1.00
0.50
0.00
06 07 08 09 10
20 20 20 20 20
Figure 3.5 IFS synthetic-recursive indicator for Greece, Portugal and Germany
Source: Authors calculations.
Table 3.9 Summary of sustainability indicators for selected EMU member states
Notes: * minor fiscal adjustment: less than 2 per cent of GDP; moderate fiscal adjustment: between
23 per cent of GDP; major fiscal adjustment: over 3 per cent of GDP.
Source: Authors calculations.
of future fiscal policies, which will call into serious question economic
feasibility, political willingness and social tolerance.
Consequently, a return to fiscal prudence (as set in the Maastricht
Treaty) and the adoption of active budget and debt stabilization poli-
cies are urgently needed in the above economies of the currency union,
which are threatened by severe asymmetric macroeconomic disequi-
libria. It turned out that these disequilibria which stem, inter alia, from
asymmetric features of undisciplined past fiscal policies (such as fis-
cal laxity and deficit-bias in good times) have resulted in rapid debt
accumulation in the recent years. In the face of these and forthcoming
challenges the countries with serious budget imbalances, now have
an opportunity to re-consider their budgetary frameworks in terms
of taxing and spending and in terms of a more prudent and effective
debt management, with a view to maximize growth potential, reduce
macro imbalances and fiscal asymmetries and to better stir their course
towards convergence to the EMU targets (Korliras and Monogios 2010).
At the same time, an apparent need to allocate resources in a more
efficient and forward-looking manner will also contribute to improved
fiscal balances, bridging at the same time the observed gap with the best
performing economies in the monetary union.
The results presented leave little room for doubt: the countries with
a sound fiscal record need to take minor-to-moderate corrective fiscal
actions to adjust their future fiscal policy in order to ensure sustainability,
as opposed to the countries with a chronic record of budget imbalances,
which have a long way to move towards that direction. Asymmetric fiscal
performance among those two groups has resulted in a diverging path
from the Maastricht objectives of fiscal convergence in the Eurozone. At
the margin, one conclusion is that after a decade of experience in the
EMU, it becomes more evident now that the existence of time-invariant
fiscal targets (as those set out in the treaty of Maastricht and the Stability
and Growth Pact), and in the absence of operational fiscal governance
rules, seem to have failed to promote fiscal consolidation.
For one thing, persistent budget deficits and rising debt/GDP ratios in
many EMU economies, if not addressed holistically, timely and effectively
and in a well-coordinated manner, they will continue to pose a growing
challenge for the long-term sustainability of EMU public finances.
Notes
* Yannis A. Monogios is Research Fellow at the Centre of Planning and
Economic Research, Greece, and Panagiotis G. Korliras is Professor at the
Yannis A. Monogios and Panagiotis G. Korliras 107
7. For a formal treatment of these and the rest of the concepts in this contribu-
tion see Appendix: An analysis of public debt dynamics.
8. According to the IMF (2002) vulnerability is the risk that the liquidity or
solvency conditions are violated and the borrower enters a crisis. However,
the IMF is lately considering integrating vulnerabilities associated with the
debt profile (debt structure and liquidity issues) into the DSA (see IMF 2011a).
Vulnerability indicators can be found in the IMFs website: http://www.imf.org
9. In 200010 the EMU 16 recorded an average in output growth of 1.38 %.
10. The EMU 16 average HICP for 200010 was 2.1 %.
11. However, this statement is not entirely correct. Ireland had an excellent
record of primary surpluses during 200007, which were reversed to primary
deficits in the advent of the crisis.
12. Greece is not the only country in the EMU with debt/GDP level higher than
100 %. In 2010 Belgium and Italy had debt/GDP ratios of 96.8 % and 119 %
respectively, all with rising trends.
13. This is almost twice as much, as the relevant ratio of the second country in
the row (Portugal at 7.0 %) and more than four times as much as the most
fiscally prudent economy in the first group (Finland at 3.5 %)
14. Long-term interest rates are one of the convergence criteria-indicators for
EMU (Article 121 of the Treaty establishing the European Community).
Article 4 of the Protocol on the convergence criteria annexed to the Treaty,
states that a Member State must have an average nominal long-term inter-
est rate that does not exceed by more than two percentage points that of,
at most, the three best performing Member States in terms of price stability
(Eurostat 2011).
15. The IMF discusses the importance of identifying criteria for fiscal sustain-
ability evaluation (IMF 2002) and conducts both scenarios-based medium
term projections and stress testing for deviations from the baseline scenario
in assessing sustainability. In addition, emphasis is placed on continuous
monitoring the evolution of key fiscal indicators as a means to complement
the formulation of reliable assessments.
16. Similarly to the case of the primary gap indicator, and by construction, this
indicator does not convey much information about the future course of
necessary policy adjustments.
17. A number of additional qualifications are required in the use of this indica-
tor. For instance, a target for debt needs to be set. Fiscal policy reaction is
triggered when the actual debt/GDP is diverging from the set target, in order
to generate the necessary primary surpluses required for convergence to the
debt target. In this perspective, IFS can be used to evaluate whether fiscal
policy in the past has been in a corrective course.
18. The projections used in the debt sustainability analysis are taken from the
IMF database: www.imf.org
19. The issue of regime changes and their implications for fiscal sustainability
opens up an interesting albeit wider discussion which however, lies beyond
the aims of this work (see for instance Makrydakis et al. 1999, Vasco and
Pataaree 2009).
20. This critique applies to any partial equilibrium analysis, since considerations
of this endogeneity can only be addressed within a general equilibrium
framework.
Yannis A. Monogios and Panagiotis G. Korliras 109
21. Da Costa and Juan-Ramon (2005) discuss a number of approaches that incor-
porate certain risks in the sustainability analysis.
22. The primary gap indicator turns out to be high in the case of the Netherlands
at 4.21, due to the fact that the primary deficit recorded in that year (2010)
was exceptionally high (at 3.4%).
23. For instance, successful fiscal consolidation episodes in Denmark (198386),
Ireland (198284, 198689), New Zealand (19862001), Finland (19922000),
Spain (199397), Canada (199499) and Sweden (19942000), resulted in
improvements in fiscal balances and the debt/GDP ratios in a relatively short
period of time. However, in most of those cases, deep fiscal and structural
reforms were backed by strong public support.
24. However, if the same assumptions for the evolution of growth and the inter-
est rates are maintained then the one year tax-gap indicator should be just
equal to the projected change in the debt/GDP. This is a direct consequence
of the fact that given the level of expenditures/GDP, the one year tax gap
indicator equals the primary gap indicator. However, in our analysis the
results are different due to the fact that the values of r and g used in the
calculations of the short-term tax gap are the historical/projected values of
these variables in the corresponding year, whereas the primary gap calcula-
tions utilize values of r and g specified according to the relevant scenarios.
25. The estimated medium term tax gap indicators reported here have, in most
of the cases, values less than those of the primary gap indicators. This is
because by construction these indicators utilize the projected values for
growth, interest rates and expenditures/GDP for each year up to 2016, as
explained in footnote 24.
26. The test has been conducted only for Germany, Greece and Portugal. It
would not make sense to apply it in the case of the Netherlands and Finland,
since during 200610 these countries had debt/GDP ratios less or about
the Maastricht debt/GDP target level. The same is true for Ireland up until
2009.
27. This was actually the case for both Greece and Portugal. In 2010 both coun-
tries found themselves in a state of extreme distress and sought international
financial assistance to overcome mounting economic and fiscal straits.
28. For the case of Greece, our results are in accord with those reached by the
recent IMF report (see IMF 2011b).
29. Blanchard (1990) actually proposes two indicators of sustainability the pri-
mary gap and the medium and long term tax gap indicators. Buiter (1985)
has also proposed a more appropriate indicator of sustainability based on
governments net worth. Apart from these, there is a growing number of
alternatives proposed in the literature to assess fiscal sustainability such as
the natural debt limit hypothesis (Mendoza and Oviedo 2004), the over-
borrowing hypothesis (Croce and Juan-Ramon 2003), the U-Statistic (Rudin
and Smith 1994), etc., to name only but a few.
30. For a detailed technical exposition see also Escolano (2010), Ley (2010).
31. Equation (5) is widely known as the law of motion of the governments
debt to GDP ratio (Ley 2010).
32. However, satisfying eq. (7) it implies that (1+r)/(1+g)>1 or that r>g.
33. For computational simplicity it is customarily assumed that the interest rate
and the growth rate of GDP are constant. If that is the case, then from the
110 The Euro Crisis
References
Akyz, Y. (2007), Debt Sustainability in Emerging Markets: A Critical Appraisal,
United Nations Department of Economic and Social Affairs, Working Paper
No. 61, ST/ESA/2007/DWP/61, November.
Arestis, P., Cipollini, A. and Fattouh, B., (2004), Threshold Effects in the U.S.
Budget Deficit, Economic Inquiry, Vol. 42, No. 2, pp. 21422.
Bandiera, L., Budina, N., Klijn, M. and van Wijnbergen, S. (2007), The How
to of Fiscal Sustainability Analysis: A Technical Manual for Using the Fiscal
Sustainability Tool, World Bank Working Paper No. 4170, World Bank,
Washington DC, pp. 141.
Blanchard, O.J. (1990), Suggestions for a New Set of Fiscal Indicators, OECD
Economics Department Working Papers, No. 79, Paris: OECD Publishing.
Blanchard, O.J. and Fischer, S. (1989), Lectures on Macroeconomics, MIT Press,
Cambridge, Massachusetts.
Blanchard, O.J. and Weil P. (2001), Dynamic Efficiency, the Riskless Rate, and
Debt Ponzi Games under Uncertainty, Advances in Macroeconomics Vol. 1,
Issue 2, Article 3.
Bohn, H. (1991), The Sustainability of Budget Deficits with Lump-Sum and with
Income-Based Taxation, Journal of Money, Credit and Banking, g Vol. 23, August,
pp. 580604.
Bohn, H. (1995), The Sustainability of Budget Deficits in a Stochastic Economy,
Journal of Money, Credit and Banking,
g Vol. 27, February., pp. 25771.
Bohn, H. (1998), The Behavior of U.S. Public Debt and Deficits, Quarterly Journal
of Economics, Vol. 113, August, pp. 94963.
Borensztein, E., Castro, C., Cavallo, E., Piedrabuena, B., Rodriguez, C., Tamayo,
C. and Valencia, O. (2010), Template for Debt Sustainability. A User Manual,
Department of Research and Chief Economist, Technical Notes, # IDB-TN-105
Inter-American Development Bank.
Buiter, W.H. (1985), A guide to public sector debt and deficits, Economic Policy,
1, November, pp. 1379. Reprinted in, Principles of Budgetary and Financial
Policy, MIT Press, by Willem H. Buiter, 1990, pp. 47101.
Buiter, W., Corsetti, G. and Roubini N. (1993), Excessive Deficits: Sense and
Nonsense in the Treaty of Maastricht, Economic Policy: A European Forum,
No. 16, pp. 57100.
Yannis A. Monogios and Panagiotis G. Korliras 111
International Monetary Fund (IMF) (2011b), Country Report No. 11/175: Greece:
Fourth Review Under the Stand-By Arrangement and Request for Modification
and Waiver of Applicability of Performance Criteria, July.
International Monetary Fund (IMF) and International Development Association
(IDA) (2004), Debt Sustainability in Low-Income Countries: Proposal for an
Operational Framework and Policy Implications (IDA/SecM20040034 and
SM/04/27).
Korliras, G.P. and Monogios, A.Y. (2010), Asymmetric Fiscal Dynamics and
the Significance of Fiscal Rules for EU Public Finances, Journal of Economic
Asymmetries, December, pp. 13969.
Krejdl, A. (2006), Fiscal Sustainability Definition, Indicators and Assessment
of Czech Republic Finance Sustainability, Working Paper Series 3, Czech
National Bank, 3/2006.
Krugman, P. (1988), Financing versus Forgiving a Debt Overhang, Journal of
Development Economics, Vol.29, No. 3, pp. 25368.
Ley, E. (2010), Fiscal (and External) Sustainability, Economic Policy and Debt
Department, Poverty Reduction and Economic Management: World Bank.
Makrydakis, S., Tzavalis, E. and Balfoussias, A. (1999) Policy regime changes and
the long-run sustainability of fiscal policy: an application to Greece, Economic
Modeling,g 16 (1), 1 January, pp. 7186.
Mendoza, E.G. and Oviedo, P.M. (2003), Public Debt Sustainability under
Uncertainty, Inter-American Development Bank, Mimeo.
Mendoza, E.G. and Oviedo, P.M. (2004), Public Debt, Fiscal Solvency, and
Macroeconomic Uncertainty in Latin America: The Cases of Brazil, Colombia,
Costa Rica, and Mexico, National Bureau of Economic Research, Working
Paper 10637 (July), Cambridge, Massachusetts.
Organization for Economic Co-operation and Development (OECD) (2009), The
Benefits of Long-term Fiscal Projections, Policy Brief, October 2009, Paris: OECD.
Roubini, N. (2001), Debt Sustainability: How to Assess Whether a Country is
Insolvent?, 20 December, Stern School of Business, New York University,
New York.
Rudin, J.R. and Smith, G.W. (1994), Government Deficits: Measuring Solvency
and Sustainability, in W.B.P. Robson and W.M. Scarth (eds) Deficit Reduction:
What Pain, What Gain?, C.D. Howe Inst.
Sachs, J. (2002), Resolving the Debt Crisis of Low-Income Countries, Brookings
Papers on Economic Activity, Vol. 2002, No. 1, pp. 25786.
Vallee, O. and Vallee, S. (2005), The Poverty of Economic Policy: Is Debt
Sustainability Really Sustainable?, Journal of International Affairs, Vol. 58.
Vasco, G. and Pataaree, S. (2009), Assessing Fiscal Sustainability Subject to
Policy Changes: a Markov Switching Cointegration Approach, Department
of Economics Discussion Papers 0309, Department of Economics, University
of Surrey.
World Bank (2006), How to Do a Debt Sustainability Analysis for Low-Income
Countries, Debt Division, World Bank, Washington, DC.
Wyplosz, C. (2007), Debt Sustainability Assessment: The IMF Approach
and Alternatives, HEI Working paper, No. 03/2007, Graduate Institute of
International Studies, Geneva.
Yannis A. Monogios and Panagiotis G. Korliras 113
Appendix
Gt rBt1 Tt (B
( t Bt1) (1)
Bt Bt1 rBt1 (T
Tt Gt) (2)
Bt (1 r)
r Bt1 PBt (3)
Bt B Y PB
= (1 + r ) t 1 t 1 t (4)
Yt Yt 1 Yt Yt
Yt Yt 1
Manipulating (4) and setting real GDP rate of growth: g t = , we get the
fiscal sustainability identity: 31 Yt 1
1 + rt
bt = bt 1 pbt (5)
1 + gt
where the small letters now denote the ratios of initial variables to GDP.
114 The Euro Crisis
The key determinants of the debt/GDP ratio in (5) are: the debt/GDP ratio in
the previous period, the interest rate/growth rate ratio and the primary balance/
GDP ratio. This formula can be extended to the long horizon by systematically
substituting the debt/GDP ratio up to the final T period (the starting reference
time is t 1 0). Based on the assumption of constant r and g rates, we simplify
calculations that yield:
T T
(1 + g ) (1 + g ) (1 + g )
bo = pb1 + ... + pbT + bT (6)
( 1 + r ) ( 1 + r ) (1 + r )
j T
+ (1 + g ) (1 + g )
b0 = j =1 pbj + lim T + bT (7)
(1 + r ) (1 + r )
j
+ (1 + g )
b0 = j =1 pbj (8)
(1 + r )
This is the governments solvency condition which shows that the discounted
value of the sum of future primary balances must equal the current value of
public debt. It follows that the government needs to produce primary budget
surpluses in the future, in order to achieve sustainability in public finances.
Nonetheless, the assumption that the discounted value of the debt at infin-
ity converges to zero is crucial for sustainability:
T
(1 + g )
bT = 0
32
lim T + (9)
(1 + r )
Calculations for the finite horizon are similar and starting from eq. (6) we get:
j T
(1 + g ) (1 + g )
bo = j =1 pb
T
+ bT (10)
(1 + r ) (1 + r )
r g
b = b pb (11)
1+ g
and if b 0 (i.e. there is no change in b), then one arrives at the required pri-
( *) necessary to stabilize the debt/GDP ratio, which depends on
mary balance (pb
the difference between (rg) g i.e. the growth-adjusted interest rate and the debt
level b0 prevailing in year t 0:
r g
pb * = b0 (12)
1+ g
If rg = 0 , i.e. r g , then from (11) we obtain bt pbt. In this case pb will be
the primary surplus equal to the change in debt Db. It is apparent that the greater
the rgg difference is, the greater the required primary surplus has to be in order
to stabilize the debt/GDP ratio. Since rg >0 is a necessary condition for dynamic
efficiency in a sense of Diamond (1965) analysis, all indicators discussed here
need to satisfy this condition.34
Nonetheless, if rg <0 then the growth rate of output exceeds the real interest
rate. In such a case the GDP grows at a faster rate than the stock of debt, which,
in other words, means that the debt/GDP ratio declines automatically. In this
instance, the government can run primary deficits which could lead to a posi-
tive but stable debt level (see Blanchard 1990). However, a situation of this sort
imposes limitations to the interpretations of the standard approach to debt sus-
tainability for it implies a declining debt/GDP ratio without the need to generate
primary surpluses in order to stabilize it. When the primary budget is in surplus,
the rate at which the debt/GDP ratio declines is given by the difference of gr.
3 Debt-target analysis
Simply stabilizing the debt/GDP ratio however, does not satisfy the governments
solvency condition (8). Producing a constant primary surplus to merely satisfy the
solvency condition cannot ensure that the debt/GDP will converge asymptoti-
cally towards zero or to some positive number. Reduction of the debt/GDP ratio
to a desired (target) level d* over a period of T years, requires a primary surplus pb**
which is calculated by first solving recursively equation (5) for b yielding
t j
1+ r t 1 1 + r
bt = b0 pbt j = 0 (13)
1+ g 1+ g
116 The Euro Crisis
and then solving equation (13) for pb, we get the primary surplus pb** required to
reduce the debt/GDP to a specific debt-target level b* in T periods:
T
1+ r
b
b0 *
1+ g
pb ** = j (14)
T 1 1 + r
j =0 1 + g
r g
pb * pbt = b0 pbt
1+ g
r g
prgap = b0 pbt
1+ g
The primary gap indicator in equation (16) shows the adjustment needed to be
carried out in terms of the primary balance in order to stabilize the outstanding
public debt ratio.
