Fiscal Consolidation in Europe

Important disclosures appear at the back of this document

European Economics Analyst Issue No: 12/04

April 12, 2012

Goldman Sachs Global Economics, Commodities and Strategy Research

at https://360.gs.com

Achieving Fiscal and External Balance (Part 4): Escaping the vicious circle This is the final article in a series assessing the challenge faced by Euro area countries in achieving external and fiscal balance. The story we have told so far is predominantly one of cyclical adjustment within constraints imposed by the structural parameters of these economies. Our results suggest that, for some Euro area countries—notably Greece and Portugal, but arguably Spain as well—the task of regaining fiscal and external balance through cyclical adjustment alone appears large, to the point of being insurmountable.

But the story does not end here. Well-designed structural reform could change the structural parameters of these economies in ways that would alleviate the trade-off that they face. Indeed, such is the severity of the ‘all else equal’ scenario set out in Parts 1-3 of this series that, for a number of these economies, structural reform provides the only realistic prospect of making the adjustment work. The need for reform is not exclusive to the periphery: Germany and France also have important work in this area.

The implementation of structural reform is also painful and the alternative—which could come about through choice or by default—would be to allow the break-up of EMU. Our own view remains that the likelihood of this outcome is low because the political commitment to EMU (and to structural reform) is strong and the cost of break-up would be high.

The good news is that in some of the peripheral economies—notably Portugal, Spain and Italy—progress has been made in implementing structural reforms. But these countries are still closer to the beginning of this journey than to the end, and the road ahead is likely to remain difficult.

Huw Pill [email protected] +44 (0)20 7774 8736 Kevin Daly [email protected] +44 (0)20 7774 5908 Dirk Schumacher [email protected] +49 (0)69 7532 1210 Andrew Benito [email protected] +44 (0)20 7051 4004 Lasse Holboell W. Nielsen [email protected] +44 (0)20 7774 5205 Natacha Valla [email protected] +33 1 4212 1343 Antoine Demongeot [email protected] +44 (0)20 7774 1169 Adrian Paul [email protected] +44 (0)20 7552 5748

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Source: GS Global ECS Research, * nom. growth assumed 2% in GRC and POR, 3% in IRE, ESP and ITA , and 4% in GER and FRA, **incl. terms of trade effects.

Real exchange rate chg.**

April 12, 2012 Issue No: 12/04 2

European Economics Analyst Goldman Sachs Global Economics, Commodities and Strategy Research

Achieving Fiscal and External Balance (Part 4): Escaping the vicious circle Achieving Fiscal and External Balance To a greater or lesser extent, peripheral countries in the Euro area (Greece, Portugal, Ireland, Spain and Italy) face two, interconnected challenges. They need to: (i) regain competitiveness (so as to effect external adjustment) and (ii) correct large public-sector deficits and debts. Countries addressing these ‘twin imbalances’ within a monetary union confront a ‘Catch 22’: dealing with one imbalance is likely to exacerbate the other. Why? With a single currency, regaining competitiveness relies largely on running lower inflation than the Euro area average to adjust the real exchange rate. But stronger nominal GDP growth is needed to address fiscal problems and put public debt on a sustainable path. The low inflation (or deflation) required to regain competitiveness will exacerbate fiscal difficulties.

Given the interconnection between external and fiscal adjustments in the Euro area, it makes sense to consider the challenges of correcting the imbalances together. This is the fourth (and final) article in a series—Achieving Fiscal and External Balance—that aims to do just that.

A summary of our results: A demanding benchmark In the first article in this series, we estimated the relative price adjustment that peripheral economies will be required to make in order to return their economies to ‘external sustainability’.1 We found that Portugal requires the largest relative price adjustment (around 35%) to achieve external balance, while the equivalent figure is just below 30% for Greece and just above 20% for Spain (Chart 1). On our ‘base-case’ estimate, Italy’s real exchange rate depreciation figure is considerably smaller,

at around 10%-15%, while Ireland’s adjustment appears broadly complete.

