European Economy Recovery Plan: An Evaluation

Paul De Grauwe

University of Leuven and CEPS

Introduction

• European Commission launched a Recovery Plan in November 2008

• Four principles– Timely, Temporary, Targeted, Co-ordinated– Mix of revenue and expenditure instruments– Within framework of SGP– Accompanied by structural reforms

• How well has this worked?

Preliminary remark

• The European Stimulus Program had very little European dimension

• It was a summing up of national stimulus programs

• that were mostly uncoordinated. • The discretionary stimulus content was

very small• Approximately two-thirds of the stimulus

came from automatic stabilizers.

EC-estimates of different components of budget deficit in euro area

• The question is: how well has Europe done?

• Given that so little discretionary stimulus was applied

• Surprisingly well• I say surprisingly because virtually all

economists predicted that Europe would suffer more than the US

• Here is the evidence from Daniel Gros

How well has Europe done?Better performance than US

Misery index for the euro ara (consumption growth and change in unemployment rate)

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Mis

ery

ind

ex

Euro area (16 countries)USUnited Kingdom

Source: Daniel Gros, CEPS

But large differences between EU-countriesMisery index (consumption growth and change in unemployment rate)

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Mis

ery

ind

ex Germany

Spain

France

Italy

Source: Daniel Gros, CEPS

• Among the big euro area countries Spain is the exception

• It did not so well

• Spain compares well with UK

• Why these differences?

• Two factors– Initial conditions: US, UK, Spain had gone

through more intense boom and bubble• Much of the growth experienced in these countries

prior to crisis was artificial• Based on exessive debt creation• Many economists were fooled by the high growth

rates of these countries• And saw mysterious productivity miracles in these

countries (especially in US but also in UK)

• And lectured everybody that continental Europe had to emulate the US

• By introducing structural reforms• This was all fiction

– Flexibility turned out to be a disadvantage• Debt deflation dynamics is intensified in flexible

countries• where social security is weak

– This being said the crisis is far from over– Also in the more succesful continental EU-

countries

Where do we go from here?Exit strategies

• Resurgence of growth has led to calls for an exit strategy, i.e. reduction in spending and increases in taxes

• Is this a good idea

• Growth alone is not sufficient to decide about timing of exit strategy.

• We have to look at origin of crisis

• Which is a debt deflation dynamics

Private and public debt prior to crisis.

Private and government liabilities in eurozone(percent GDP)

0

50

100

150

200

250

300

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

per

cen

t

Bank liabilities

Government debt

Household debt

Corporate debt

Source: CEPS and European Commission

A little blowup of previous figure

Household and government debt in eurozone(percent GDP)

20

30

40

50

60

70

80

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

per

cen

t

Government debt

Household debt

Provisional conclusion

• In period prior to crisis, the problem was excessive and fast increasing PRIVATE debt, rather than public debt

• Yet, Eurozone had set up elaborate mechanism watching and controlling public debt and deficits

• No such mechanism existed to contain private debt,

• despite the fact that governments were implicity guaranteeing significant parts of private debt, especially debt of financial institutions

Role of the ECB during boom years

• The ECB has set up its two-pillar strategy that should have warned about excessive growth of bank credit and liabilities

• It did not

• True ECB was successful in keeping inflation low

• But why did this two-pillar strategy fail to detect the credit boom?

Growth rate of total bank loans (left) and Stock price index(right) in euro area

2%

4%

6%

8%

10%

12%

14%

2003Jan 2004Jan 2005Jan 2006Jan 2007Jan 2008Jan

% c

han

ge

60

80

100

120

140

160

180

200

ind

ex

Loans

Stock price

Source: ECB

• Two-pillar strategy was used exclusively to target CPI-inflation

• Information about M3-growth was not used to temper asset prices and bank credit

• As a result the euro area experienced similar boom and bust cycle as the US

• Different two-pillar strategy is necessary

• Using additional instruments

After the bailout: hangover in eurozone …and even bigger hangover in US

Government debt in Eurozone and US(2009, 2010 forecasts)

40

50

60

70

80

90

100

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

per

cen

t o

f G

DP

EA-12

USA

Source: European Commission

• Explosion of government debt is direct result of explosion of private debt

• It came about as result of debt deflation dynamics discussed earlier

Debt deflation dynamics

• The simultaneous action of individuals to reduce their debt is self-defeating: • They all sell assets at the same time, thereby reducing

the value of these assets.• This leads to a deterioration of the solvency of

everybody else, • forcing everybody to increase their attempts at

reducing their debt by selling assets.

• This can only be solved by government willing to increase its debt, thereby allowing private sector to reduce its own debt without a meltdown in economic activity.

• A refusal of government to increase its debt so as to allow the private sector to reduce its own could have led to

• intense depression in economic activity• leading to large losses of government revenues• which would equally have led to an explosion of

government debt. • Thus refusal to increase government debt would

have led to both a depression and an explosion of government debt

• In other words it would not have prevented a deterioration of government budgets

• Previous discussion suggests that exit strategies are premature

• Private debt is still too high in many countries (US, UK, Ireland, Spain)

• Exit strategy would start debt deflation dynamics again

• Note that this problem is more acute for US, UK, Ireland, Spain

• Than for the “rigid” continental EU-countries

• Paradoxically, those with the highest budget deficits (US, UK, Ireland, Spain) can least afford to start a process of budgetary restrictions.

Academic note

• Previous analysis is based on idea that macroeconomy can experience potential for instability

• This feature is absent from mainstream macroeconomic models (DSGE)

• which are stable equilibrium models• assuming Ricardian equivalence• That is also why these models will always tell us

that fiscal stimulus have few beneficial effects • and should not be undertaken

Source: Volker Wieland, et al.

Impact of permanent increase in US government spending of 1% of US-GDP

0

0,2

0,4

0,6

0,8

1

1,2

1,4

1,6

1,8

2009Q1 2009Q4 2010Q4 2011Q4 2012Q4

%in

cre

as

e i

n r

ea

l U

S-G

DP

Keynesian camp

Ricardian camp

Are present debt levels in euro-area sustainable?

• Let’s first get some perspective

• Forecast of budget deficits (European Commission:

EA-12 US

2009 5.3% 12.1%

2010 6.5% 14.2%

If euro area deficit and debt level are unsustainable, US debt level appears even more unsustainable

Interest payments as % GDP

EA-12 US

2009 3.1% 2.6%

2010 3.2% 2.6%

“Exorbitant privilege” of the US?

Common eurobond issue?

Are Government deficits sustainable?

• Clearly if deficit levels are maintained indefinetely

• and if nominal growth rate remains low

• these deficits are not sustainable

• This can easily be seen from fact that stability condition :– Primary surplus > interest rate – Nominal growth – Is not satisfied today

• In euro-area (2009):

• interest rate - nominal growth = 6%

• However, primary surplus is - 3% So there is shortfall of 9% to guarantee stability

• But this is only a temporary snapshot

• Forecasts for 2010 (EC): 2% and - 4%

• Thus shortfall is 6% due to forecasted pickup of economic activity

Conclusion

• Present government debt levels are unsustainable

• but necessary• An exit strategy is premature especially in

countries with highest deficits• Government debt will be easier to deal with

when nominal growth increases• I also believe that modern democracies are

sufficiently mature to deal with this problem• By adjusting primary surplus (i.e. spending and

taxation)

• The fear that government debt levels will lead to defaults is excessive

• And so is the fear that it may lead to a disintegration of the euro area, when some countries default and others refuse to bail-out

• There will be problems and strains

• But they can be managed