( rgap pb* pb < 0) indicates that the debt-sta-
In formula (16) a negative gap (pr
bilizing primary surplus is lower than the actual primary surplus, implying down-
ward pressure on the debt to GDP ratio and thus fiscal sustainability. A positive
value for the indicator suggests that the required primary surplus for debt stabili-
zation is higher than the actual primary surplus, which implies that government
must embark on fiscal adjustment to ensure that the debt/GDP ratio will not
increase any further. In this case, fiscal policy is on an unsustainable trajectory.
Since the budgetary balance (surplus) is usually an important objective of fiscal
policy, this is a useful indicator as it defines an appropriate fiscal target for fiscal
sustainability. The primary gap is a measure of the adjustment that is warranted in
order to bring the fiscal balance to a level consistent with debt sustainability.
A primary gap of zero in the present indicates that no fiscal policy adjustment
in the budget is necessary. This is however, not a safe conclusion, because in the
future a number of factors may exert an upward pressure in the spending ratio
(such as ageing-related or pension expenditures), thus maintaining the primary
Yannis A. Monogios and Panagiotis G. Korliras 117
balance pb* at a sustainable level, would inevitably call for some sort of adjust-
ment in revenues and/or expenditures. Therefore, the requirement of a sustain-
able (i.e. constant) primary balance will eventually need to be relaxed.
Since primary surplus is the difference between current revenues and current
non-interest expenditures (all expressed as ratios to GDP) we get:
pbt t t (17)
Substituting equation (17) to equation (8), applying some algebra and solving for
a constant we arrive at an expression for the sustainable (i.e. time invariant)
revenues ratio *:
r g + 1 + g j
* =
1 + g j= 1 ( j )
+
+ b0
(18)
1 r
If we subtract the current level of revenues to GDP from the sustainable rev-
enues ratio *, we get the tax gap indicator:
xgap *
tax (19)
The finite version of the above indicator can be obtained by an analogous sub-
stitution of equation (17) into equation (10). Algebraic manipulations yield the
sustainable tax ratio *:
T 1
1 + g j
T
r g 1 1 + r b b 1 + r +
* = j
T
(20)
1 + g
1 + g
0 T
1 + g
j= 1 1 + r
which in the case where the debt/GDP ratio is required to equal the initial level
of debt at period T, it becomes:
T 1
r g 1 + r 1 + g j
* = b0 + 1
T
1 + g 1 + g j=1 j 1 + r (21)
In the case of the infinite time horizon, * in equation (19) needs to be substituted
by its equivalent from equation (18), whereas in the case of the finite horizon equa-
tion (19) must be modified by incorporating the value of * from equation (21).
Different values of the tax xgap indicator have different implications for sustain-
ability, since they are largely dependent on the current tax level. In case of a
xgap * > 0), the sustainable tax ratio * is greater than
positive tax gap (i.e. tax
the current tax ratio . This is an indication of unsustainability and suggests that
fiscal adjustments need to be initiated to prevent future increases in debt. A posi-
tive tax gap implies that future expenditures cannot be financed or that the debt
cannot be serviced based on the current tax ratio. In order to satisfy the inter-tem-
poral budget constraint and to stabilize the debt ratio, fiscal adjustments in future
taxation and/or government spending will eventually need to be instigated.
In case of a negative tax gap (tax xgap * < 0) fiscal policy is on a sustainable
path. The current tax ratio is greater than the constant tax ratio required for debt
118 The Euro Crisis
sustainability and thus no immediate adjustments are necessary. In any case, the
value of the tax gap indicator determines the magnitude of the adjustment in the
tax ratio and as such it constitutes a useful policy guide.
In sum, the primary gap criterion indicates the extent of reduction in the
primary deficit or increase in primary surplus required for debt sustainability.
On the other hand, the tax gap criterion indicates the increase in tax ratio (tax
effort) required for public debt sustainability given current levels of government
spending. Both the primary gap (equation 16) and the tax gap (equation 19)
indicators suggest that the government may have to engage in some sort of fiscal
adjustment in the future in order to stabilize the debt/GDP ratio.
1 + r pbt pb *
IFSt = *
(22)
1 + g bt 1 b
119
120 The Euro Crisis
1 Introduction
Greece in the 1950s was the poorest country among its EU-15 peers
in terms of per capita GDP but grew to reach the average level by
Evangelia Desli and Theodore Pelagidis 121
15%
10%
5%
0%
5%
10%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Real GDP growth rate: Eurozone and Greece
Source: OECD, Economic Survey of Greece, Paris 2009, OECD.
Change in net credit issued by the private banking sector to enterprises and households.
Change in the stock of financing over the year as a percentage of GDP.
Net inflows from the E.U. as a % of year end GDP.
Change in General Government debt as a % of GDP. Percentage points. * In 1993 all guarantees issued
by the Government that had been claimed were added to the public debt.
30%
25%
20%
15%
10%
5%
0%
5%
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
7 60
6 50
5
40
4
3 30
2 20
1 10
0
1 0
2 10
12-98/6
12-99/6
12-00/6
12-01/6
12-02/6
12-03/6
12-04/6
12-05/6
12-06/6
12-07/6
12-08/6
12-09/6
Figure 4.3 Credit expansion and private consumption, yearly change, Greece
Source: Authors elaboration, Bank of Greece, Annual Report of the Chairman,various issues,
Athens, Bank of Greece.
Source: Authors elaboration based on efficiency data from Desli and Chatzigiannis (2011).
GR EU15 EU27
100%
95%
90%
85%
80%
75%
70%
65%
60%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Countries 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
EU-15 91 93 95 95 95 95 95 93 91 91 91 91 91 85
DE 100 100 100 100 100 100 100 100 100 100 100 100 100 100
ES 81 86 89 88 86 82 80 78 73 71 68 67 68 60
FI 72 75 79 84 84 83 81 79 79 84 82 83 84 72
GR 65 68 70 69 69 69 72 71 73 75 74 76 76 67
IE 100 100 100 100 96 91 88 79 79 77 77 75 78 71
IT 100 100 100 100 100 100 100 92 88 85 84 83 85 73
PT 50 52 54 54 55 53 53 50 51 51 53 54 56 48
Source: Authors elaboration based on efficiency data from Desli and Chatzigiannis (2011).
Evangelia Desli and Theodore Pelagidis 127
handling of the financial crisis. Portugal seems to fare worse than Greece
during the entire period 19952008, Spain experienced a deterioration of
its efficiency from 89 per cent in 1997 to 60 per cent in 2008 and a simi-
lar but not as severe corrosion is observed for Italy and Ireland with their
efficiency levels for 2008 to fare slightly above 70 per cent. Overall the
average efficiency of the EU-15 area prior to EMU accession was slightly
improved but afterwards it was stabilized at a level of 91%. Based on the
efficiency studies there may be other countries too among the EU-15
with efficiency levels consistently lower than the EU-15 average so that
their economies ought to have a closer examination, like Finland.
2.4 Warning signs in the real economy during the last decade:
Low competitiveness
A wide range of factors persisted in contributing towards the poor
performance in certain aspects of the Greek economy. The poor per-
formance regarding competitiveness, to name just the most important
one, is not only documented by numerous databases and surveys by
international organizations and researchers, but also by the persistent
deficit of the current account in double-digit numbers (as percentage of
GDP); also, the persisting positive differential with the eurozone aver-
age inflation and the unattractiveness of Greece to foreign direct invest-
ments that are practically zero (inflows minus outflows).
The interesting part about the inflation differential of Greece with the
eurozone (see Figure 4.5) is not that it is there, something that many
would explain with the Balassa-Samuelson effect because of the rapid
growth rate of the country. It is rather that it seems to emerge both
in the goods (tradable sector) and services (non-tradable) sub-indexes,
something that initially seems to refute the Balassa-Samuelson line of
argument.2 An expository comparison with Ireland, where the inflation
rate of the price of goods is much lower than the inflation rate of services,
which thus emerges as a textbook Balassa-Samuelson case, is most reveal-
ing. The high inflation of Greece therefore seems to emerge as a result
more of the demand increase, which is largely driven by the expansion of
credit and the inflows from the EU structural funds as well as from tour-
ism and shipping industry or public borrowing, which is not matched by
a similar increase in the domestic supply of goods and services. And this is
unlike the case of Ireland in which the surplus of the goods balance seems
to finance a deficit in the services balance following again a pattern that
well fits the standard predictions of the Balassa-Samuelson model.
The second piece of evidence that supports this argument is the
increasing deficit of the goods trade balance, as a percentage of GDP
128 The Euro Crisis
5%
4%
1% 0.5%
0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
Inflation, HICP, services. EUROSTAT.
5%
4% 1.4%
1.4% 1.6% 1.2%
3% 1.3% 1.2%
2.2% 1.1%
2% 1.1%
1%
0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
Ireland Greece
0%
5%
5% 4%
6% 7% 7% 7%
8% 8% 8%
10%
11% 11%
15% 13%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Goods balance as % of GDP. Eurostat.
35%
26% 26% 28%
25% 20% 20% 23% 24% 22%
18% 19% 18%
15%
15%
5%
5%
15%
11% 12% 12% 13% 14% 17% 14% 15% 15% 16% 15% 16%
25%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
FDI inward flows for Greece as a percentage of GDP are very low for
almost all years, something that is in line with the link between the
attractiveness of the business environment and FDI (as described by
authors such as Hajkova et al. 2007). The performance of the goods
balance together with the inflation differentials with the eurozone for
tradable goods suggests also that the cost of importing and distributing
these competitive imported goods is higher compared to the eurozone,
as a country, to face the sky-high current account deficit, needed to
borrow massively to cover it . Furthermore, it suggests that the imports
remain competitive in the domestic market in spite of this high cost of
importing and distributing, which seems to be really damning for the
competitiveness of the domestic supply of goods.
It has to be noted that for the two sectors that contribute to the serv-
ices account surplus, namely shipping and tourism, it should be noted
that they are less affected by the regulatory environment of the Greek
economy. This is so either because they operate almost completely
outside the Greek jurisdiction and administrative reality, in the case of
shipping, or because they draw their competitive strength largely from
the geographical attractiveness and the cultural heritage of Greece, as is
the case for tourism.
These pieces of evidence manifest themselves in the compelling
case for the low competitiveness of the Greek economy that is docu-
mented by a number of annual surveys by World Bank, Transparency
International and World Economic Forum. The impressive part to note
here is that a wide selection of different surveys, including those that
measure governance and corruption, rank Greece in a roughly similar
way even though they often use different methods based either on
the evaluation of hard evidence, the responses to questionnaires, or a
combination of both.
standards are excessively lax (Paterson et al. 2003; OECD 2007) and that
the business environment, as an aggregate, is unattractive.
These findings are complemented by more general statements that
indicate weak institutions, poor governance (Kaufmann et al. 2005) and
high levels of corruption that seem to follow as a consequence of the
high administrative burden and the poor governance (Ackerman 2006).
The magnitude of the weaknesses documented by these pieces of
evidence matches the size of the competitiveness deficit documented
for Greece by the inflation differential with the eurozone, the current
account deficit and the low level of FDIs. It has to be added that, not
surprisingly, Greece is found to be the OECD country that has the most
to gain from rectifying these documented deficiencies, such as product
market regulation (Conway et al. 2006), in terms of increased productiv-
ity. This performance can be labelled dismal not because of its absolute
level, but because of the large discrepancy between the performance
of the country in all these aspects and the per capita GDP that it has
achieved in the past years. In particular, following the strong perform-
ance till the 1970s and the strong performance of the past years, per
capita GDP is relatively close to the per capita GDP of the other OECD
and EU member countries. And while Greece remains among the poorer
half of these groups, it still can distance itself clearly from most other
countries that do not participate in these two groups of privileged
countries. On the other hand all the other performance indicators
mentioned above are clearly much weaker than the performance of all
other OECD and EU member countries. Here Greece clearly is placed,
repeatedly, in the middle of the sample of all the countries in the world,
and not in the top 20 per cent of the countries, as is the case with per
capita GDP. Greece, ultimately, emerges as a country with almost first-
class per capita GDP but clearly second-class governance, institutions,
business environment and corruption.
The factors analysed previously that document why Greece grew so
fast in spite of these shortcomings can also reconcile the recent per-
formance of Greece with the now extended literature, mainly of OECD
Economic Department Working Papers,3 that directly link the perform-
ance of an economy with the quality of the regulatory framework and
the prevalence of competitive markets. In a similar way one can rec-
oncile also almost all of the other weak performances of the country,
which range from research and innovation (Bassanini et al. 2000) to the
protection of the environment, the quality of public health services and
schools and the performance of the higher education system (Bassanini
and Scarpetta 2001; Mitsopoulos and Pelagidis 2007; OECD 2007b).
132 The Euro Crisis
65
60
55
50
45
40
35
30
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Figure 4.7 Employment ratio for the population over 15 years of age
Source: Authors elaboration from Eurostat database, 2011, Brussels,Eurostat.
Evangelia Desli and Theodore Pelagidis 133
and especially the young that seek salaried labour. Under 26 year-olds
unemployment is more than 35 per cent and 20 per cent for women and
men correspondingly today. This should be read as under-utilization of
a dynamic labour force, and should not be considered solely as a major
social or ethical issue. Also, one would be right to suppose that the riots
of December 2008 had their roots in the marginalization of huge masses
of unemployed young people.
The main index that is used regarding the debt sustainability is the
debt-to-GDP ratio. Debt-to-GDP ratio did not increase due to high GDP
growth but alarmingly did not experience a decline. As long as GDP
experienced a strong growth the denominator in the ratio would keep
the various components in stable mode. Alongside this, a low interest
rate environment was enjoyed as a result of being part of the eurozone.
Thus, it was perceived that the debt was under control. However, this
was deceiving as after 2003 government expenses were rising and at the
end of 2009 the projected budget deficit was 12.7 per cent vs. expected
5.1 per cent of GDP (in the Annual Budget of 2009) leading in May 2010
to the a110 billion bailout package offered by the EU, the ECB, and the
IMF (troika).
35%
22.9%
22.2%
21.7%
21.5%
21.6%
21.3%
21.2%
30%
20.7%
25%
17.5%
15.2%
15.6%
15.0%
20% 14.7%
19.2%
19.0%
14.8%
17.5%
17.1%
17.2%
14.4%
15.3%
14.4%
16.3%
15%
14.6%
13.9%
15.7%
15.7%
15.2%
13.7%
14.1%
14.0%
10%
5%
0%
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010E
2011B
Figure 4.8 Net revenue, primary expenditure and interest expenditure of Greek
central government budget
Notes: E estimate, B budget, including stability and Growth Program update of budget
with measures taken up to March 2011.
Source: Annual government budgets, various years.
Notes: *GDP 2005 upward revised 20% by adding part of the Black economy. ** Central
Government Debt.
Source: Ministry of Finance, Annual Government Budget 2010 (p. 49 and p. 64).
136 The Euro Crisis
0.30 1.2
1.0
0.8
0.25 0.6
0.4
0.2
0.20
0.0
0.2
0.15 0.4
0.6
0.8
0.10 1.0
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009E
2010B
Figure 4.9 Interest cover of Greek general government
Source: Ministry of Finance, Annual Government Budgets, various years.
permanent once the new tax law is finalized and adopted by the end
of September 2011. Only a smaller part of these measures, less than
one third,4 comprises expenditure cuts or the freezing of expenditure
increases. In addition, these additional measures will probably simply
cancel out revenue shortfalls. This could easily happen if the recession
of the Greek economy gathers pace until determined efforts to reform
the issues analysed in this chapter are undertaken.
The significance and size of these risks, as well as the potential sug-
gested from the experience of other countries regarding these reforms
in combination with the currently adverse ranking of Greece on these
aspects, strongly suggests the appropriate way to move forward, swiftly
and decisively. At the same time it has to be stressed that in such a
virtuous development it will be much easier to implement a program
to reduce the shadow economy and to extract tax revenue from it.
Of course even if these three issues are tackled, with a determined
product reform program, a satisfactory reform of the social security sys-
tem and a continuation of other efforts that would lead to a rapid decline
in the cost of borrowing for the Greek government, a number of realities
will still prevail in the short term for the Greek public finances. So, it
will remain as a reality that the Greek public sector not only has more
employees than it needs, but that they are paid on average very gener-
ously when compared to private sector salaries. It will remain, above
these realities, that the human resources management and the organiza-
tional chart of the public sector does not permit its efficient operation
and the supply of quality services at low cost to society. Unfortunately
this problem has no easy and fast solution. Given that a reduction in
the size of public sector employees not only will adversely affect the job
market, but also will probably involve the risk of expelling the better
working but less well connected, in clientelistic terms, part of the staff.
Thereby cuts in the average pay of public sector employees should be
preferred over lay-offs. The argument for pay cuts, over lay-offs, is also
substantiated by the high average wage bill per public employee that was
revealed by the data presented in Mitsopoulos and Pelagidis (2011). At
the same time the better management of wage bills will become possible
through the operation of a centralized payment system. This system to
be introduced should be able to identify potential cuts in a way that
will not hurt too much those who receive relatively low pay and mainly
seek out those cases in which numerous hand-outs and wage related
payments lead to very high annual incomes that are not justified by the
quality and quantity of the services provided. Tackling the issue of public
sector pay is of significant importance, as after the payments for public
Evangelia Desli and Theodore Pelagidis 139
sector pensioners and social security funds and interests on debt the
wage bill is the third big expenditure of the budget amounting to 28.4
per cent of all central government expenditure in 2009, with all other
expenditure items such as wage bills, being less significant.
The reform of the social security system and the reduction of the wage
bill are pressing priorities since projections to increase taxes are subject to
the developments of the economy and the resilience of economic activ-
ity, while expenditure cuts will yield the budgeted savings with certainty,
regardless of the developments of the economic situation and despite the
fact that some reductions in tax revenues should be expected as a result
of. As a result the measures implemented since December 2009 and till
May 2010, which included increases in consumption taxes on value
added, fuels, tobacco, alcohol and so called luxury items as well as a
number of extraordinary taxes on profitable corporations, high personal
incomes and big estates are all subject to the development of this con-
jecture. A deepening of the recession will easily evaporate the projected
increase of revenue, undermining the effort of fiscal consolidation. On
the other hand only 30 per cent of the measures announced in this period
refer to cuts in expenditures or the freezing of increases in expenditure.