In the second article, we considered how much ‘pain’ is likely to be required in peripheral economies—in terms of output and employment sacrificed—to achieve the required price adjustments estimated in Part 1.2 We based this assessment on estimated ‘sacrifice ratios’—which relate reductions in inflation to output losses (or rises in unemployment). Assuming a ten-year adjustment period, the implied additional output losses relative to trend (i.e., over and above those already suffered) are large in Greece and Portugal (with estimates ranging from 5% to 10% of GDP; Chart 2). That reflects both the scale of adjustment required in those countries and their high estimated sacrifice ratios. In Italy and Spain, where inflation is already at or below the Euro area average, much of the adjustment in output relative to trend already appears complete. In Germany, sustained above-trend output growth is required to drive inflation higher.

In the third article, we described how the process of regaining competitiveness through relative price adjustment interacts with the fiscal adjustments that are also underway in these economies.3 We considered the impact on public debt dynamics of our estimates of the required real depreciation (derived in Part 1) and output loss (from Part 2). Over 10 years, these two effects imply an increase in the debt-to-GDP ratio of around 35ppt in Portugal, 30ppt in Greece, 10ppt-15ppt in Spain and France, 5ppt in Italy, but zero in Ireland (Chart 3). Expressed in terms of the required primary deficit to stabilise the fiscal situation, Greece and Portugal need an improvement of 1.5ppt-2ppt, France and Spain 0.5ppt, and Italy around 0.25ppt.

1. “Achieving Fiscal and External Balance (Part 1): The price adjustment required for external sustainability”, European Economics Analyst, March 15, 2012.

2. “Achieving Fiscal and External Balance (Part 2): The price of competitiveness”, European Economics Analyst, March 22, 2012. 3. “Achieving fiscal and external balance (Part 3): External adjustment, weaker prices and public debt”, European Economics Analyst, March 29, 2012.

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Source: GS Global ECS Research, * nom. growth assumed 2% in GRC and POR, 3% in IRE, ESP and ITA , and 4% in GER and FRA, **incl. terms of trade effects.

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Note: NIIP is the net international investment (net foreign asset) position

April 12, 2012 Issue No: 12/04 3


How do these results compare with financial markets’ perception of each country (as reflected, for instance, in government bond spreads)? Greece—perhaps unsurprisingly—emerges relatively badly from this analysis. More surprising is that Portugal performs just as poorly as Greece on a number of metrics. Our analysis also suggests that the challenge faced by Spain to regain fiscal and external balance is significantly more arduous than that faced by Italy (something that has been reflected in the recent trading recommendations from our markets group). Ireland comes out relatively well: while its fiscal challenge remains large, the task of regaining external balance is complete. Finally, while France’s fiscal and internal imbalances are significantly smaller than those in the peripheral economies, the small size of its tradables sector implies that large relative price adjustments are needed to re-establish a sustainable external balance.

Escaping the vicious circle Our focus in this article is on whether policymakers—at the national and Euro area level—have the means to ease the painful adjustment that they currently face. For some Euro area countries—notably Greece and Portugal, but arguably Spain as well—the task of regaining fiscal and external balance implied by our analysis (so far) appears large, to the point of being insurmountable. Were our analysis to end here, it would suggest that—at best—these peripheral economies face a prolonged period of exceptional economic weakness while the required adjustments take place.

However, this is not the end of the story. The estimates provided in Parts 1-3 of this series provide a realistic benchmark of the challenge that Euro area countries face on an ‘all else equal’ basis. The story we have told so far

is predominantly one of cyclical adjustment within the constraints imposed by the structural parameters of these economies. But all else need not be equal: well-designed structural reform could change the structural parameters of these economies in ways that could alleviate the trade-off that they face. Indeed, such is the severity of the ‘all else equal’ scenario set out in Parts 1-3 that, for a number of these economies, structural reform provides the only realistic prospect of making the adjustment work.