This is unfortunate since, according to Guichard et al. (2007), episodes
of fiscal consolidation that are based on government revenue increases
are generally less successful and long-lived than the ones that are based
on expenditure cuts. The size and historic growth rates of the wage bill
and the social security related items that have been mentioned singles
out these two items as the preferred targets for such cuts, as has already
been described. Such cuts will have also a further implication. Today the
numerous public sector employees that, relative to the private sector,
receive high pay and produce no value added contribute to the pattern
of disproportionally, when compared to other European countries, and
high consumption as a percentage of GDP that prevails today in Greece.
A reduction in the excessive public sector wage and public sector pensions
bill will contribute towards the rationalization of this statistic as well.
consolidation, one can identify during the first year of the implemen-
tation of the Memorandum an initial unwillingness of the responsi-
ble ministers to fully conform with the spirit of the Memorandum.
Subsequent and increasing pressure from the lenders led finally, with
great delay, to the presentation of initiatives that seem to conform with
the basic guidelines of the Memorandum. Road freight was deregulated,
with a three-year adaptation period, only after repeated oscillations by
the responsible ministers and after the exercise of intense pressure from
the lenders. An initial effort to deregulate professional services with
law 3919/2011 ultimately succumbed, at least partly, to the pressures
of the legal profession and, especially, engineering representatives. This
is clearly documented by the opinion 11/VI/2011 of the Competition
Authority, which was mandated by the Memorandum. Further uncer-
tainties regarding the genuine deregulation for the competitiveness of
the economy, job market and government budget professions emerged
with the postponement of the deadline for the deregulation of medical
professions to the end of 2011, which is to be added to the half-hearted
deregulation of the pharmacists profession, in which for example
constraints such as the mandatory ownership by a licensed pharmacist
remain. Regarding the reduction of red-tape, a one-stop shop for com-
pany start-ups was created, even though the underlying procedure was
not significantly simplified and its effectiveness seems to be questioned
by various observers. Furthermore, an action plan to identify 30 obsta-
cles to doing business still had not been implemented by summer 2011,
even though working groups supposedly made progress in their draft-
ing. Finally, regarding the energy market the entire main challenges
still remained by the summer of 2011. On other fronts though, some
behind-the-scenes progress was gradually becoming apparent, as for
example with the important issue relating to licensing and spatial plan-
ning, which is especially important to production and manufacturing.
By the summer of 2011 key pieces of legislation had been put in place,
for example, law 3982/2011 which significantly simplifies the process
for smaller establishments. By the summer of 2011 the new process for
environmental licensing, which is the crucial remaining obstacle for
larger establishments, was still in progress, though reportedly very
advanced. Also missing were a couple of secondary decrees, which were
expected to be completed within a reasonable amount of time. Drafts
for the two last were announced soon after a cabinet reshuffling in early
2011 and were due to be legislated by SeptemberOctober 2011.
Since product market reforms usually take some time to bear
fruit, the insistence to allocate them mostly towards the end of the
Evangelia Desli and Theodore Pelagidis 143
Y / dt pY iY f Y.
d(lY) (4.1)
l p (ig)
g f, (4.2)
Evangelia Desli and Theodore Pelagidis 145
20
15
10
% GDP
10
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 4.10 Greek debt-to-GDP ratio since 1991 and its decomposition
Source: European Commission, AMECO database, 2011.
146 The Euro Crisis
l
4.2 Greek debt dynamics (l)
4.2.1 GDP growth (g)
According to the response of the Greek government to the updated
Stability and Growth Program submitted at the beginning of 2010,
the return of satisfactory growth from 2011 will gradually dilute the
ratio of general government expenditures to GDP. This is expected to
materialize without necessitating their decline in absolute size or even
permitting their increase after 2010. At the same time the increase of
taxable incomes and profits, along with the growth of GDP, will permit
an increase in the revenue of the general government not only as a per-
centage of GDP but, most significantly, by a sizeable absolute number.
Another path to the reduction of debt is via the snowball effect
which is the contribution of interest and nominal growth (ig). g The
success of this strategy evidently depends crucially on the ability of
the economy to return to the projected, as in the Stability and Growth
Program, positive growth rates after 2010. However, one cannot pre-
dict with relative certainty. According to the Hellenic National Reform
Programme 201114 (April 2011) the forecast for 2011 is 3 per cent
and for 2012 is +1.1 per cent. The main question here is what will
be the sources of growth: investment is falling, 16 per cent in 2010;
imports are also falling to 4.8 per cent for 2010 from 18.6 per cent
for 2009 while exports recorded a rebound in 2010 at 3.8 per cent of
GDP (as opposed to 20.1 per cent in 2009) and they are expected to
exceed 6 per cent in 2011 but they cannot compensate for the severe
domestic expenditure contraction. If the euro continues to recover as
has been observed during recent months, things will get worse. What is
more close to reality is Buiters et al. (2011) forecast for a negative real
growth of 1 per cent in 2012.
(p)
4.2.2 Primary budget (p
The primary budget is expected to be 0.9 per cent in 2012.6 This can
be mainly achieved with strengthening the revenue administration so it
can succeed in big revenue increases as well as with budgetary discipline
with a focus on expenditure cutting.
Greece collects less direct and indirect taxes as percentage of GDP
when compared to the average of EU with tax evasion being a system-
atic problem. The European Commission shows the collection of tax
revenue as percentage of GDP is almost half the amount that the EU
member states collect7 and so there is plenty of room for the Greek tax
authorities to broaden the tax base and substantially increase revenue
148 The Euro Crisis
from direct taxes, a fact that will help the country to show a positive
primary balance at least from 2012.
Here it is also worth noting that the income tax in 2010 compared to
2009 was reduced by 13.9 per cent and the estimated tax evasion dur-
ing the same period increased by a magnitude of 1 billion euros. The
tax amnesty in 2010 contributed almost 1 billion euros (0.4 per cent of
GDP) to revenues, but it also provided the incentive to continue such a
practice and thus it is expected to reduce future tax compliance further.
One should not forget that any great success on that issue, that is, suc-
ceeding in closing the tax loopholes, will always drag down GDP, which
on the other hand, is absolutely crucial to service the debt.
Source: Authors own estimations from Ministry of Finance, Annual Budget Report 2011,
Athens 2011.
Evangelia Desli and Theodore Pelagidis 149
with an average primary surplus of 5 per cent and the snowball effect
g changing from 2 per cent to 9 per cent. The rather optimistic
(ig)
7 per cent reduction of the snowball effect will be mainly due to the
reduction of the interest payment as percentage of GDP originating
from achieving the 30-year repayment period along with an average low
interest rate of 4.5 per cent for all the renewed bonds; this is explained
in Appendix A. When no stock flow adjustments are assumed the debt-
to-GDP ratio would drop to 80 per cent and with successful privatiza-
tion it would drop to 60 per cent. This is the only scenario that the
debt-to-GDP ratio falls below the 100 per cent threshold and becomes
sustainable and if additionally the privatization is successful, along with
no other out-of-budget expenditure surprises, the debt threshold that
the global financial markets would find sufficient is reached. All the
scenarios are presented in Appendix A.
Therefore even after a reduction of the interest payments a realistic
scenario indicates debt unsustainability and only the most optimistic
scenario brings the debt-to-GDP ratio to the acceptable levels. As most
likely the true state will be closer to scenario 4, it seems unlikely that
the debt-to-GDP ratio will fall below the 100 per cent at the end of
the 2015 or at best it will fall marginally below this threshold. Hence,
in the long run, a serious debt restructuring may be the only way
forward.
In this paper we have started out with a brief description and analysis
of the prosperous years 19952008 where high growth rates along with
high productivity prevailed. The prosperity was mainly due to demand
injections such as cheap credit, money from tourism and the shipping
boom, EU structural funds, the boost from the Olympic Games and
Athens area infrastructure, limited reforms (banking, telecoms, some
PrivatePublic Partnerships, but that is all, more or less) and most
importantly extensive public borrowing.
At the same time the falling competitiveness of Greeces economy was
indicated by persisting inflation differentials and double-digit current
account deficits and budget deficits as well as close to zero net FDIs. The
country in terms of competitiveness, business environment, administra-
tive cost and governance surveys was consistently ranked at a level that
is disproportionally low when compared to its per capita GDP or even
to GDP per worker.
Additionally we observe the presence of institutional weaknesses
and poor governance along with the incidence of extensive market
regulation that forced on both the real economy and the economic
institutions obsolete and rigid structures along with corruption. Both of
the above weaknesses were present for a number of decades and were
disregarded or set aside by looking only at the spectacular GDP growth
but they consistently led to the actual output of Greece to be lower than
its potential output (persistent inefficiency).
Finally, the high productivity is rather a deception as during that
period it is the result of a combination of an artificially ballooning
GDP (nominator) and low labour force participation rate (denomina-
tor). On the one hand, very few unregulated and tax evading self-
employed (over) work while, on the other hand, few salaried employees
work, within a context of closed and rigid product, service and labour
markets. So, unemployment and non-employed rates are very high,
especially among unconnected young.
All of the above had a major negative impact on the primary deficit
surplus/deficit and at the end of 2009 the projected budget deficit was
12.7 per cent vs. an expected 5.1 per cent of GDP (currently at 15.4
per cent). Initially the deterioration of the budget deficit and its impact on
public debt was masked by the low borrowing interest rate environment
that resulted from the EMU accession. However, as most EU countries
seemed to get out of recession at the end of 2009, Greece did not follow
and the result was the widening spreads during spring 2010. The Greek
Evangelia Desli and Theodore Pelagidis 153
debt-to-GDP ratio from 71 per cent in 1990 exceeded the 100 per cent
threshold in 2000 and it is expected to reach 158 per cent in 2011 and
even higher in 2012. Looking through the debt dynamics identity, the
contributing components of the debt (structural and cyclical primary defi-
cit ratio, snowball effect, which is mainly affected by the interest payments
and nominal growth, and the stock flow adjustment ratio) are discussed.
We constructed five scenarios regarding the level of public debt at the
end of the 201115 period in which it is commonly accepted that Greece
could return to global financial markets to finance its debt. We find that
only under a very optimistic scenario of robust growth of the economy,
based on structural and institutional reforms that boost productivity,
significantly improve competitiveness, and boost the financial sector, as
described in the Growth and Stability Program, can this happen. Only
under these conditions, along with a successful privatization of 50 billion
euros, the public debt to GDP ratio can reach the 60 per cent threshold
that the financial markets find comfortable. Alarmingly the more realistic
scenarios put the debt to GDP ratio above the 100 per cent threshold and
this raises many questions about the sustainability of the Greek debt.
So, the only possible options the Greek economy has are the follow-
ing: open markets; reduce unnecessary regulation; encourage reform in
education and job creation (through any kind of tax credits); fix public
finances by cutting public waste and taxing the untaxed privileged so as
not to hit domestic demand; create incentives for the black economy to
incorporate to the official one; and build well-functioning, independent
institutions and an administration not corrupted by the rents the closed
markets create now.
Notes
1. Parts of this paper have been presented at the LSE/HO seminar on 9 February
2010, at the Brookings Roundtable Series on the State of the Eurozone on
4 March 2011, and at the Bilbao Conference 27 June1 July 2011. It has
benefited from comments and suggestions from the audiences, especially
from J. Spraos, K. Featherstone, V. Monastiriotis, R. Henning, A. de Lecea,
C. Bastasin, J. Vaise, as well as from an anonumous referee. The paper
also draws from the work of T. Pelagidis with M. Mitsopoulos, especially
Mitsopoulos and Pelagidis (2011). The usual disclaimer applies.
2. Although to a certain extent, tourism that constitutes a significant part of
services should be considered also as a tradable service.
3. An indicative selection of related OECD and non-OECD related publications
is: OECD 2007a; Conway et al. 2006; Bassanini and Duval 2006; Nicoletti and
Scarpetta 2005; Nicoletti and Scarpetta 2006; Conway et al. 2005; Bassanini
and Ernst 2002; Scarpetta et al. 2002; Scarpetta and Tressel 2002; Nicoletti and
154 The Euro Crisis
Scarpetta 2003; OECD 2003; Alesina et al. 2003; Nicoletti et al. 2001; Conway
et al. 2006.
4. See Greek Stability and Growth Program, projections. January 2010, Greek
Government.
5. As this paper is written it is expected that this figure will be updated to
28 billion euros in the latest projections in The Economic Adjustment
Programme for Greece Fourth Review spring 2011 (European Commission
Directorate-General for Economic and Financial Affairs, 2011). As no specific
figures exist as of September 2011, we used the initial figure of 50 billion euros
in the scenarios for the progress of the public debt over the period 201115.
6. Bruegel Institute (http://www.bruegel.org/) estimates that to bring debt down
to 60%, the primary surplus should be strongly positive, around 8.4% during
201434. No country except Norway has managed to keep such a surplus
for so many years and without any negative repercussions on growth as it
requires large expenditure cuts and huge tax increases.
7. European Commission, Taxation Trends in EU, U Brussels, 2010.
References
Ackerman, S.A. (ed.) (2006). International Handbook on the Economics of Corruption,
Yale University Press.
Afonso, A., and M.S. Aubyn (2005). Non-Parametric Approaches to Education
and Health Efficieny in OECD Countries, Journal of Applied Economics, VIII
(2), pp. 22746.
Afonso A., L. Schuknecht and V. Tanzi (2005). Public sector efficiency: An inter-
national comparison, Public Choice, 123 (34), pp. 32147.
Arestis, P., G. Chortareas and E. Desli (2006). Financial Development and
Productive Efficiency in OECD Countries: An explanatory Analysis, The
Manchester School, 74 (4), pp. 41740.
Bank of Greece (2009), Annual Report of the President, Athens, Bank of Greece.
Bassanini, A., S. Scarpetta and I. Visco (2000). Knowledge, Technology and Econ-
omic Growth: Recent Evidence from OECD Countries, OECD ECO WP 259.
Bassanini, A. and S. Scarpetta (2001). Does Human Capital Matter for Growth in
OECD Countries?, ECO WP 282.
Bassanini, A. and E. Ernst. (2002). Labour Market Institutions, Product Market
Regulation and Innovation. Cross Country Evidence, ECO WP 316.
Bassanini, A. and R. Duval. (2006). Employment Patterns in OECD Countries.
Reassessing the Role of Policies and Institutions, ECO WP 486.
Buiter, W., E. Rahbari, J. Michels, and G. Giani (2011). Global Economics View.
The Debt of Nations, Citigroup Publications #1, http://www.nber.org/~wbuiter/
DoN.pdf.
Conway, P., V. Janod, and G. Nicoletti (2005). Product Market Regulation in
OECD Countries: 1998 to 2003, OECD ECO WP 419.
Conway, P., D. de Rosa, G. Nicoletti and F. Steiner (2006). Regulation,
Competition and Productivity Convergence, OECD ECO WP No. 509.
Conway, P. and G. Nicoletti (2006). Product Market Regulation in the Non-
manufacturing Sectors of OECD Countries: Measurement and Highlights,
OECD ECO WP 530.
Evangelia Desli and Theodore Pelagidis 155
Appendix A
Applying the debt dynamics described in equation (1) on the five debt scenarios
the level of debt to GDP ratio at the end of 2015(_2015) is given in Tables 4.5
and 4.6. Table 4.5 assumes no stock flow adjustment while Table 4.6 assumes
that privatization will be fully successful raising 50 billion euros along with
minor budget expenditures (5 billion euros) related adjustments (scenarios
A and C) or partially successful raising 25 billion euros along with the same
minor budget expenditures related adjustments (scenario B).
1. Scenario IMF A: the base reform scenario, with an average primary surplus of
5 per cent and zero snowball effect (ig=0).
g
2. Scenario IMF B: a more realistic scenario with an average primary surplus of
3 per cent and a snowball effect (ig)
g of +3 per cent to reflect concerns of lack
of a timely and strong GDP growth.
3. Scenario IMF C: an optimistic reform scenario, with an average primary
surplus of 5 per cent and a snowball effect (ig)g of 2 per cent that is the
result of a robust growth of the economy based on structural and institutional
reforms that boost productivity, significantly improve competitiveness, and
boost the financial sector.
Annual
Scenarios without financial dl/dt
dl l_(2015)
l p ig f
adjustments
1 IMF scenario A 5 125 5 0 0
2 IMF scenario B 0 150 3 3 0
3 IMF scenario C 7 115 5 2 0
4 IMF scenario B plus 5 125 3 2 0
interest reduction 5
5 IMF scenario C plus 14 80 5 9 0
interest reduction 7
Annual
Scenarios without financial dl/dt
dl l
l_(2015) p ig f
adjustments
1 IMF scenario A 9 105 5 0 20
2 IMF scenario B 2 140 3 3 10
3 IMF scenario C 11 95 5 2 20
4 IMF scenario B plus 7 115 3 2 10
interest reduction 5
5 IMF scenario C plus 18 60 5 9 20
interest reduction 7
158 The Euro Crisis
Scenarios 4 and 5 assume that approximately 210 billion euros of the Greek debt
is due to be refinanced during the period (2011)15 with an average interest
rate of 13 per cent and average length of 7.5 years. Following the latest efforts
to reduce the Greek debt, a realistic scenario would be that these bonds will be
replaced by an average interest rate of 7 per cent and average length of 15 years
(or equivalently interest rate of 10 per cent and average length of 30 years) deliv-
ering an overall reduction to the snowball effect of 5 per cent. An optimistic
scenario would be that these bonds will be replaced by an average interest rate
of 4.5 per cent and average length of 30 years delivering an overall reduction to
the snowball effect of 7 per cent.
4. Scenario IMF B plus an interest payment reduction of 5 per cent: the more
g changing from 3 per cent
realistic scenario (2) with the snowball effect (ig)
to 2%.
5. Scenario IMF C plus a severe interest payment reduction of 7 per cent: the
optimistic reform scenario, with the snowball effect (ig)g changing from 2
per cent to 7 per cent.
5
The Irish Tragedy
Yiannis Kitromilides1
1 Introduction
Within the space of one year, over the period May 2010 and May 2011,
and at roughly equal intervals, there have been three bail-outs of euro-
zone economies. Ireland was the second economy to have received an
EU/IMF bail-out in November 2010. It was preceded by Greece in May
2010 and followed by Portugal in May 2011. The inclusion of Ireland
among the three euro-zone countries in need of an international bail-
out was surprising. This is because Ireland, unlike Greece and Portugal,
was a miracle growth economy, a Celtic Tiger that was transformed
in the space of 20 years from a poor, stagnant peripheral economy to
one of the richest in terms of per capita income economies in Europe.
In fact, Ireland became a role model for other peripheral economies.