What can Euro area countries do to reduce the ‘pain’ of these adjustments implied by our analysis? Specifically, what are the parameters that need to change and what are the structural reforms that can deliver the required changes to those parameters? We focus on the task of regaining external competitiveness, as it is the negative feedback from this to deficit and debt dynamics which exacerbates the task of regaining fiscal balance.4

We set out the parameters of the problem using a standard Phillips curve relationship that links the size of the output gap (or the level of unemployment) to inflation (Chart 4). Inflation tends to fall when an economy is cyclically weak (i.e., there is a negative output gap), and it tends to rise when an economy is operating above capacity. However, for most economies, the relationship between spare capacity and inflation that the Phillips curve describes is not linear: even if the output gap turns significantly negative, inflation typically struggles to fall below zero. This downward price rigidity at large negative output gaps reflects the importance of the 0% nominal threshold in the setting of prices and the fact that nominal wages, in particular, are rigid downwards (i.e., workers are less prepared to accept a 1% decline in nominal wages when inflation is zero than a 1% rise in wages when inflation is 2%).5 In economies where there

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4. This leaves aside the question of how the fiscal correction should be designed in order to minimise the damage that it inflicts on the economy. Cross-country evidence suggests that growth tends to fare better in fiscal corrections driven by reductions in current spending rather than those driven by higher taxes or cuts in investment. See, “Limiting the fall-out of fiscal adjustment”, Global Economics Paper No. 195, April 14, 2010.

5. Because economies face sectoral and regional shocks over time that necessitate relative adjustments in real wages, the reluctance of all workers to accept nominal wage cuts results in overall inflation stickiness kicking in at a level above 0% (put another way, the truncation of the distribution at zero results in the mean of the distribution becoming sticky at a rate well above zero). The evidence of the 0% bound exists in both micro and macro data. For instance, in a cross-sectional distribution of pay-settlements data, there is typically a large clumping together of results at 0%. For a review of the empirical evidence in this regard, see Holden and Wulfsberg, 2007, “Are Real Wages Rigid Downwards?”, CESifo Working Paper Series No. 1983.

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Chart 3: Weaker* potential growth raises debt-to-GDP by 5-10ppt by 2020

Impact on debt-to-GDP in 2020 from weaker-than-base-case growth

Source: GS Global ECS Research, *Relative to IMF base-case for POR, IRE and GRC, and EWA 12/06 base-base for ITA, FRA and ESP, with growth assumed 1ppt lower in POR;0.5ppt lower in elsewhere (excl. GER)

April 12, 2012 Issue No: 12/04 4


is a high degree of flexibility in the setting of wages and other prices, the importance of the 0% threshold typically appears less pronounced.6

That the Phillips curve tends to be flat at large negative output gaps is one reason why the task of regaining external competitiveness through cyclical forces alone is very difficult. Starting off from Point A in Chart 4, the decline in inflation implied by the transition to Point B starts the process of regaining competitiveness. But, as the output gap turns increasingly negative (Point C), the additional benefit in terms of lower inflation is small. No matter how weak the economy becomes, it takes a long time for competitiveness to be regained if inflation does not turn negative.

The Phillips curve sets out—in a stylised sense—the structural parameters of the adjustment problem. How can these parameters be altered to ease the adjustment process? There are two ways this can occur:

Adjusting the slope of the Phillips curve: Chart 5 shows how the situation would differ if the Phillips curve did not flatten out as the output gap turns negative. If wage growth is responsive to labour market weakness, then unemployment will need to rise by less to bring about the required competitiveness adjustment. (In Chart 5, as the economy weakens, it transitions to Points B’ and C’, where inflation is lower than B and C and, thus, the ‘pain’ required to regain competitiveness is less.) The example of Ireland—where inflation and nominal wages both turned negative during the recession—showed that this is possible given sufficient flexibility in the setting of wages and other prices. Labour market reform can improve the unemployment-inflation trade-off in this way, if it increases flexibility and increases the labour market’s ability to adjust to negative shocks once they occur.