This paper is an examination of Irelands rags to riches journey and its
tragic collapse in 2008. It begins by considering the main elements of
the Irish growth model and the various explanations for the astonish-
ing success of the model. It proceeds to review three periods of Irish
economic history: the protectionist and inward-looking period between
1922 to the early 1950s; the modernization period of the early 1950s to
the late 1980s that laid the foundations for an export-led growth strat-
egy relying on Foreign Direct Investment (FDI); and the Celtic Tiger
period of early 1990s to 2008.
It is worth repeating that Ireland does not fit in well either within the
group of countries that have received bail-out assistance or within the
wider grouping of the PIGS countries. (Portugal, Ireland, Greece, Spain,
to which Italy is sometimes added to give PIIGS.) The letter I in the
often-used acronym seems, at least geographically, out of place. Ireland
is not, of course part of southern Europe. Neither is the alternative (and
no less offensive) description of the heavily indebted economies of the
euro-zone countries as the siesta states2 remotely relevant in the case of
Ireland. What makes Ireland stand out, especially among the group of
euro-zone countries in receipt of an international bail-out is, above all,
the fact that unlike Greece or Portugal the Irish economy was considered
prior to the onset of the Great Recession in 2008 to be an example and a
role model for other small peripheral economies. From 1995 until 2007
Ireland experienced spectacularly high levels of economic growth which
produced a radical transformation of the Irish economy and society.
Unemployment, for long a persistent problem of the Irish economy,
was effectively eliminated. Moreover, a country used for long periods of
its history to seeing successive generations of its youth emigrating had
the novel experience of becoming a destination for immigrants, from
Yiannis Kitromilides 161
Eastern Europe, Africa, Latin America and Asia, attracted to Ireland by its
long economic boom. With regard to public finances and total indebted-
ness Ireland had consistently remained within the Maastricht criteria of
less than 3 per cent budget deficits and 60 per cent total debt-to-GDP
ratios. This economic boom made Ireland a Tiger economy, a term bor-
rowed from the success of the East Asian economies in the 1980s and
early 1990s (Kirby 2010b). Nothing of comparable size in terms of eco-
nomic growth and rise in per capita incomes occurred during the same
period in either Greece or Portugal. In fact, had the global financial crisis
occurred in 1988 instead of 2008 it would not have been at all surprising
to find Ireland grouped with Greece and Portugal as economies so dam-
aged by the crisis as to require international bail-outs. During the 1980s
Irelands total debt-to-GDP ratio had reached 125 per cent while eco-
nomic growth averaged only 1.9 per cent (Duff 2007, p. 2). This paper is
an examination of Irelands tragic journey: from the economic take-off
away from the periphery of Europe to the crash landing back into the
economic periphery in the space of 20 years.
The plan of the paper is as follows: section 2 briefly examines the
economic history of Ireland prior to the 2008 global economic crisis and
considers the nature of economic policymaking that produced the rags
to riches transformation of Ireland from one of the poorest economies
in terms of per capita GDP in Europe to one of the richest; section 3
describes the main features of the catastrophic collapse of the Irish
economy after 2008, while section 4 evaluates alternative explanations
concerning the underlying causes of the Irish crisis; section 5 considers
developments in Ireland and Europe since the Irish bail-out and section
6 summarizes and concludes.
to the openness of the Irish economy and high emigration, this time
of highly-skilled young graduates. In addition to the many economic
problems, the 1980s was also a period of extreme political instability
with frequent changes of government punctuated with many instances
of political corruption. As Dorgan (2006) points out: The atmosphere
of the 1980s was more redolent of the dark years of the 1950s than of
the optimism that had permeated the two decades in between This
was not what the policies of the previous 25 years had been designed to
achieve. What had gone wrong? (p. 6).
Implicit in the what went wrong question in the quote above is
the assumption that the answer is to be sought outside the economic
model that underpinned the growth strategy and the economic policies
pursued during the second phase of Irish economic history between the
mid-1950s and the end of the 1980s: the assumption was that the model
was sound but there was something missing in its application. The cen-
tral elements of the neoliberal model were: trade liberalization; a low
corporation tax regime and other market-friendly public policies; unim-
peded access of foreign multinationals to the European market using an
English-speaking, highly-educated and low-cost work-force. Despite the
gradual introduction of all these measures the Irish economy during
the 1980s was in a critical state of high unemployment, high inflation,
high emigration, high public indebtedness and low economic growth.
According to Dorgan (2006) although external factors such as the weak
global economic conditions, persistent inflation and the fading impact
of EEC entry all contributed to the economic problems of the 1980s,
the principle cause of the Irish economic malaise was Big Government.
A similar conclusion was reached by Duff (2007). The missing element
for the successful implementation of the Irish economic model was of
course considered to be the establishment of small government, the
abandonment of Keynesian4 macroeconomic policies and the achieve-
ment of a climate of political stability. What this required was cuts in
public spending, reduction in public sector employment, a sustained
reduction in public indebtedness and budget deficits, and the establish-
ment of a political consensus on all of these objectives. Efforts towards
achieving a national consensus culminated in 1987 in a successful
Social Partnership Agreement, the result of negotiations organized by
the government and major employer and labour interests, which was to
mark the dawn of the Celtic Tiger phase of Irish economic history.
In 1987 the Fianna Fil party under the leadership of Charles Haughey
won power and, although largely responsible for huge increases in public
spending during their previous period in office and with a pre-election
Yiannis Kitromilides 165
out that small government became part of the road to success (p. 7). It
should of course be noted here that the successful fiscal consolidation
that occurred in Ireland during this period was helped enormously by
the booming conditions in the UK economy which pushed up demand
for Irish exports.
After 1987 the Irish government continued to cut both public spend-
ing and taxes, maintaining some of the lowest levels, as a percentage
of GDP, in these categories in Europe. Small government, however,
did not mean that there was no state intervention in the economy.
The Irish state continued taking steps to promote business investment
and encourage FDI through measures, such as the creation of the
International Financial Services Centre in Dublin, and heavy invest-
ment in the telecommunications industry, which remained under
public ownership until the late 1990s.
The Celtic Tiger phase of Irish economic history between the early
1990s and 2008 can be divided into two sub-periods: the period before
and the period after the collapse of the dotcom bubble in 2001. The
dominant feature of the first sub-period was the huge influx of FDI, by
mainly US multinational corporations and mainly from the computer
and pharmaceutical sectors. In 1989, following years of efforts, the IDA
succeeded in persuading the Intel Corporation to build its first European
manufacturing centre in Ireland. Intel was soon followed by other lead-
ing-edge technology firms including Dell, IBM, Hewlett-Packard and
Microsoft. Ireland attracted, according to Duff (2007), over $70 billion in
investments from the US alone from 1993 to 2002. Undoubtedly FDI was
a significant contributory factor to the Irish economic success during this
sub-period. The favourable global economic condition of the 1990s was
another important contributory factor. A further contributory factor was
the role of EU economic transfers. The truly remarkable transformation
of the Irish economy from one of the poorest to one of the wealthiest
in Europe cannot be explained solely by the prevailing global economic
conditions or EU transfers. Similar global economic conditions prevailed
and comparable EU transfers were made to other peripheral European
economies without achieving similar growth. Economic growth in
Ireland rose to record levels, averaging 9.4 per cent per annum between
1995 and 2000. There were dramatic increases in employment growth
during the same period, while the unemployment rate fell from over
15 per cent in 1993 to just over 4 per cent by 2002. Average industrial
wages grew at one of the highest rates in Europe and at the same time
a striking reversal of previous trends in population growth and emigra-
tion took place: the traditional trend of net emigration was reversed as
Yiannis Kitromilides 167
The bursting of the dotcom bubble in the US and the stalling of many
IT businesses produced the first warning signs of impending trouble for the
Irish Tiger economy. The slow-down in the US economy had an obvious
impact on the Irish economy, given the strong economic links between the
two countries and the leading role played by Ireland in the global IT indus-
try. The large reduction in investment in the global IT industry, therefore,
combined with the global economic slow-down had serious adverse effects
on Irelands high-tech export sector which experienced a decline in the
sectors growth by nearly half. GDP growth also declined but it remained
by international standards relatively robust. In fact the economic down-
turn in Ireland was merely a slow-down in the rate of economic expansion,
not a full-blown recession. There were signs of a recovery in late 2003 and
by 2004 Irish economic growth rates started accelerating again.
The resumption of another period of spectacular Irish economic growth
had been dubbed by the media as the Tiger 2 period. The main engine
for growth during this period was no longer the (mainly) US high-tech,
export-orientated FDI. Rapid economic growth during the Tiger 2 period
was predominantly the result of the activities of the domestic banking
and construction sectors. Understanding the inter-connections between
the two sectors and also the relationship of both sectors with government
is crucial in explaining the nature of the boom conditions in Ireland after
2004. The construction sector in Ireland accounted for nearly 12 per cent
of GDP and a large proportion of employment among young, unskilled
men. Between the early 1990s and 2007 employment in the construction
industry nearly doubled, from about 7 per cent to just over 13 per cent of
the work-force (see Honohan 2009, p. 212). In 2004 80,000 new homes
were constructed in Ireland, half as many as those completed in the
same year in the United Kingdom, which has 15 times Irelands popula-
tion. According to the 2006 census of population, about 15 per cent of
the housing stock was vacant at census date, indicating the speculative
nature of additional housing construction and purchases, mostly by pros-
perous households. One possible explanation for the gigantic construc-
tion boom is that what the large construction sector was doing during the
Tiger 2 period was merely catching up with the demand for construction
caused by the first boom. The first boom created not only big increases
in per capita income but also, for Ireland, an unprecedented increase in
net migration. The construction sector however would not have been
able to do so much catching up, let alone create a property price bubble,
without the finance provided by the Irish banking sector. At the peak of
the boom house prices (deflated by CPI) were rising at nearly 4 per cent
per annum (see Honohan 2009, p. 211). The banking sector, on the other
Yiannis Kitromilides 169
hand, would probably not have been able to finance the property bub-
ble to such a huge and unsustainable extent without two crucial policy
choices made by the Irish political system.
The first set of policy choices go back to the early 1990s when the Irish
government decided that Ireland should become a leading international
centre for off-shore financial services. The major additional attraction for
foreign financial services firms considering setting up operations in Ireland
was, of course, the countrys very light-touch, virtually no-existent, tax
and regulatory framework. This decision would have some unintended but
devastating consequences on the Irish economy: so light-touch and lax was
the countrys banking supervision and financial regulation that by 2005
the New York Times was describing Ireland as the wild west of European
finance (see Lavery and OBrien 2005). The wild west reputation of
Irish banking regulation led to the creation of the Irish Financial Services
Regulatory Authority, which however still failed to spot and prevent some
extremely dubious accounting practices by domestic banks, some of which
came to light after the 2008 crisis including revelations about the corrupt
relationships between the financial sector and Irish politicians. Connor
et al. (2010) put it in a nutshell when they point out: In addition to ignor-
ing, or even condoning, fraudulent accounting, the financial regulator and
Irish central bank made strategic errors in not responding to the build-up
of systemic risk to the banking system (p. 15).
The nature of these policy errors and the various basic warning
signs which the Irish system of prudential regulation and supervision
had ignored are fully analysed by Honohan (2009). First there was an
unhealthy over-expansion in the balance sheet of Irish financial institu-
tions. Balance sheet growth in excess of 20 per cent in any one year is
generally considered imprudent. Yet as Honohan (2009) points out:
The Irish regulator should have taken steps to prevent these danger-
ously high balance-sheet growth rates. Second, the Irish banking sectors
170 The Euro Crisis
up to 12 per cent higher in 2000 (p. 12). The so-called basic design
flaws of the euro-zone are extensively discussed by Arestis and Sawyer
in Chapter 1 in this volume. They can be summarized as follows: first,
the centralization of monetary policy while keeping other instruments
of economic policy under national control is incoherent (Arestis and
Sawyer 2006a, 2006b, 2006c). Second, there is the problem of the one
size fits all interest rate policy: it is clearly impossible to determine one
interest rate level that is appropriate for the needs of 17 heterogeneous
economies. Third, members of a monetary union lack the capacity dur-
ing a crisis to stimulate their economy through the instrument of cur-
rency depreciation. Finally, a budget deficit in a member country can be
transformed by market sentiment from a liquidity crisis into a solvency
crisis, which in turn, through contagion, may threaten the stability of
the whole system. As DeGrauwe (2011) argues, the separation of mon-
etary and fiscal authority is likely to create vulnerabilities and fragilities
in individual member states that are not present in states not belonging
to a monetary union: in a monetary union, financial markets acquire
tremendous power and can force any member country on its knees
(p. 5). As McDonnell (2011) puts it: The absence of control over the
Lender of Last Resort (LOLR) can generate a liquidity crisis for member
states borrowing to support a budget deficit. A loss of confidence by
investors can become a self-fulfilling prophecy, and the liquidity crisis
can degenerate into a solvency crisis (p. 3). The so-called design flaws
of the euro zone, therefore, have not only contributed to the emergence
of the crisis in the periphery but also prevented and continue to pre-
vent, in the absence of radical reforms, its quick resolution.
In the case of Ireland there is little doubt that inappropriately low
interest rates, in combination with the large inflow of credit associated
with this distortion in interest rates and exchange rate risk premiums,
played a crucial role in the creation of the property bubble in Ireland. As
if additional fuel to the property bubble were needed, the Irish govern-
ment aided and abetted the construction frenzy by further providing a
high level of subsidy to the construction sector. It should be noted that
the construction boom and property bubble generated a very high level
of tax revenues from taxes based on property transactions. This tempo-
rary increase in tax revenue, however, was used as an excuse for reduc-
ing income tax and capital gains taxes. With the collapse of the property
boom in 2008, therefore, the Irish tax base had been narrowed to such
an extent that tax receipts collapsed by a third. Further consideration
of how the design flaws of the euro-zone impacted Ireland are given in
section 3 below.
172 The Euro Crisis
Critics of this strategy consider the Tiger 2 boom years as a lost oppor-
tunity for a radical change in policy direction. Clancy and McDonnell
(2011) insist that instead of an unsustainable construction boom Ireland
needed a significant increase in productive infrastructure:
Although the capital stock of the Irish economy soared by 157 per cent
in real terms in 20002008, housing accounted for almost two-thirds
of the increase. Private investment in core productive infrastructure
was described as pitiful in a report by Davy Stockbrokers. For example,
private sector net investment in the capital stock apart from retail,
storage, transportation and house building was only 14.5 bn euro
in the eight years to 2008 (in constant 2007 prices). That equates to
an increase in the volume of the capital stock of 26 per cent. Under-
investment in telecommunications is a particular concern, with Ireland
lagging badly behind for a range of broadband indicators. For example,
Irelands fixed broadband subscription rate per 100 people is the third
lowest in the EU. Ireland followed the low tax/low spend neoliberal
model during the years of the Celtic Tiger. Over the period 1995 to
2008 the level of public spending averaged 34 per cent of GDP, the
third lowest average level of public spending in the OECD during this
period. This was a time when Ireland had relatively low social welfare
demands because of low unemployment and relatively few pensioners.
Ireland failed to exploit this benign fiscal position to ramp up invest-
ment in critical areas such as education, research and development,
child care and social infrastructure, important for the future competi-
tiveness of the country and the long-term well-being of citizens. (p. 2)
Kirby (2010) also insists that the post-2001 period was a missed oppor-
tunity for Ireland to change its growth strategy to one that promoted
domestic industrial development. Once the risks of a growth strategy
that relies heavily on the prospects of foreign MNCs became appar-
ent in the early 2000s, Ireland should have changed course towards a
strategy of encouraging the development of a domestic industrial base
as well as a change in its taxation and distribution policy. This strategy
would have probably produced a less rapid but a more balanced and less
unequal growth path for Ireland.
Moreover, the benefits of rapid miracle economic growth have not
been equally distributed. As Dellepiane and Hardiman (2011) point out:
was the first to feel the impact of the global downturn and when the
property price bubble finally burst in early 2008 the consequences for
Ireland were disastrous: for the construction companies and the work-
ers employed in the industry; for the indebted households who found
themselves in negative equity territory; and for the Irish government
whose major source of revenue was property related taxes. For the Irish
banking sector, however, the consequences of the property crash were
devastating.
The problems for Irish banks caused by the domestic conditions in
the property market were, of course, compounded by the international
financial crisis during 2008. Not only Irish banks and financial insti-
tutions found themselves, owing to domestic factors, with a rapidly
deteriorating loan book but they also found themselves, owing to
international factors (mainly the global liquidity crisis), experiencing
difficulties of rolling over their huge foreign borrowings. As the global
financial crisis gathered momentum during 2008, culminating in the
collapse of Lehman Brothers, Ireland was inevitably engulfed in the
global turmoil over uncertainties concerning the health of the interna-
tional banking system.
As Dellepiane and Hardiman (2011) correctly point out, the Irish crisis
had three inter-linked dimensions: it was not only a financial crisis but
also a crisis in competitiveness and a fiscal crisis. The financial crisis
as we saw above had domestic origins but it was also greatly influ-
enced by Irelands euro-zone membership. Similarly the decline in the
relative competitiveness position of Ireland had domestic origins: the
inflationary effects of cheap credit and rising house prices, fuelled by
irresponsible lending by domestic banks led to loss of competitiveness.
The decline in competitiveness, however, was exacerbated, as was the
decline in the relative competitiveness of Greece, Portugal and Spain,
by structural imbalances between economies of the European single cur-
rency area: the counterpart to the loss of competitiveness in the periph-
ery was the gain in competitiveness in Germany and other countries of
Northern Europe. As already noted above, the domestic origins of the
financial and competitiveness crises need to be seen in relation to the
design flaws of the euro-zone. Undeniably the creation of monetary
union in Europe was as much a political as an economic project from
the outset. The ultimate objective of the political project was of course
closer European integration. The central dilemma was whether politi-
cal integration was a pre-condition for monetary union or whether a
common currency would become an instrument of closer integration.
Eventually the latter view prevailed that nominal unity through a
Yiannis Kitromilides 175
The third factor accounting for the Irish crisis, also extensively
discussed in relation to the crises in other countries, notably the US and
the UK, was regulatory imprudence. As already discussed above, the
problem in Ireland was not so much a failure to regulatee but a failure to
supervisee the banking and financial system. The Irish financial system
neither produced nor consumed any of the toxic financial products that
the US regulators failed to control. The Irish regulatory system simply
failed in its macro-prudential function: it failed to heed all the warning
signs, discussed in section 3 above, concerning the increased systemic
risk that the reckless activities of Irish banks and financial institutions
had created.