And, as Andrew Benito argued in a recent piece, a more flexible labour market also implies a reduced impact from fiscal austerity on growth.7

Shifting the position of the Phillips curve: A shift in the Phillips curve to the right—displayed in Chart 6—would imply an improved trade-off between the output gap and inflation at all points along the curve. Such a move would imply higher output, for a given inflation rate. What could induce such a shift? Labour market reform, in addition to increasing the ability to adjust to shocks once they occur, can also bring about such a move by pushing up average employment rates. An increase in whole-economy productivity growth would also result in a rightward shift in the Phillips curve. However, while there is a fairly direct link between well-designed labour market reforms and labour market outcomes, productivity growth is more difficult for governments to influence directly. An added complication is that, while higher whole-economy productivity growth would clearly improve the trade-off that the peripheral countries face, higher productivity growth in the ‘wrong’ sectors could have the effect of exacerbating external imbalances.8 As we discussed in Part 1 of this series, the peripheral economies require a rebalancing in output from the non-traded to the traded sectors, while Germany requires the converse adjustment. To increase the elasticity between traded and non-traded sectors in peripheral economies and Germany alike, structural reform in the peripheral states should focus on the traded sectors, while reform in Germany should focus on non-traded sectors, such as services. In this respect, reforming Germany’s retail sector, for example, could play just as important a role in rebalancing the Euro area economy as improving productivity in the periphery’s traded sector.

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Chart 6: A rightward shift in the Phillips curve implies more output for a given inflation rate


6. Different labour market structures create their own individual complexities. In Spain, for instance, the dual labour market structure results in a sharp ‘kink’ in the Phillips curve: a fall in employment in the ‘flexible sector’ influences wage dynamics up to the point where most/all of these workers lose their jobs, leaving only ‘protected sector’ employees who are resistant to wage changes.

7. “Avoiding Austerity and Inflexibility in a ‘Keynesian’ Labour Market: Some Good and Bad News”, European Weekly Analyst, February 2, 2012. 8. In this respect, the challenges of correcting external and fiscal imbalances are distinct. Stronger productivity growth would improve the fiscal

imbalance but, depending on the sector in which it is located, it would not necessarily improve the external imbalance.

April 12, 2012 Issue No: 12/04 5


9. “Next steps for the Euro area—A primer”, European Weekly Analyst, September 15, 2011.

Optimising structural reform With this framework and these parameters in mind, how are Euro area member states progressing in implementing structural reforms that would improve the terms of the trade-off? The discussion here is brief—we will look at individual countries in more detail in future research—and our focus is on the implementation of structural reform (rather than on the implementation of fiscal adjustment). Considering each of the countries in turn:

Greece implemented important labour market legislation in mid-2010 but its subsequent progress in implementing structural reform to labour and product markets has been disappointing. Notably, the liberalisation of regulated professions (lawyers, auditors, engineers, etc.) has been delayed.

While the challenge that Portugal faces is daunting, it has already made significant progress. The government, unions and employers have reached agreement on a set of labour market reforms that make it easier for companies to hire and fire, and that reduce compensation for redundancy and holiday entitlements. Earlier this month, EU/IMF assessors declared that Portugal’s programme of economic reforms was “on track”.

For Ireland, given that labour and product markets are already relatively flexible and external competitiveness has been regained, there is less need for structural reform (i.e., the primary focus is on regaining fiscal balance).

For Spain, labour market reform is the key area where urgent progress is required. The Spanish authorities have successfully implemented some reforms—such as allowing firms to opt out of centralised pay-setting—and these should help to facilitate greater pay flexibility over time. However, even with these changes, Spain’s labour market is less flexible than elsewhere in the Euro area.