The fourth factor contributing to the crisis was the moral hazard prob-
lem: the incentive to act recklessly because of the absence of any personal
consequences to an agents risky and reckless behaviour. There are several
types of moral hazard problems in the financial services sector: there are
moral hazard problems in the originate-and-distribute loan generation
system; in the performance-related bonus system of compensation which
encourages short-termism; and in the implicit government deposit guar-
antee because of the too big to fail or privatization of profits and sociali-
zation of losses argument. The latter moral hazard problem is, of course,
one of the central questions in the debate concerning the reform of the
international banking system in order to prevent recurrence of the crisis:
how to ensure systemic stability without encouraging reckless behaviour
by bankers? In the Irish crisis, however, according to Connor et al. (2010),
although the implicit government guarantee of bank deposits may have
encouraged reckless behaviour, the major source of moral hazard was
weak law enforcement and the ability of politically powerful interests
to manipulate regulatory and legislative processes to their advantage.
As they point out with regard to the two rogue institutions, Anglo Irish
Bank and Irish Nationwide Building Society, which stoked the fires of the
bubble with particularly reckless lending practices: When the magnitude
of the bad loans at the two institutions became clear, along with a host
of accounting and share trading irregularities, both of these bank heads
were forced into retirement. Both of the two rogue-bank heads retired
with their large fortunes intact, and there is little or any hope of financial
recourse by taxpayers or others (p.19). Weak law enforcement induced
reckless behaviour not only in the financial services sector but also in the
construction sector. Many large property developers in Ireland had very
close connections to the ruling political Fianna Fil party. As Kelly (2009)
explains, in the Irish business environment it was not a question of being
too big to fail but of being too connected to fail.
180 The Euro Crisis
losses (p. 3). Capitalization needs of a 24 billion for the four domestic
banks have been identified by the 2011 Prudential Capital Assessment
Review (PCAR) whose calculations have been informed by the Black
Rock Solutions projections. These capital requirements should allow
the banks to offset potential losses and still meet 10.5 per cent and
6 per cent of Core Tier 1 capital ratios in base and stress scenarios,
respectively. The net fiscal cost is to be mitigated by liability manage-
ment exercises on subordinated debt assumed to be about a 5 billion
(see Central Bank of Ireland 2011).
With regard to the deleveraging of the Irish banking system the FMP
also included a Prudential Liquidity Assessment Review (PLAR) for 2011.
This review establishes funding targets for banks included in the PCAR
with the aim of reducing the leverage of the banking system and reduce
banks reliance on short-term, largely central bank, funding. Moreover
these measures ensure convergence to Basel III liquidity standards over
time, in particular a loan-to-deposit ratio of 122.5 per cent by end 2013.
The Central Bank of Ireland completed the assessment of the banks
restructuring plans to meet those targets.7
In addition to the recapitilization and deleveraging of the banking
system, the Department of Finance (2011) announced a reorganization
of the domestic banks around two pillar banks: the first pillar bank
will be created from the already strong franchise of Bank of Ireland and
the second pillar bank will be formed by strengthening the franchises
of Allied Irish Bank and EBS building society. As the Finance Minister
puts it: Each of these banks will re-organise their operations into
core and non-core functions. With a carefully managed programme
of deleveraging, by 2013, as the non-core assets which do not serve
growth on the island of Ireland disappear, the Pillar banks should
start to better serve the economy as functioning banks rather than the
oversized, overleveraged banks they now are (Department of Finance
2011, p. 1).
The Irish governments banking announcements at the end of March
2011 were welcomed by the EC, ECB and IMF as a major step towards
restoring the health of the Irish banking system. Market reaction to the
banking announcements was also positive since the markets considered
the Bank of Irelands PCAR/PLAR calculations credible. Initially bond
spreads declined but only temporarily. The upward trend in Irish bond
spreads resumed as soon as wider concerns reflecting developments
in Portugal and Greece and further ratings downgrades reflecting the
potential for debt restructuring and sovereign defaults in Europe started
dominating market sentiment.
184 The Euro Crisis
Starting from the principle that Irish and European taxpayers should
not to be obliged to honour any of the private debts of the failed banks
McDonnell (2011) recommends that the recapitalization process of the
Irish banking system proposed by the Irish government and endorsed
by the ECECBIMF should be halted immediately:
The program risks must be actively managed with support from a more
comprehensive European plan. Timely implementation of the banking
strategy recapitalization, reorganizing and deleveraging the viable
banks, and resolving the non-viable banks remains critical for pro-
gram success in restoring the banking sector to healthy functionality
so it can begin to contribute to renewed growth. This intensive effort
must continue to be underpinned by fiscal consolidation and structural
reforms to overcome doubts regarding the feasibility of the fiscal adjust-
ment and regarding growth prospects in the medium term. (p. 1)
186 The Euro Crisis
According to the IMF Report (2011) the recession in Ireland has been
protracted and deep, with no firm recovery in sight.
A comprehensive European plan, however, so crucial, according to
the IMF, for the recovery in Ireland and by implication in other distressed
euro-zone economies is also nowhere in sight, despite the euphoria cre-
ated by the measures announced in July 2011 after the second bail-out
of Greece. These measures can be summarized as follows. First, Greece
is not only to receive more bail-out loans to the tune of 109 billion euro
but also some interest debt relief. Lower interest rates will be extended
also to Portugal and Ireland. Lower interest rates will undoubtedly ease
the debt burden in all three countries. However, whether by itself this
measure will make the debt load sustainable is a moot point. Second,
maturities on a chunk of Greek debt, currently estimated at 160 per cent
of GDP, will be pushed off well into the future up to 30 years while
some will actually be bought back and retired. A voluntary agreement by
private sector creditors to accept a hair-cut on their Greek debt was also
announced. What proportion of the Greek debt will actually be reduced
by this measure will depend to a great extent on how much voluntary
involvement the euro-zone gets from private investors. Third, the leaders
of the 17 euro-zone countries expanded the use of the European Financial
Stability Facility (EFSF) and the European Stability Mechanism (ESM).
The strengthening of the EFSF and ESM, if it materializes, will represent a
significant step towards the creation of a mini IMF for the euro-zone. By
permitting money to be used for weak euro members before their situa-
tion becomes critical future bail-outs in the euro-zone may be prevented.
Finally, euro-zone leaders announced a Marshall Plan to boost growth
in Europe. The Final Statement (2011) issued at the summit says: We call
for a comprehensive strategy for growth and investment in Greece. We
welcome the Commissions decision to create a Task Force which will work
with the Greek authorities to target the structural funds on competitive-
ness and growth, job creation and training. We will mobilise EU funds
and institutions such as the EIB towards this goal and relaunch the Greek
economy. Europes leaders made a bold commitment to stand behind the
euro-zones bailed-out economies indefinitely and according to the Final
Statement (2011): We are determined to continue to provide support to
countries under programmes until they have regained market access, pro-
vided they successfully implement those programmes (p. 1).
Similarly, Baroin and Schauble (2011), the finance ministers of France
and Germany respectively insist:
a crisis that could damage the euro-zone as a whole, and the euro
as a consequence. But we are not naive. Rebuilding confidence
in the euro-zone will require patience, considerable stamina and
vision. We have embarked on a way to ever closer co-ordination and
co-operation of our national fiscal policies. Only by evolving the
European monetary unions institutional structures in such a way
that euro members are obliged to adopt a fiscal and economic policy
that reflects their joint responsibility for the common currency will
we master the challenges that lie ahead. (p. 1)
Notes
1. The author is Visiting Research Fellow at the Centre for International Business
and Sustainability, London Metropolitan University. He has previously
taught at the University of Greenwich, University of Westminster, University
of Middlesex, and at the School of Oriental and African Studies, University of
London. He is grateful for helpful comments by the participants to the 8th
International Conference, entitled Developments in Economic Theory and Policy,
held at Universidad del Pais Vasco, Bilbao, Spain, 29 June1 July 2011. He
is particularly grateful to Philip Arestis, Gary Dymski and Photis Lysandrou
who, of course, are not responsible for any remaining errors and omissions.
2. The term siesta states was first used by Liddle (2010).
3. In 1937 the Eamon de Valera government introduced, after referendum, a
new constitution, replacing the one agreed after the formation of the Irish
Free State. According to the new constitution the Irish Free State was to be
renamed Eire and the head of state would be an elected president, not the
British monarch.
4. The ideological attack on the failure of Keynesian policies during this period
ignores the fact that Keynes (1936) in the Notes on Mercantilism in the
General Theory advised caution on the use of expansionary fiscal policy in an
open economy.
5. The strategy was named after a speech given by Alan Dukes to the Tallaght
Chamber of Commerce on 2 September 1987.
6. The term Celtic Tiger was first used by Gardiner (1994). The East Asian
tiger economies are normally taken to refer to South Korea, Taiwan,
Singapore and Hong Kong. In the case of South Korea and Taiwan, their
export-led growth was based on developing the competitiveness of domes-
tically-owned firms; in the case of Ireland, its export-led growth was based
on developing the competitive capacity and profitability of foreign-owned
(mainly US) firms.
7. See BIS (2010) for full details on Basel III.
8. For an interesting article, exploring some parallels between the ancient Greek
tragedy of Antigone by Sophocles and contemporary austerity protests in
Greece see Higgins (2011).
References
Arestis, P. and M. Sawyer (2006a). Alternatives for the Policy Framework of the
Euro, in W. Mitchell, J. Muysken and T.V. Veen (eds), Growth and Cohesion in
the European Union: The Impact of Macroeconomic Policy, Cheltenham: Edward
Elgar Publishing Ltd.
192 The Euro Crisis
195
196 The Euro Crisis
1 Introduction
The sovereign debt crisis in 2010 of Greece and other peripheral Eurozone
countries like Portugal has brought to the fore the rising heterogeneity
observed within the Eurozone and the macroeconomic imbalances that
have led to such heterogeneity. First, there has been a persistent loss in
international competitiveness (measured by relative unit labour costs) in
the four Mediterranean Eurozone countries (Greece, Italy, Portugal and
Spain) vis--vis Germany since the launch of the Euro in 1999. According
to Lapavitsas et al. (2010), this is largely the result of a race to the bottom
led (and won) by Germany encouraging flexibility, wage restraint, and
part-time work even more than peripheral Eurozone countries.1 Secondly,
the vigorous process of financial integration between the North and the
South has also contributed to the emergence of large macroeconomic
imbalances within the Eurozone by boosting demand, particularly private
consumption and real estate investment, in the countries of the South.
These two phenomena have led to large current account (hereafter CA)
deficits in Greece, Portugal and Spain (and Ireland) against Germany as
well as high levels of indebtedness by both the private and public sector.
Despite the proposition of Frankel and Rose (1998) that the suitability
of European countries for EMU [Economic and Monetary Union] can-
not be judged on the basis of historical data since the structure of these
economies is likely to change dramatically as a result of EMU (p. 1011),
the evidence so far suggests that, except for financial integration which
has admittedly proceeded apace, there is no clear pattern of economic
integration among Eurozone countries (Santos Silva and Tenreyro
2010). In the last decade, growth in Mediterranean Eurozone countries
and Ireland has mainly come from expansion of consumption financed
by rising private sector indebtedness (as in Greece and Portugal) or vig-
orous investment linked to real estate bubbles (as in Ireland and Spain).
Therefore, the integration of peripheral countries into the Eurozone has
so far been one-sided in the sense that it has largely consisted of a rapid
process of financial integration whereby these countries have financed
their large CA deficits by way of increasing their indebtedness vis--vis
core Eurozone countries, predominantly Germany.
Pedro Leao and Alfonso Palacio-Vera 197
quality of products. Finally, they argue that the only way out of the
current dilemma is to implement structural reforms. They deny that the
former will actually lead to a race to the bottom with respect to wage
cuts. Instead, they predict that intra-euro area current account imbal-
ances would diminish and the international competitiveness of Europe
as a whole would rise (Zemanek et al. 2009, p. 31).
To conclude this section, we should like to mention that the different
explanations for the large intra-EMU CA imbalances that we reviewed
above are potentially compatible with each other. The initial differ-
ences in GDP per capita and inflation rates at the time of the launch
of the Euro can be blamed for the intense capital flows from relatively
rich/high-saving to relatively poor/low-saving Eurozone countries
observed ever since 1999. The intensity of these flows was probably
augmented by the fact that real interest rates were relatively high in the
former and relatively low (or negative) in the latter because of differ-
ences in their initial inflation rates. Eventually, large intra-EMU capital
flows fuelled credit-led economic growth in peripheral Eurozone
countries and this, in turn, led to further deterioration in their rela-
tive competitiveness. This suggests that the institutional framework
currently underlying the EMU has failed to devise mechanisms that
properly take account of the large and persistent structural differences
exhibited by Eurozone countries and enable them to reach a sustain-
able and robust growth path.
As explained in the previous two sections, there has been a steady diver-
gence in terms of relative competitiveness, inflation, and CA balances
among Eurozone countries ever since the launch of the Euro in 1999.
The purpose of this section is to analyse the causes behind this phenom-
enon by focusing on the case of Portugal.
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Private consumption 5.3 3.7 1.3 1.3 0.2 2.5 1.9 1.9 1.7 1.7 0.8
Public consumption 4.1 3.6 3.3 2.6 0.2 2.6 3.2 1.4 0.0 1.1 3.5
Investment 7.8 3.5 1.0 3.5 7.4 0.2 0.9 0.7 3.1 0.7 11.1
Domestic demand* 6.2 3.6 1.8 0.1 2.2 2.7 1.6 0.9 1.9 1.3 2.8
Total exports 3.0 8.4 1.8 1.4 3.9 4.0 2.1 8.7 7.8 0.5 11.6
Service exports 2.8 9.0 2.3 0.4 2.8 5.8 2.1 11.7 12.9 1.5 6.5
Imports 8.6 5.3 0.9 0.7 0.9 6.7 3.5 5.2 6.1 2.7 9.2
Net Exports* 2.4 0.3 0.2 0.7 1.4 1.2 0.7 0.5 0.0 1.2 0.1
Unemployment 4.4 3.9 4.0 5.0 6.3 6.7 7.6 7.7 8.0 7.6 9.5
GDP 3.8 3.9 2.0 0.8 0.8 1.5 0.9 1.4 1.9 0.0 2.7
Current account 8.5 10.2 9.8 8.0 6.0 7.5 9.4 9.9 9.4 12.0 10.3
Int. Inv. Position 33.1 41.1 48.6 57.1 59.0 63.8 70.0 81.1 92.4 99.2 111.5
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Current 4.2 5.9 7.0 8.5 10.2 9.8 8.0 6.0 7.5 9.4 9.9 9.4 12.0 10.3
Account
Goods 8.4 9.4 10.8 11.9 12.9 12.0 10.4 9.1 10.3 11.0 10.8 10.8 12.8 10.5
Services 1.2 1.3 1.6 1.6 1.8 2.3 2.5 2.7 2.9 2.7 3.3 4.0 4.0 3.7
Factor 0.8 1.2 1.3 1.4 2.1 3.0 2.3 1.7 2.1 2.6 4.0 4.2 4.7 4.8
Incomes
Remitt. 2.9 2.9 2.7 2.6 2.7 2.6 1.8 1.4 1.4 1.2 1.2 1.2 1.1 1.1
Table 6.3 Portugal, current account, per cent of GDP, 20059 vs. 1999
Let us start off by looking at the three favourable trends. First, the
trade deficit excluding energy declined from about 10 per cent in 1999
to about 7.3 per cent of GDP in 20059.8 This was due mainly to a
combination of a stagnant domestic demand in Portugal which exhib-
ited 0.4 per cent annual growth and d a strong growth of imports of the
main Portuguese trading partners amounting to 5.2 per cent average
annual growth. In fact, the stagnant demand prevented a rapid growth
of imports of goods in 20028 (3 per cent average annual growth). In
turn, the strong growth of imports of goods by Portugals main trading
partners led to a more rapid growth of goods exports in 20028 (3.7
per cent average annual growth). The key contributors to the growth of
Portuguese exports were Angola and Spain. In 20028, goods exports to
Spain and Angola grew at annual average rates of 10.1 and 21 per cent
respectively.
A second favourable factor affecting the Portuguese CA was the evolu-
tion of the balance of services, whose surplus rose from 1.6 per cent in
1999 to an average of 3.6 per cent of GDP in 20059. This was the result
of an excellent performance of export of services, especially since 2006.
In nominal terms, the exports of services grew by 19.9, 15.6 and 5.3
per cent in 2006, 2007 and 2008, respectively (Bank of Portugal 2010,
p. 148, Table 5.4). These rates exceeded the growth rates of nominal
imports of services in the same years, which were 15.9, 8.4, and 5.1
per cent respectively (Bank of Portugal 2010, p. 149, Table 5.5), and led
to an increase in the weight of services in total exports from 27 per cent
in 2005 to 33 per cent in 2009. Further, it should be noted that this was
an acceleration of a trend dating back to 1996, when services made up
only 24 per cent of total exports. In fact, between 1996 and 2009 export
of services grew at twice the annual average rate of exports of goods: 7.9
per cent compared to 3.9 per cent (Cabral 2010). One consequence of
this development is that in 20079 the surplus in the balance of serv-
ices already covered 35 per cent of the deficit in the balance of goods
compared to only 14 per cent back in 1996 (see Table 6.2). In turn, these
numbers tell us that the specialization of Portugal has been switching
towards the exports of services. In this respect, it is remarkable to note
that by 2008 the weight of services in total exports, 33 per cent, was
more than three times the weight of textiles, clothes, and footwear 9.5
per cent which used to be the major Portuguese export sectors. Lastly,
the high growth of export of services in the last decade or so did not
reflect the behaviour of its main sector tourism.9 Instead, the high
growth of export of services can be ascribed mainly to the behaviour of
transport and professional services. These two types of services grew
Pedro Leao and Alfonso Palacio-Vera 207
at double digit rates in 20068 and accounted for 26.5 and 30 per cent
of export of services in 2008 and 2009, respectively (Bank of Portugal,
2010, p. 148).
The third and last factor that affected favourably the evolution of
the Portuguese CA was the reorientation of Portuguese exports over the
last decade from its traditional markets to other countries outside the
EU-15. Indeed, the share of Portuguese exports in the EU-15 declined
by one third between 2003 and 2009 (Constncio 2010).10 Yet, over the
same period the market share of goods exports in its main 34 trading
partners declined by only 13 per cent.11 This difference was due to the
fact that from 1999 to 2008 exports to new markets grew at an annual
average rate of 13.8 per cent, compared to only 3.8 per cent in the case
of EU-15 markets.
Next, let us address two key trends that affected the Portuguese CA
adversely. First, that relative prices and ULC in Portugal increased in this
period owing to an especially high excess of nominal wage growth over
labour productivity that was equal to 2.7 percentage points per year
compared to only 1.7 percentage points on average in the Eurozone.
Indeed, according to the IMF (see Figure 6.1 below), the Portuguese
REER rose by about 13 per cent between 1999 and 2008, measured both
in HICP and in ULC. Most of this increase occurred between 1999 and
2003.12 This diagnosis is supported by the results in Felipe and Kumar
(2011) who proposed measuring aggregate ULC as the economys labour
share times the price deflator. Their analysis shows that Greece and
Portugal experienced much faster increases in aggregate ULC than the
other Eurozone countries in the period 19802007. Portugals loss of
international competitiveness is also depicted in Figure 6.2 below which
shows the presence of a positive differential between the average rate of
inflation in the Eurozone and the rate of inflation in Portugal in the
period 19972007.
Second, and crucially, over the same period Portugal was subject to
a marked increase in competition from China and Central and Eastern
European (CEE) countries (Ahearne and Pisany-Ferry 2006). This led to
an increase in the penetration of imports in the Portuguese market and,
simultaneously, to a sharp decline in the market share of Portuguese
exports in the EU-15. In particular, between 2003 and 2008 imports
grew at an annual average rate of 3.9 per cent, more than twice the rate
of total demand. In addition, the market share of Portuguese exports
in the EU-15 declined by 33 per cent between 2003 and 2009, mainly
in favour of China and the CEE countries (referred to as the new 10
countries in Figure 6.3). In fact, the market shares of these two regions
208
90 90 90 90
80 80 80 80
70 70 70 70
60 60 60 60
95
97
99
01
03
05
07
95
97
99
01
03
05
07
19
19
19
20
20
20
20
19
19
19
20
20
20
20
Figure 6.1 REER based on HIPC and ULC, 19952008
Source: IMF (2010).
% 6
0
Jan-97
Feb-98
Mar-99
Apr-00
May-01
Jun-02
Jul-03
Aug-04
Sep-05
Oct-06
Nov-07
Jan-09
Feb-10
400
375
350
China
325
300
275
250
New 10
225 countries
200
175
150
125
Spain
100 Italy
75
Greece Portugal
50
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 6.3 The evolution of market shares (goods) in the EU-15, 19952009
Source: Constncio (2010). 1995 = 100.
Figure 6.4 Portugal, saving, investment and the current account, 19962009
Source: Bank of Portugal (1997, 2005, 2009a, and 2010).
led to the suggestion that the current Portuguese malaise can be solved
through an increase in the saving rate by the private sector.15 Indeed,
an increase in the saving rate, by reducing consumption, would trim
down imports, and lead to a smaller CA deficit. However, an increase
in the private saving rate would also have some adverse effects. First,
by depressing sales, the ensuing cutback in consumption would have
a negative impact on investment, which after almost uninterrupted
declines in the last eight years, is already well below its 2001 level.
Second, it would also slash the demand faced by Portuguese busi-
nesses thus bringing about further increases in unemployment.
model with three economies (two Eurozone countries and the US) and
two currencies (the US dollar and the Euro) where output is demand-
determined. Their results suggest that a decrease in ULC in an individ-
ual Eurozone economy will tend to be offset by nominal appreciations
of the Euro thus leaving the real exchange rate roughly constant. In
particular, they simulate the impact on the relative income levels of
three economies (the US economy and two Eurozone economies) of an
increase in the import propensity in one of the Eurozone economies.
They find that, after an initial and temporary increase, the US GDP set-
tles at the initial level in the new stationary-state owing to the relative
appreciation of the US dollar vis--vis the Euro. Crucially, they find that,
owing to the relative depreciation of the Euro, the GDP of the Eurozone
economy whose import propensity initially increased settles at a lower
level whereas the GDP of the other Eurozone economy settles at a higher
level. Importantly, this exercise confirms that, were the import propen-
sity of an individual Eurozone economy to decline due, for instance, to
a decrease in its nominal wage costs, there would be a relative (nominal)
appreciation of the Euro so that, in the new stationary state, the GDP
of the Eurozone economy whose import propensity initially decreased,
would settle at a higher level, whereas the GDP of the other Eurozone
economy would now settle at a lowerr level. In other words, the decline
in nominal wages in an individual Eurozone economy does not lead to
an increase in the GDP of the Eurozone as a whole but rather redistrib-
utes a given level of output between the two economies.
Next, a withdrawal from the EMU in the case of Portugal would pre-
dictably lead to a large depreciation (perhaps of 50 per cent) of the old
national currency (the Escudo) vis--vis the Euro as currency markets
may initially overreact because of the pervasive uncertainty gener-
ated by the countrys complex withdrawal from the EMU. Hence, it
would give, after one or two years, the tremendous boost to net exports
Portugal needs if it is to resume sustained economic growth. Yet, the
large depreciation would also produce three adverse consequences in
the short run.24 First, any hint that a Member State plans to withdraw
from the Eurozone would likely unleash both massive capital outflows
and withdrawals of deposits from domestic banks. In the latter case,
holders of deposits denominated in Euros would try hard to avoid the
devaluation implied by the conversion of their deposits into the reintro-
duced old national currency. To staunch this bleeding, the government
would need to impose limits to bank deposit withdrawals as well as
to introduce severe capital controls. This scenario resembles the tragic
situation Argentina went through in 2002 in the wake of the collapse
of the currency board that pegged the exchange rate of the peso to the
US dollar.25 In turn, it is very likely that the adoption of such measures
would result in a credit crunch and, hence, in a further contraction
of aggregate demand, output and employment. Secondly, and to the
extent that debt contracts set up prior to withdrawal from the EMU
would still be denominated in Euros, the depreciation of the domestic
currency would perilously raise the level of indebtedness of households,
businesses, and the government. Finally, the large depreciation would
increase sharply the prices of imported goods drastically depressing real
incomes. From all this we conclude that withdrawal from the EMU is
not a sensible option for Portugal and that, instead, efforts should be
directed towards institutional reform of the EMU itself.
Portugal, Ireland, Greece and Spain. In the first half of the 1990s, the
CAs of both groups of countries were close to equilibrium. Afterwards,
the CA balance of the South deteriorated dramatically reaching a defi-
cit of almost 10 per cent of GDP in 2007, while at the same time the
CA of the North improved continuously into a surplus of more than 6
per cent of GDP in 2007. The increase in the CA surplus of the North
from 1999 through 2007, of 4 percentage points of GDP, was basically
associated with an increase of 3 percentage points of GDP in private
saving (see Holinski et al. 2010, Figure 4). This, in turn, may have
reflected the strong wage restraint engendered in Germany over the
last decade and the associated increase in personal income inequality
(see Table 6.4).
In addition, the magnitude of the imbalances created since the crea-
tion of the Euro is remarkable: in 19992007, the CAs in the South and
in the North were on average equal to 6.8 per cent and 4.6 per cent
Pedro Leao and Alfonso Palacio-Vera 219
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
North
Germany 25 25 25 : : : 26.1 26.8 30.4 30.2
Netherlands 26 29 27 27 27 : 26.9 26.4 27.6 27.6
Austria 26 24 24 : 27.4 26 26.2 25.3 26,2 26.2
Finland 24 24 27 26 26 26 26 25.9 26.2 26.3
South
Portugal 36 36 37 : : 38 38.1 37.7 36.8 35.8
Ireland 32 30 29 : 30.6 32 31.9 31.9 31.3 29.9
Greece 34 33 33 : 34.7 33 33.2 34.3 34.3 33.4
Spain 33 32 33 31 31 31 31.8 31.2 31.3 31.3
Source: Eurostat.
imports of the South from the North exports of the North to the South
will also depress output and employment in the North. Hence, we may
say that the Stability and Growth Pact imparts macroeconomic policy
in the Eurozone with a deflationaryy bias by making the whole burden
of the adjustment fall on the Eurozone countries running CA deficits
(Stockhammer 2011).
Is there an alternative? At the moment, expansionary fiscal policy
in the South is clearly nott an option: financial investors would simply
refuse to advance the required financing. But even if they did and
Southern economies enjoyed a short-lived boost, it could be argued that
it would merely lead the South to resume its unsustainable path of the
last decade: high CA deficits and ever-growing external indebtedness.
A comprehensive (long-term) solution for the problems of Southern
countries public, private and external deficits, stagnant output and
rising unemployment must ultimately involve robust growth of their
net exports. Indeed, besides cutting the CA deficit in the South, it would
boost their output and employment and this, by raising tax revenues,
would slash their budget deficits as well. So the crucial question is: how
can export growth be boosted in the South?
We believe that the best option is through expansionary fiscal policy
in the North.30 Indeed, this would, in a first stage, boost output and
employment in the North and afterwards, once full-employment was
reached, increase wage and price inflation there. And these two develop-
ments in the North would correct the imbalances currently affecting
the Eurozone: not only the CA imbalances, but also unemployment,
which stands at 10.1 per cent for the Eurozone as a whole and afflicts
the North and the South alike (see Table 6.5).
How would expansionary fiscal policy in the North lead to the correc-
tion of these imbalances? First, the acceleration of demand growth in
the North would not only reduce unemployment there but also boost
its imports and lessen its CA surplus. Secondly, the increase in wage and
price inflation in the North would reduce its competitiveness vis--vis the
South and thereby shift demand from the North to the South, further rais-
ing imports of the North from the South and reducing the Northern CA
surplus. Finally, the increase in imports of the North from the South
exports of the South to the North would raise output and employment in
the South and, at the same time, narrow its budget and CA deficits.31
Hence the question: what could force Northern Eurozone countries
to implement expansionary fiscal policies? If they faced an upper limit
on their CA imbalances of (say) 2 per cent of GDP, they would have no
alternative.
Table 6.5 Unemployment rates and CAs in the Eurozone, 2010
Eurozone Germany Belgium Ireland Greece Spain France Italy Portugal Slovenia Slovakia Finland Austria Netherlands Estonia
Unemploy- 10.1 7.1 8.3 13.7 12.6 20.1 9.7 8.4 11 7.3 14.4 8.4 4.4 4.5 17
ment rates
CAs (% of 0.35 5.1 2.7 0.7 11.8 4.5 3.5 4.2 9.8 0.9 2.9 2.8 3.2 6.8 2.8
GDP)
if investors feared that its government might default on its debt, they
would still sell their bonds and drive up interest rates but, crucially, were
the government unable to roll over its debt at reasonable interest rates,
the countrys central bank would buy up that debt. The superior force
of last resort, the central bank, would thus prevent investors from trig-
gering a liquidity crisis and the ensuing default.35
How can the fragility of Eurozone countries issuing debt in a cur-
rency over which they have no control be addressed? In the wake of the
Greek sovereign debt crisis which erupted in Spring 2010, the European
Council decided to set up the so-called European Stability Mechanism
(ESM) that will enter permanentlyy into force on 1 January 2013 and
whose main aim is to provide financial assistance, under strict condition-
ality, to those Eurozone countries exhibiting severe financial problems
(European Council 2011).36 The ESM will be funded by contributions
from Eurozone countries, will (initially) have an effective lending capac-
ity of a500 billion and will be enshrined into Article 136 of the Treaty
of Lisbon.
Unfortunately, the fact that Eurozone countries applying for financ-
ing will have to adopt austerity measures will aggravate their reces-
sions. Moreover, the high interest rate the ESM will charge on loans
(two hundred basis points above its funding rate) and the collective
actions clauses on new government bonds (asking private bondholders
to share in the restructuring of the debt) may jeopardize the wanted
financial stability (see De Grauwe 2011). Therefore, the current chal-
lenge to European authorities is to devise a financial mechanism that
reaches a compromise between the need to make some room for the
working of fiscal automatic stabilizers at the national level and simul-
taneously discourage governments from pursuing unsustainable fiscal
policies. In this sense, we believe that one way forward is to allow the
ESM to issue Euro-bonds in order to fund loans at a preferential rate to
Eurozone countries with financial problems and then allow the ECB to
subsequently buy these bonds either directly or in secondary markets.37
The monetization of Euro-bonds would both help reverse the divorce
between monetary and fiscal policy currently embedded in the Treaty
of Lisbon and reduce the political cost inflicted upon some EU national
governments as a result of being perceived by their respective elector-
ates as bailing-out irresponsible countries. In any case, we believe that,
in the long run, guaranteeing financial stability in the Eurozone will
require consolidating national government budgets into the federal
budget so that a system of fiscal transfers among Eurozone countries
can be duly set up. Needless to say, this objective requires a good deal of
Pedro Leao and Alfonso Palacio-Vera 227
further political union and we do not currently see this process coming
about in the near future.
The purpose of this contribution has been to analyse the causes of the
Portuguese economic malaise, evaluate the different policy options
currently available to the Portuguese government and make several
proposals for institutional reform of the EMU. Our main conclusion is
that, given the terrible short-term economic consequences that Portugal
would face were it to withdraw from the Eurozone, the best way forward
for it is to join forces with other peripheral Eurozone countries in order
to push for reform of the EMU along the following lines.
First, the limits on budget deficits imposed by the Stability and
Growth Pact should be replaced by (legally-binding) ceilings on the CA
imbalances of individual Eurozone countries, so that the latter resort
assiduously to discretionary fiscal policy in order to fully comply with
the previously agreed ceilings on CA imbalances. More specifically,
countries exhibiting a CA surplus (deficit) that exceeds the agreed ceil-
ing would be forced to adopt an expansionary (restrictive) discretionary
fiscal policy. Second, the ECB should let inflation temporarily rise to
(say) 5 per cent so as to create a mechanism that helps change relative
levels of competitiveness in the Eurozone, and thereby shifts demand
from surplus to deficit countries. Third, the ECB should impose adjust-
able asset-based reserve requirements on banks to prevent the develop-
ment of bubbles in the real estate sector and stock market of individual
Eurozone countries. Fourth, the European Stability Mechanism should
be allowed to issue Euro-bonds to fund credit at reasonable interest rates
aimed at Eurozone countries facing liquidity crises. Last, but not least,
the ECB should be empowered with a superior force of last resort and
be allowed to purchase Euro-bonds if needed.
We believe that an institutional reform of the EMU along the lines
proposed above is necessary if the current intra-EMU macroeconomic
imbalances and deflationary bias that currently pervade macroeco-
nomic policy in the Eurozone are to be overcome. Failure to address
these two problems will painfully delay the much needed economic
recovery in the Eurozone and imperil the whole European political inte-
gration project. European policymakers stand at a crossroads and they
cannot afford to repeat the mistakes of the past by adopting ill-designed
macroeconomic policies. Future generations will judge them by their
current policy decisions. Let us hope they get it right in time!
228 The Euro Crisis
Notes
* This paper was presented at the Conference titled The Greek and Euro Crisis
held at the University of the Basque Country, Bilbao (Spain) on 17 December
2010 and at the 8th Conference on Developments in Economic Theory and
Policy held also at the University of the Basque Country on 30th June 2011. The
authors would like to thank Philip Arestis for kindly inviting them to participate
in both Conferences. They also wish to thank participants in the Conferences
and the editors of IPPE for their useful comments and suggestions. Of course, the
authors are responsible for any remaining errors.
1. This dim state of affairs was long predicted by Kregel (1999) who propheti-
cally wrote that Germany might be said to be exporting its unemployment
to the rest of the EU member countries. The other member countries can only
allow their nominal wage levels to evolve independently of Germany to the
extent they can rely on productivity growth in excess of that of Germany
The result will be that beggar-thy-neighbor nominal exchange rate deprecia-
tions are replaced by beggar-thy-neighbor reductions in wage costs and prices
(p. 40).
2. Although not reviewed here, a recent study by Barnes et al. (2010) attributes
a substantial part of the blame for the current account imbalances exhibited
by Eurozone countries to different demographic trends and initial net foreign
asset positions.
3. See, in particular, their Figure 11 (Holinski et al. 2010, p. 14).
4. When an economy is at full employment, the value of its CA provides an
indication of the deviation of the REER from its equilibrium level. More
specifically, a CA deficit signals a REER that is above its equilibrium value,
a surplus indicates a REER below it, and a zero CA balance suggests that
the REER is at its equilibrium value. The same does nott hold if an economy
is below full employment. In this case, we cannot say a priori whether the
REER is at or out of equilibrium since, for instance, a CA surplus may reflect a
deficient domestic demand. If so, an increase in domestic demand up to full
employment will raise imports and thus make the CA balance worsen at an
unchanged REER.
5. By contrast, they estimate that the Spanish peseta was only appreciated
around 6 per cent against the Deutsche mark when Spain joined the Euro in
1999 which, according to them, explains the much better performance of the
Spanish economy until 2007.
6. IIP = external reserves of the Portuguese monetary system (net external
debt + net stock of foreign direct investment in Portugal + net foreign
holdings of Portuguese stocks).
7. The net external financial position of a country is the difference between the
market value of foreign assets owned by residents and domestic assets owned
by non-residents.
8. These values were obtained by adding the values of the goods and services
balances shown in Table 6.2 and subtracting for each year the corresponding
value of the energy balance provided by the Bank of Portugal (2010, p. 173
and p. 176).
9. Tourism has accounted for about 40 per cent of total Portuguese services
exports in the last decade.
Pedro Leao and Alfonso Palacio-Vera 229
10. The EU-15 is the main destination of Portuguese goods exports, having
accounted for 71 per cent of the total in 2008. It includes Austria, Belgium,
Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal, Spain, Sweden, and the United Kingdom.
11. These partners currently account for roughly 85 per cent of Portuguese
exports and include, besides the EU-15, Angola and the US (see Bank of
Portugal 2010, p. 146).
12. HIPC harmonized consumer price index; ULC unit labour cost. The REER
based on ULC indicates the relation between ULCs in Portugal and in its
main trading partners when expressed in the same currency. An increase in
this indicator thus reveals that the ULC has risen by more in Portugal than
in its trading partners, i.e., that Portuguese competitiveness has deteriorated.
The REER based on HIPC indicates the relation between consumer prices in
Portugal and its main trading partners. An increase in this indicator there-
fore implies that consumer prices have grown by more in Portugal than in
its trading partners.
13. By 2008, however, the hourly wage in these countries had risen to almost
the Portuguese level, $12.23 (see Bureau of Labour Statistics, International
Labour Comparisons homepage).
14. To this we may add the fact that since the onset of the financial crisis the
real effective Euro exchange rate has appreciated slightly by about 5 per cent
(Wyplosz 2010, p. 14).