For Italy, with most inflation measures already running below the Euro area average and a primary fiscal surplus, the key challenge is to raise potential growth. In this regard, some of the reforms introduced by the Monti government are likely to have helped but significant work remains. Important labour market reforms remain in the balance: while the government recently announced compromises to proposed legislation, the substance of the measures remains intact. If the government succeeds in implementing the legislation in its current form—against union opposition—it would represent an important development in the liberalisation of Italy’s labour market.

While there has been much less focus on the need for reform in ‘core’ Euro area economies, changes are necessary here too:

For France, the small size of its tradables sector implies that large relative price adjustments are needed to re-establish a sustainable external balance. It will be difficult to bring about such an adjustment without shifting resources from the domestically-oriented public sector into the externally-oriented parts of the private sector. Ahead of the Presidential election, progress in this regard has been limited.

Germany also has an important role to play in the adjustment process (and not only in underwriting the system financially as others readjust). As already discussed, reforming Germany’s services sector would aid the adjustment process in the Euro area periphery. However, proposed changes in this area appear to have fallen off the agenda. And, while relatively high inflation may be politically unpopular in Germany, it is difficult to see how the periphery’s return to external competitiveness can take place without it.

Accepting the obligations of Euro membership The analysis set out in Parts 1-3 of this series of articles suggests that, for some Euro area countries, the task of regaining fiscal and external balance through cyclical adjustment alone is likely to prove exceptionally difficult. Such is the severity of the problem that, for a number of economies, structural reform provides the only realistic prospect of making the adjustment work. The need for reform is not exclusive to the periphery: Germany and France also have important work in this area.

Of course, the implementation of structural reform is itself difficult. But, if the members of the Euro area want the Euro to survive, they need to accept the obligations that this entails and the implementation of structural reform represents a necessary part of those obligations.

The alternative—which could come about either through choice or by default—would be to allow the break-up of the Euro area. Our own view remains that the likelihood of this outcome is low because the political commitment to EMU (and to structural reform) is strong and the cost of break-up would be high.9 While the reintroduction of exchange rate flexibility would bring some clear advantages, it would also involve substantial costs (widespread public-sector defaults and the collapse of banking systems around Europe, to name just two likely outcomes) and a great deal of uncertainty.

The good news is that in some of the peripheral economies—notably Portugal, Spain and Italy—progress has been made in implementing structural reforms. But these countries are still closer to the beginning of this journey than to the end, and the road ahead is likely to remain difficult.

Kevin Daly

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April 12, 2012 Issue No: 12/04

Key European Indicators

...and our UK Current Activity Indicator picked up in March.

Our survey-based GDP tracker points to very modest positive growth in the Euro area...

We expect a significant convergence in Euro area and UK inflation in 2012, to rates below 2%.

Data releases have surprised on the upside in recent months.

Business sentiment softens in the Euro area, while the UK improves.

European financial conditions are easy, with the exception of Switzerland.

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April 12, 2012 Issue No: 12/04

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Main Economic Forecasts GDP Consumer Prices Current Account Budget Balance

(Annual % change) (Annual % change) (% of GDP) (% of GDP)2011 2012(f) 2013(f) 2011 2012(f) 2013(f) 2011 (f) 2012(f) 2013(f) 2011(f) 2012(f) 2013(f)

Euro area 1.5 -0.5 0.6 2.7 2.0 1.5 -0.3 -0.1 -0.1 -4.7 -4.0 -3.2Germany 3.1 0.9 1.5 2.5 1.5 1.7 5.3 4.1 3.9 -1.5 -1.0 -0.7France 1.7 0.3 1.0 2.3 2.0 1.7 -2.3 -0.8 -0.9 -5.4 -5.0 -4.0Italy 0.5 -1.3 0.0 2.9 2.3 1.3 -3.2 -1.2 -0.8 -4.1 -3.2 -2.2Spain 0.7 -1.7 -0.7 3.1 1.7 1.1 -3.7 -3.2 -2.3 -8.5 -6.7 -5.9