15. This suggestion has been recently made by many Portuguese economists
including President Anbal Cavaco Silva, a retired Economics Professor
(Cavaco Silva 2010).
16. As Bohle (2010) aptly puts it while so-called responsible governments
pretend that they are still living in a slow sort of country, where youd
generally get to somewhere else if you ran very fast for a long time, what
governments really are suggesting is to move on to a place where it takes
all the running you can do, to keep in the same place (p. 7).
17. The height of the supply curve reflects the level of unit production costs
including the normal profit margin of the successive firms.
18. From 1999 to 2008, productivity growth in Portugal and the Eurozone was
similar, slightly less than 1 per cent a year.
19. However, it is unclear whether the boost to net exports would be substan-
tial. For instance, Felipe and Kumar (2011) argue that the increase in rela-
tive competitiveness vis--vis Germany of an across-the-board reduction
of money wages in peripheral countries would be meagre since Germanys
export basket is very different from that of Southern Eurozone countries and
Ireland.
20. At the end of 2009, the total debt of households reached 99.1 per cent of GDP,
the total debt of non-financial firms rose to 151.3 per cent of GDP, and govern-
ment debt represented 76.8 per cent of GDP (Bank of Portugal 2010). These
debts add up to 327.2 per cent of GDP. Who owns these debts? Slightly less
than one-third of the total debt is owned by non-residents. The rest comprises
domestic savings in bonds and deposit accounts as counterparts.
21. This assumption is realistic since the CA of the Eurozone vis--vis the rest of
the world has been broadly in balance ever since the launch of the EMU in
1999.
230 The Euro Crisis
References
Ahearne, A. and Pisani-Ferry, J. (2006). The Euro: Only for the Agile, Bruegel Policy
Brief,
f Issue 2006/01, February.
232 The Euro Crisis
Ahearne, A., Schmitz, B. and von Hagen, J. (2008). Current Account Imbalances in
the Euro Area, in A. Aslund and M. Dabrowski (eds), Challenges of Globalization,
pp. 4157, Peterson Institute for International Economics, Center for Social
and Economic Research, Washington, DC.
Arestis, P. and Sawyer, M. (2006). Alternatives for the Policy Framework of the
Euro, in W. Mitchell, J. Muysken and Tom van Veen (eds), Growth and Cohesion
in the European Union, pp. 5773, Cheltenham: Edward Elgar.
Athanassiou, P. (2009). Withdrawal and expulsion from the EU and EMU. Some
Reflections, European Central Bank Legal Working Paperr no. 10, December.
Bank of Portugal (1997). 1996 Annual Report.
Bank of Portugal (1998). 1997 Annual Report.
Bank of Portugal (2000). 1998 Annual Report.
Bank of Portugal (2005). 2004 Annual Report.
Bank of Portugal (2007). 2006 Annual Report.
Bank of Portugal (2009a). 2008 Annual Report.
Bank of Portugal (2009b). A Economia Portuguesa no Contexto da Integrao
Econmica, Monetria e Financeira, Departamento de Estudos Econmicos,
Lisbon.
Bank of Portugal (2010). 2009 Annual Report.
Barnes, S., Lawson, J., and Radziwill, A. (2010). Current Account Imbalances
in the Euro Area: A Comparative Perspective, OECD Economics Department
Working Paperr No. 826.
Bell, S. (2003). Neglected costs of monetary union: The loss of sovereignty in
the sphere of public policy, in S.A. Bell and E.J. Nell (eds), The State, the Market
and the Euro: Chartalism versus Metallism in the Theory of Money, pp. 16083,
Cheltenham: Edward Elgar.
Blanchard, O. (2007). Adjustment within the euro. The difficult case of Portugal,
Portuguese Economic Journal, 6, pp. 121.
Blanchard, O. and Giavazzi, F. (2002). Current Account Deficits in the Euro Area:
The End of the Feldstein-Horioka Puzzle?, Brookings Papers on Economic Activity,
2, pp. 147209.
Bohle, D. (2010). The Crisis of the Eurozone, European University Institute,
Working Paper No. 2010/77.
Bureau of Labour Statistics, International Labour Comparisons homepage. http://
www.bls.gov/web/ichcc.supp.toc.htm
Cabral, M. (2010). Portugal exporta cada vez mais services, Jornal de Negcios,
22 April, p. 34.
Cavaco Silva, A. (2010). Discurso do dia 10 de Junho, Cerimmina Comemorativa
do Dia de Portugal.
Constncio, V. (2010). Perspectivas sobre a Economia Portuguesa, Slides pre-
sented in the 5th Conference of the Bank of Portugal Desenvolvimento
Econmico Portugus no Espao Europeu.
Davidson, P. (2009). The Keynes Solution: The path to global economic prosperity,
New York: Palgrave Macmillan.
De Grauwe, P. (2010). A mechanism of self-destruction of the eurozone, CEPS
commentary, 9 November.
De Grauwe, P. (2011). The Governance of a Fragile Eurozone, Center for European
Policy Studies Working Document No. 346, May.
ECB (2004). The Monetary Policy of the ECB,Frankfurt: ECB.
Pedro Leao and Alfonso Palacio-Vera 233
Santos Silva, J.M.C. and Tenreyro, S. (2010). Currency Unions in Prospect and
Retrospect, CEP Discussion Paperr no. 986, June.
Stockhammer, E. (2011). Peripheral Europes Debt and German Wages. The Role
of Wage Policy in the Euro Area, Research on Money and Finance Discussion Paper
no. 29, March.
Zemanek, H., Belke, A. and Schnabl, G. (2009). Current Account Imbalances and
Structural Adjustment in the Euro Area: How to Rebalance Competitiveness,
CESifo Working Paperr no. 2639, May.
Wyplosz, C. (2010). The Eurozone in the Current Crisis, Asian Development Bank
Institute Working Paper No. 207, March.
7
The Economic Crisis in Spain:
Contagion Effects and Distinctive
Factors
Jess Ferreiro and Felipe Serrano
Department of Applied Economics V, University of the Basque Country
Abstract: Since the year 2008, the Spanish economy has been immersed
in the deepest crisis of its history. From being one of the most dynamic
European economies in the decade of the 2000s, Spain has moved to
be a nearly stagnant economy whose short-term prospects are far from
being optimistic, clearly worse than those of most European countries.
The aim of the chapter is to provide an explanation of the bad perform-
ance of Spains economy since 2008. In this chapter we argue that the
current economic problems of Spain can be found in the unsustainable
strategy of economic growth that was followed since the early 1990s.
This expansion was based on an excessive resource to the external fund-
ing, leading to an unsustainable growth of the external debt, whose
problems unleashed, first with the financial turmoils that took place in
the years 2007 and 2008, and, second, with the crisis of the sovereign
debt in the euro area that started with the crises of Greece, Ireland
and Portugal. Also, there is the existence of unsolved structural prob-
lems in the labour market, namely the excessive use of the fixed-term
employment contracts, which since the early 1990s have contributed to
amplifying any shock affecting the Spanish economy, making it more
unstable and pro-cyclical; and, finally, the wrong fiscal policy imple-
mented both before and during the crisis, which led to a pro-cyclical
fiscal stance before the crisis, to the generation of an unsustainable fis-
cal deficit at the very beginning of the crisis, and to a pro-cyclical fiscal
stance during the crisis because of the need to adjust the fiscal deficit.
235
236 The Euro Crisis
1 Introduction1
The years preceding the current crisis were the most lasting and success-
ful period of economic growth of the Spanish economy in the last five
decades. Since 1996 Spain entered on a path of high economic growth,
reaching a peak in the first quarter of 2000 when Spain registered an
annual rate of growth of its GDP of 5.8 per cent. After that date, as in
the rest of the developed economies, the Spanish GDP growth slowed
down. As a result, in the third quarter of 2002, Spain registered the low-
est rate of economic growth of this period, with the real GDP growing
at a rate of 2.6 per cent. Since then, the Spanish economy accelerated
again, and in 2006 Q3, the GDP grew at a rate of 4.1 per cent.
The true dimension of this expansion phase can only be properly
understood from a long-term perspective. What is remarkable about
238 The Euro Crisis
the last boom period is not only the intensity of the expansion. Indeed,
in the year 1977, or even in the years preceding the economic crisis of
the early 1990s, high rates of economic growth were also registered,
even higher than those registered in the last decade. The novelty of the
decade 19972007 is the higher length of the expansion. The Spanish
economy grew at year-on-year rates above 2.5 per cent during 51 con-
secutive quarters: from 1996 Q3 to 2008 Q1 inclusive.
Moreover, the economic expansion in Spain was much more intense
than that registered in most European countries, clearly greater than
that registered in the bigger European economies. According to the data
obtained at the AMECO database,3 between the years 1996 and 2007,
the real size of the Spanish economy (measured as the increase in real
GDP) increased by 51.1 per cent, 20 percentage points higher than the
accumulated growth registered in the European Union EU-27, 23 per-
centage points more than in the euro area, and, of course, much more
than in the four main European countries, i.e., France (29.1 per cent),
Germany (19.5 per cent), Italy (17.6 per cent) or the United Kingdom
(37.4 per cent).
The high rates of economic growth led to an outstanding increase in
the Spanish GDP per capita. Between 1997 and 2007, the real GDP per
capita increased by 28.1 per cent, from 13,900 to 17,800 euros. This
increase in the income per capita was well above that of other countries
in the European Union, the euro area or the main European countries.4
But if we measure the GDP per capita in purchasing power standard
units, the increase in the GDP in Purchasing Power Standard (PPS) units
per capita is even much higher: 73.5 per cent.5
When we measure the relative size of the Spanish GDP per capita, com-
paring it with that of other European countries, we can see that the gap
between Spain and the rest of Europe falls, and even, in some significant
cases, disappears. If we focus on the European Union (EU-27), the Spanish
GDP per capita rose from 79.9 per cent of that of EU-27 to 82.4 per cent.
When the comparison is made with the euro area (17 countries) the
Spanish GDP per capita rose from 70.2 per cent in 1997 to 75.1 per cent
in 2007. The fall in that gap is even more intense when the GDP per capita
is now measured in PPS units. Now, the Spanish PPS GDP per capita
increased from 93.2 per cent of that of EU-27 in 1997 to 104.8 per cent
in 2007. If the focus is made on the euro area, the Spanish PPS GDP per
capita increased from 82.5 per cent of that of the euro area (17 countries)
in 1997 to 96.3 per cent in 2007, exceeding that of a country like Italy.6
It must be noted that this outstanding performance of the Spanish
income per capita takes place in a context of an unparalleled growth
Jess Ferreiro and Felipe Serrano 239
Until the beginning of 2008 the spread of the Spanish public debt in
relation to the German public debt (measured by the ten-year spread
over German bund in basic points) was nearly zero. Since then, the
turbulence in the financial markets has moved the yield of the Spanish
10-year bonds far away from the German ones.12 Thus, in February 2009,
the spread of the Spanish bonds reached 128 basis points, but since then
the spread started to fall. In any case, the spread widens in the context
of the declining yield of Spanish bonds. It was in March 2010, at the
beginning of the turbulence that affected the Greek economy, that the
yield of the Spanish 10-year bond started a rising path.
At the time of the rescue of Greece, on 3 May 2010, the yield of
the Spanish 10-year bond was 4.149 per cent, with the spread to the
German bund reaching 99 basis points. Since then, both figures have
grown without interruption. On 24 November 2010, at the time of the
Irish rescue, the yield of the Spanish 10-year bond had climbed to 2.016
per cent, and the spread with the German bund was 246 basis points.
On 6 April 2001, at the time of the Portuguese rescue, the yield of the
Spanish bond was 5.224 per cent, but the spread with the German bund
had fallen to 182 basis points. But, since that date, both rates have been
rising, and thus, On 2 August 2011, the yield of the Spanish 10-year
bond had reached 6.323 per cent, and the spread with the German
bund was placed at 390.5 basis points, both figures unparalleled since
the creation of the euro.
According to the data of the Spanish Ministry of Economics and
Finance,13 in July 2011 the average interest rate of the outstanding public
debt (denominated in euros) of the central government was 3.9 per cent.
This average interest rate is much higher than the official forecast (April
2011) of nominal growth (2.6 per cent) for Spain in 2011.14 This involves
a snowball effect that, in the absence of an offsetting increase in the
primary balance, will keep pushing upwards the current size of the fiscal
deficit and the size of the outstanding public debt.
It is important to emphasize that the problem with the interest rate
of the public debt is not the nominal interest rate. Despite the hike of
the interest rate paid in the public debt issued, the nominal interest rate
of the outstanding public debt is below that paid since 1999, when the
nominal interest rate of the central government outstanding debt was
5.65 per cent.15 The problem has a twofold origin. On the one hand,
the real interest rate of the public debt has significantly increased since
then. In 1999, the real interest rate of the outstanding debt (calculated
as the nominal interest rate of the outstanding public debt minus the
GDP deflator) was 2.85 per cent. Since then, the real cost of that debt
Jess Ferreiro and Felipe Serrano 247
2008 Q12009 Q4 at an average rate of 2.65 per cent. This wage push
led to an increase in total costs and to a fall in the competitiveness of
Spanish firms, which partially explains the employment adjustment
registered in this period.
This process of wage increases only halted in 2010. Thus, since the
third quarter of 2010, the remarkable moderation in the growth of
nominal wage costs has led to a fall in total real wage costs in the last
three quarters.
In this section, we will focus our analysis on the role played by the
Spanish fiscal policy in the generation of the current situation. We
argue that the bad management of fiscal policy before and during the
crisis contributed to the exacerbation of the disequilibria in the Spanish
economy, thereby amplifying the consequences of the financial tur-
moils generated, at first, in the international financial markets, and
later in certain EMU countries.
Thus, we will indentify and discuss four problems of the Spanish fiscal
policy implemented before and after the crisis:31
The first problem of the fiscal policy mentioned above is that it should
have adopted a more restrictive (anti-cyclical) fiscal stance during the
expansion phase. As we explained in preceding sections, Spanish eco-
nomic growth was based on excessive recourse to external borrowing to
finance the increasing capital accumulation. This excessive growth led
to a huge trade deficit and to an enormous external debt. In this sense,
fiscal policy should have tried to avoid the overheating of the Spanish
economy, which could have led to lower trade deficits and external
debt, something that would have placed Spain in a better situation to
face the impact of the financial crisis.
During the first phase of the economic expansion, until the year
2003, the improvement in the fiscal balance is generated in view of a
significant fall in the expenditures side. Between 1995 and 2003, the
fiscal deficit fell from 6.5 per cent to 0.2 per cent GDP, with total expen-
ditures falling from 44.4 per cent GDP to 38.4 per cent GDP. However,
and despite the economic acceleration, the figure of revenues remains
almost unchanged, regardless of whether we measure these variables in
absolute values or in cyclical adjustment terms, that is, removing the
impact of the business cycle on the figures of revenues and expendi-
tures.32 In absolute values, total revenues increased from 38 per cent
GDP to 38.2 per cent GDP, while the cyclically adjusted total revenues
Jess Ferreiro and Felipe Serrano 255
fell from 38.9 per cent to 37.9 per cent GDP. The reason has to do with
the continuous fiscal cuts, mainly in direct taxes, which prevented a
higher increase in the public revenues. This means that if these tax
cuts had not been adopted, Spain in 2003 would have enjoyed a fiscal
surplus of 0.8 per cent GDP (instead of the actual deficit of 0.2 per cent
GDP); also a cyclically adjusted surplus equivalent to 0.5 per cent GDP,
instead of the actual deficit of 0.5 per cent GDP.33 This fiscal tighten-
ing should have been more intense in the years 2006 to 2008. As we
analysed above, it is in this period when the external imbalance of the
Spanish economy reached its bigger dimension. The external debt and
the trade deficits register unparalleled values in a context defined by an
extraordinary level of investment that comes with declining national
savings.
If we focus on the period 20047, excluding the year 2008 for reasons
that will become apparent later, the improvement in the fiscal balance
was not too high; hardly two percentage points of the GDP. Contrary to
what happened in earlier years, public revenues increased significantly
in this period, but this took place with an increase in public expendi-
tures. Thus, cyclically adjusted expenditures increased by 0.8 percentage
points of the GDP between 2003 and 2007.
In sum, and mainly since 2003, Spain should have adopted a tighter
fiscal stance. Fiscal cuts, mostly concentrated in direct taxation, and
the increase in public expenditures should have been avoided.34 Higher
fiscal surpluses, that is, a more intense use of a counter-cyclical fiscal
policy, would have slowed down the rate of economic growth, reduced
the internal and external borrowing of the households and the (finan-
cial and non-financial) companies, and would have placed the eco-
nomic growth of Spain on a more sustainable path. This would have
reduced the consequences generated by the collapse of the international
financial and monetary markets in 2007 and 2008, and the contagion
effect coming from the fiscal crises in Greece, Ireland and Portugal.
But even more worrying than the absence of a deep counter-cyclical
fiscal policy during the boom period, is the fact that Spain wasted and
ruined all the available leeway to develop an effective counter-cyclical
fiscal policy during the recession before it entered recession. Again, it
is important to note that when Spain joined the club of countries in
recession in the last quarter of 2008, it is in this quarter that Spanish
GDP registers its first negative record of year-to-year growth.35 That is
to say, it is in the second half of 2008 when Spain starts to suffer the
world recession.36 However, as a consequence of the measures adopted
in 2006 and, mainly in 2007, the fiscal situation had suffered a strong
256 The Euro Crisis
1.2 percentage points of GDP, and, thus, the cyclically adjusted deficit
rose 5.5 percentage points of the GDP.
In 2009, when the output gap was 5.2 per cent, the public expendi-
tures fell by 0.8 percentage points of GDP, and public revenues rose by
1 percentage point of GDP, with the fiscal deficit falling 1.8 percentage
points of GDP. The cyclically adjusted expenditures fell 0.9 percent-
age points of GDP, and the cyclically adjusted revenues increased 1.3
percentage points of GDP, and, therefore, the cyclically adjusted deficit
fell 2.2 percentage points of GDP.
In sum, the Spanish authorities introduced a big fiscal impulse at a
time when it was not necessary, and even when it was counterproduc-
tive, that is, during an expansion phase. As far as the crisis was getting
worse, the fiscal impulse lost weight, and when it became more neces-
sary, in the year 2010, the public authorities were forced to adopt a
discretionary tight fiscal stance in order to improve the bad situation of
the public finances. The only aim was to reduce the fiscal deficit, since
then the main priority of the Spanish government.
However, the implementation of these fiscal stimuli does not mean
that they had a significant impact on the economic growth, which
could have contributed to offsetting the decline in private expendi-
ture (both consumption and investment). Indeed, as we next analyse,
another problem of the Spanish fiscal policy is due to the low multiplier
effect of the tax cuts and the rising expenditures. The small impact on
economic activity is explained by the combination of the use of fiscal
tools with low multipliers (tax cuts, transfers, investment with low
potential of lasting employment creation), and the implementation of
a loose fiscal policy in a context of a tight monetary policy and rising
interest rates implemented by the European Central Bank in 2007 and
2008. The final outcome of these measures was the generation of a huge
fiscal deficit that did not have the needed positive impact on economic
activity.37 This working of the Spanish fiscal policy is different from that
implemented in other European economies, where lower fiscal impulses
led to a smaller deterioration of the public finances, but with a more
positive effect on the economic activity.
Let us analyse more deeply these elements, comparing the fiscal impulse
implemented in Spain with those implemented in other European coun-
tries. In this sense, we identify the fiscal impulse as the impact on public
finances of the discretionary fiscal measures adopted by European eco-
nomic authorities, both on the sides of revenues and expenditure. The
fiscal impulse is identified by the change in the cyclically adjusted fiscal
balance (measured as a percentage of the GDP). That is, we measure the
258 The Euro Crisis
fiscal impulse as the difference between the cyclically adjusted fiscal bal-
ances of the years 2009 and 2007. Thus a () sign represents a worsening
in the corresponding cyclically adjusted fiscal balance, and a (+) sign an
improvement in that balance. Consequently, a () represents an expan-
sionary discretionary fiscal policy, and a () represents a restrictive discre-
tionary fiscal policy. That fiscal impulse is divided into two components:
the change in the revenues and in the expenditures.38
In Spain the change in the cyclically adjusted total revenue of general
government amounted to 4.2 per cent GDP, while the change in the
cyclically adjusted total expenditures of general government amounted
+6.3 per cent GDP. As a result, the total fiscal impulse was equivalent to
10.5 points of Spanish GDP.
If we compare the Spanish impulse with those implemented in the
rest of Europe, it is worth noting two elements. The first is that the
Spanish fiscal impulse was the highest impulse in the European Union,
nearly twice the average fiscal impulse in the European Union (EU-27
countries) (+2.8 per cent GDP) or the euro area (2.6 per cent GDP), 26
times larger than the German one (0.4 per cent GDP), or six times larger
than the French (1.8 per cent GDP). In fact, only Ireland implemented
a similar fiscal impulse amounting to 10.2 per cent GDP. The higher fis-
cal impulses, excluding Spain and Ireland, were implemented in Cyprus
(+8.2 per cent GDP), Greece (+7.5 per cent GDP), Portugal (+5.6 per cent
GDP), and United Kingdom (+5.3 per cent GDP). The second remark-
able element is the high share in that fiscal impulse of the measures
adopted to cut taxes. In fact, an expansionary fiscal policy via tax cuts
was implemented only in seven countries (Bulgaria, Greece, Spain,
Cyprus, Malta, Poland, and Portugal), and in Spain this discretionary
cut in taxation had the largest impact on public finances. Thus, in Spain
the size of cyclically adjusted total revenues of the general government
fell by 4.2 per cent of GDP. In Cyprus, they fell in 3.7 per cent GDP, but
in Bulgaria and Portugal they only fell 2.1 per cent GDP.
This particular pattern of the discretionary Spanish fiscal policy had
two negative consequences. The first consequence was that by cutting
taxes, the fiscal deficit increased more than in other countries, reducing
the leeway to adopt further fiscal expansionary measures in the form
of increasing public expenditures. This led to the implementation of
restrictive measures to reduce the fiscal deficit once it reached excessive
and unsustainable levels, regardless of the negative cyclical situation of
the economy.
The second consequence was that the fiscal impulse was concentrated
on those items of the public budget with the lowest multipliers. The
Jess Ferreiro and Felipe Serrano 259
analysis made before the crisis in Spain concluded that the multipliers
of revenues were much lower than those of public expenditures; and
that among the latter, gross capital formation was the item of expendi-
ture with the higher positive multiplier. Compensation of employees
expenditure had also a positive, but lower, multiplier, and that the
expenditure on compensation of employees had a negative multiplier
(De Castro 2005).
The main body of fiscal stimulus that the Spanish government devel-
oped in 2008 was through direct tax decreases. A part of that stimulus
was designed and implemented during that year with the aim of curbing
the plummeting of demand. However, the most important part of that
stimulus comes from the corporation tax reform and from the income
tax changes which had come into force during 2007. When these
reforms were designed they had a clear pro-cyclical bias, since they were
oriented to increase the disposable income of families and companies.
The change of cycle, though, turned them anti-cyclical at the moment
they became operative. The same can be said about the stimulus through
public expenditure (1.6 per cent of the GDP). The increase in wages and
salaries of public servants is the component which best explains this
expansion.
The fiscal impact of those tax cuts with permanent effects on public
finances is estimated to be 2 percent of GDP. The impact of the rest of
the tax cuts with temporary effects on public finance would be equiva-
lent to 0.8 percent of GDP.39
If we assess these measures bearing in mind the values of the
coefficients mentioned above, the conclusion is obvious: the fiscal stim-
ulus the Spanish economy received in 2008 is the one with lower mul-
tipliers and, therefore, its effects on the economy were minimal. There
are partial indicators that reinforce this assessment, the most significant
being the household saving behaviour. As a result of the tax decrease a
3.8 per cent increase of their disposable income was observed in 2008.
However, their consumption grew only 0.1 per cent. The result was an
increase in the saving rate of almost 3 points, rising from 10.3 per cent
in 2007 to 13 per cent in 2008. In conclusion, fiscal stimulus moved
towards saving in a context of great uncertainty and high interest rates.
The ECB kept a rising interest rate policy, which was not relieved until
the last quarter of 2008.
In 2009 fiscal policies were reoriented towards expenditure and, espe-
cially, towards public investment and the increase of transfers to unem-
ployed workers. Nowadays, it is not possible to estimate the fiscal costs
of all the fiscal measures implemented. The programmes supporting
260 The Euro Crisis
The financial crisis that began in the summer of 2007 has caused the
Spanish economy to move in a couple of years from being one of the
most dynamic European economies to one of the most deeply affected
by the crises. Not only has this materialized because of the financial
turbulences that took place at a worldwide level in the years 2007 and
2008, but also because of its direct involvement in the turbulences
affecting the sovereign debt markets in the euro area as a result of the
crises of Greece, Ireland and Portugal. Also, because of the differences
262 The Euro Crisis
existing among the euro area countries about the rescue of these three
economies, mainly in the case of Greece.
The greatest depth of the Spains problems, in comparison with other
European countries, is explained by the existence of long-lasting struc-
tural problems in the Spanish economy. We argue in the introduction
that these problems were the high levels of external indebtedness, the
inefficient design of the Spanish labour market, and the inappropriate
management of the fiscal policy. All these causes are relevant before
and during the crisis and the consequent problems of economic policy
that burden the credibility of the economic authorities and the imple-
mented measures.
In this sense, the analysis of these elements allows us to learn some
lessons from the Spanish strategy of economic growth and economic
policy. The first lesson is that the strategies of growth based on perma-
nent recourse to external borrowing are unsustainable and can lead to
financial problems, although the accumulation of external debt does
not lead to a currency crisis, as in the case of the members of a currency
union. These problems can take place although, as in the case of Spain,
the external funds do not finance the spending in consumption but the
spending on investment.
The second lesson is the need to have in the economy institutions
that can play a counter-cyclical role. In the Spanish case, the design
and working of the labour market, characterized by the excessive use
of temporary employment contracts, has generated direct and indirect
consequences, from the supply and the demand sides, that have con-
tributed to the increase in the negative impact of the (external) shocks
and to the delay the exit of the crisis.
The third lesson is the relevance of the fiscal policy. In the case of
Spain the bad management of fiscal policy before and during the crisis,
a fiscal policy that, besides not offsetting the negative impact from the
financial turbulences, has contributed to generating some fiscal imbal-
ances that have put Spain on the spot in terms of the strains on the
financial markets. Thus, learning from the experience of the bad fiscal
policy in Spain, a good fiscal policy must consider the following aspects:
the need to adopt a solid counter-cyclical stance during booms and
busts; the need to consider multipliers of the different items of public
expenditure and revenues at the time of implementing an expansionary
fiscal policy; the importance of the timing of fiscal policy; and, finally,
the importance of political economy aspects: namely, the existence of
parliamentary majorities, the coordination with sub-regional govern-
ments, and finally the credibility-reputation of the public authorities.
Jess Ferreiro and Felipe Serrano 263
Notes
1. Previous versions of this chapter were presented at the European Association
for Evolutionary Political Economy, EAEPE 2010 Conference (Bordeaux,
2830 October 2010), at the Conference entitled The Greek and the Euro Area
Crises (Bilbao, 17 December 2010), and at the 8th International Conference
entitled Developments in Economic Theory and Policy (Bilbao, 29 July1
July 2011). Comments from participants at these conferences and the edi-
tors of this volume are acknowledged. The usual disclaimer applies. We also
thank the support of the Basque Government (Consolidated Research Group
GIC10/153).
2. According to the most recent available data of the Quarterly Spanish National
Accounts corresponding to the second quarter of 2011 elaborated by the Spanish
National Institute of Statistics (data available at the Institutes website: www.
ine.es), the exports of goods are the only dynamic component of the aggregate
demand since 2010 Q1. Actually, in the second quarter of 2011, exports of
goods are growing at a year-to-year rate of 8.5%. Household final consumption
expenditure is falling at the rate of 0.2%, and the final consumption expendi-
ture by the government is falling at a rate of 1.0%. Meanwhile, gross capital
formation expenditure is falling at a rate of 6.7%. From the perspective of the
aggregate supply, the industrial sector is growing at a rate of 3.2%. Since the
GDP on the whole is growing at a rate of only 0.7%, it is clear, that the external
sector is the only one pulling the economic activity, and that it is the recovery
of Spains main trade partners, France and Germany, that is maintaining the
level of economic activity, avoiding an even worse situation than the current
one. Actually, the slow-down in the economic growth of France and Germany,
registered in 2011 Q2, has led to a lower rate of economic growth in Spain in
2011 Q2 compared to the figures registered in the previous quarter.
3. AMECO database, European Commissions Directorate General for Economic
and Financial Affairs (DG ECFIN), July 2011
4. Real GDP per capita rose +24.1% in the EU-27, +19.7% in the euro area
(17 countries), +17.1% in Germany, +18.9% in France, +10.7% in Italy,
and +27.1% in the United Kingdom (all data obtained in Eurostat, Annual
National Accounts, August 2011).
5. Nominal GDP in PPS per capita rose +54.3% in the EU-27, +48.6% in the
euro area (17 countries), +43.1% in Germany, +44.6% in France, +34.2% in
Italy, and +51% in the United Kingdom (all data obtained in Eurostat, Annual
National Accounts, August 2011).
6. Measured in PPS the Spanish GDP per capita increased in that period from
93.2% to 101.2 % of that of the European Union (EU-27), from the 82.5% to
96.3% of that of the euro area (17 countries), from 74.8% to 90.7% of that
of Germany, from 81.2% to 97.4% of that of France, from 78.6% to 90.3% of
that of the United Kingdom, and from 78.2% to 101.2% of that of Italy.
7. Much of the increase in the Spanish population is explained by the intense
immigration process registered in these years. Thus, between 1998 and 2007,
the foreign population living in Spain increased by 3.9 million people, rising
from 637,000 people in 1998 to 4,520,000 people in 2007. As a result, the
rate of foreign population in Spain increased from 1.6% of total population
in 1998 to 10% ten years later.
264 The Euro Crisis
For example, in the Spanish case, it has been observed that the structural
component of fiscal revenues is lower than the estimated one (De Castro
et al. 2008), since the estimation method of the balance attributes a part
of the extra incomes generated as a consequence of the housing boom as
structural income. The fiscal boost of 5.4 percentage points of GDP for 2008
is very likely to be lower than the one that has actually taken place. The loss
of tax collection caused by the bursting housing bubble may be imputed
to that value. In the case of expenditures, the only cyclical component
is that of unemployment benefits. The information currently available at
the time of writing does not permit marking out the structural component
of the expenditure from the cyclical component. For this reason, in the
information provided by the EU on cyclical adjusted balances, the cyclical
component takes a value of zero in most countries. Therefore, the structural
component of the expenditure is likely to be upwardly biased. In conclusion,
the intensities of the fiscal impulse must be interpreted cautiously (Serrano
2010).
33. Own calculations based on AMECO database, European Commissions
Directorate General for Economic and Financial Affairs (DG ECFIN), July
2011.
34. Given the low size of public expenditures in Spain, a tighter fiscal stance
should have been reached through the revenues side. This tighter fiscal
policy would have led to a lower size of public debt and to a lower debt bur-
den, increasing the fiscal surplus thanks to a lower spending on public debt
interests.
35. In terms of the quarter-to-quarter growth, the first quarter with negative
records is 2008 Q3.
36. The year-to-year rate of growth of the GDP in 2008 Q1 and 2008 Q2 were,
respectively, 2.7% and 1.9%.
37. For a deeper analysis of the different measures in the public expenditure and
revenues side, and the budgetary impact of these measures, see Bank of Spain
2009, 2010, and 2011.
38. The source of the data is AMECO database, European Commissions
Directorate General for Economic and Financial Affairs (DG ECFIN), July
2011.
39. These estimations have been made considering all the tax reforms (including
both direct and indirect taxes) implemented in 2008 and 2009, according
to the information provided by the Spanish Central Bank (Spanish Central
Bank 2009).
40. Source: Bank of Spain, Boletn Estadstico, General Government, June 2011
(available at www.bde.es).
41. Source: Bank of Spain, Boletn Estadstico, General Government, June 2011
(available at www.bde.es).
42. According to the most recent data available (8 September 2011), the accumu-
lated deficit of the regional governments in the period JanuarySeptember
2011 amounted to 1.2% of Spanish GDP. The objective of the fiscal deficit
of the regional governments for the whole year 2011 (JanuaryDecember)
agreed between central government and the regional governments is 1.3%
of Spanish GDP. This situation reflects the problems existing for a proper
control of the fiscal imbalances of the regional administrations.
Jess Ferreiro and Felipe Serrano 267
References
Altuzarra, A. and Esteban, M. (2008) A model of the Spanish housing market,
Journal of Post Keynesian Economics, Vol. 30, No. 3, Spring, pp. 35373.
Altuzarra, A. and Serrano, F. (2010) Firms innovation activity and numeri-
cal flexibility, Industrial & Labor Relations Review, Vol. 63, No. 2, January,
pp. 32739.
Arghyrou, M.G. and Kontonikas, A. (2011) The EMU sovereign debt crisis: fun-
damentals, expectations and contagion, Economic Papers, No. 436, February,
European Commission, Directorate-General for Economic and Financial
Affairs.
Bank of Spain (2009) Annual Report 2008, Bank of Spain, Madrid.
Bank of Spain (2010) Annual Report 2009, Bank of Spain, Madrid.
Bank of Spain (2011) Annual Report 2010, Bank of Spain, Madrid.
De Castro, F. (2005) Una evaluacin macroeconomtrica de la poltica fiscal en
Espaa (A macroeconometric valuation of the fiscal policy in Spain), Estudios
Econmicos del Banco de Espaa, No. 76.
De Castro, F., Estrada, A., Hernndez de Cos, P. and Mart, F. (2008) Una aproxi-
macin al componente transitorio del saldo pblico en Espaa (An approxi-
mation to the cyclical component of the fiscal balance in Spain), Boletn
Econmico del Banco de Espaa, June, pp. 7181.
Debrun, X., Pisani-Ferry, J. and Sapir, A. (2008) Government size and output
volatility: Should we forsake automatic stabilization? IMF Working Paper, r
WP/08/122.
European Commission (2010) Employment in Europe 2010, Directorate-General
for Employment, Social Affairs and Equal Opportunities, Employment Analysis
Unit, European Union, Luxembourg.
Ferreiro, J. (2004) Decentralized versus centralized collective bargaining: Is the
collective bargaining structure in Spain efficient?, Journal of Post Keynesian
Economics, Summer, Vol. 26, No. 4, pp. 695728.
Ferreiro, J. and Gmez, C. (2006a) New incomes policy in Spain, in Hein, E.,
Heise, A., Truger, A. (eds), European Economic Policies Alternatives to Orthodox
Analysis and Policy Concepts, pp. 12948, Metropolis, Marburg.
Ferreiro, J. and Gmez, C. (2006b) Permanent and temporary workers. The
insideroutsider model applied to the Spanish labour market, conomie
Applique, Vol. LIX, No. 1, pp. 12152.
Ferreiro, J. and Gmez, C. (2008) Is wage policy again in the agenda of trade
unions? Voluntary wage moderation in Spain, Economic and Industrial
Democracy, Vol. 29, No. 1, pp. 6495.
Ferreiro, J., Gmez, C., and Serrano, F. (2007) How much room for expansionary
economic policies in the EMU: The case of Spain, in Hein, E., Priewe, J. and
Truger, A. (eds) European Integration in Crisis, pp. 195219, Metropolis Verlag,
Marburg.
Ferreiro, J. and Serrano, F. (2001) The Spanish labour market: Reforms and con-
sequences, International Review of Applied Economics, Vol. 15, No. 1, January,
pp. 3153.
Ferreiro, J. and Serrano, F. (2004) The Economic Policy in Spain during the
Decades of the 1980s and the 1990s, in Arestis, P. and Sawyer, M. (eds) Neo-
Liberal Economic Policy, Edward Elgar, Cheltenham, pp. 11757.
268 The Euro Crisis
International Monetary Fund (2009) Spain: Selected Issues, IMF Country Report
No. 09/129, April.
International Monetary Fund (2010) Cross-Cutting Themes in Employment
Experiences during the Crisis, 8 October 2010.
International Monetary Fund (2011) Spain 2011 Article IV Consultation
Concluding Statement of the Mission, Madrid, June 21.
Jaumotte, F. (2011) The Spanish labor market in cross-country perspective, IMF
Working Paper,r WP/11/11.
Larch, M. and Turrini, A. (2009) The cyclically-adjusted budget balance in EU
fiscal policy marking: A love at first sight turned into a mature relationship,
European Economy, Economic Papers, March, No. 374, pp. 144.
Serrano, F. (2010) The Spanish fiscal policy during the great recession, Journal of
Post Keynesian Economics, Vol. 32, No. 3, Spring, pp. 37188.
Index
269
270 Index