UK 0.8 1.2 2.3 4.5 2.7 1.8 -2.4 -1.9 -2.3 -8.0 -7.2 -5.9Switzerland 1.9 0.1 1.4 0.2 0.4 0.7 16.0 15.6 15.4 -0.3 -0.2 -0.1Sweden 4.0 0.9 2.3 2.6 2.0 2.2 7.2 6.2 6.0 0.3 0.1 0.6Denmark 1.0 0.2 1.4 2.7 1.1 1.6 5.6 5.6 4.0 -3.7 -5.6 -5.4Norway* 2.7 2.3 2.5 1.3 1.2 1.6 14.6 15.0 15.0 - - -Poland 4.3 2.6 3.4 4.3 4.1 2.8 -4.1 -3.9 -4.1 -5.2 -3.3 -3.0Czech Republic 1.6 0.6 2.5 1.9 3.3 1.0 -2.5 -2.5 -2.6 -3.9 -3.0 -2.8Hungary 1.6 -0.5 1.8 3.9 6.0 5.7 1.2 2.2 1.9 1.5 -3.5 -3.0

*Mainland GDP grow th.

Source: GS Global ECS Research.

8 April 12, 2012 Issue No: 12/04

European calendar

Focus for the Week Ahead

March CPI inflation figures for the Euro area and the UK will be released on Tuesday. We expect Harmonised CPI inflation to come in at +2.6%yoy in the Euro area, in line with its flash estimate. However, the higher-than-expected CPI inflation print for France points to upside risks to the Euro area aggregate. In the UK, we expect CPI inflation to continue to decline, to +3.3%yoy in March from +3.4%yoy in February—its sixth consecutive fall from a peak in September.

The ILO unemployment rate is also due in the UK next week (on Wednesday). We expect it to have remained unchanged at 8.4% in the three months to February. We do not expect any major developments from the Minutes of the MPC’s April decision (also on Wednesday).

Elsewhere in Europe, the Swedish Riksbank meets next Wednesday. We expect the Central Bank to leave the repo rate unchanged at 1.5%; indeed, we expect no change in monetary policy in Sweden until the second quarter of next year.

In Germany, the April Ifo is due on Friday. Last month the overall business climate component rose from 109.7 to 109.8, widening its divergence with the PMI.

Economic Releases and Other Events

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

07 08 09 10 11 12

ppt

EnergyAll food, alcohol & tobaccoCoreTotal

Source: Eurostat, GS Global ECS Research

GS forecast

Inflation should moderate later in 2012

Country Time Economic Statistic/Indicator Period EMEA-MAP(UK) mom/qoq yoy mom/qoq yoy Relevance

Fri 13th AprilGermany 07:00 Harmonised CPI Mar F — +2.3%yoy — 2.5%yoy -Spain 08:00 Harmonised CPI Mar — +1.8% — +1.9% -Italy 09:00 Industrial Production Feb — — –2.5% –4.1% 5UK 09:30 Producer Prices Mar — — +0.6% +4.1%UK 09:30 PPI - Ex Food, Drink, Tobacco & Petrol Mar — — +0.5% +3.0% -Italy 10:00 Harmonised CPI Mar F — +3.8% — +3.4% -

Mon 16th AprilSwitzerland 08:15 Producer & Import Prices Mar — — — –1.9% -Norway 09:00 Trade Balance Mar — — NOK 45.3bn — 1Euro area 10:00 Trade Balance Feb — — EUR 5.9bn (sa) — 0

Tues 17th AprilUK 09:30 CPI Mar — +3.3% — +3.4% -UK 09:30 RPI Mar — +3.6% — +3.7% -Germany 10:00 ZEW Financial Markets Indicator Apr — — — 37.6 2Euro area 10:00 Harmonised CPI Mar F — +2.6% — +2.7% -

Wed 18th AprilSweden 08:30 Monetary Policy Meeting Apr 1.5% — 1.5% — -UK 09:30 Minutes of MPC Meeting Mar — — — — -UK 09:30 ILO Unemployment Rate 3m-Feb 8.4% — 8.4% — 4UK 09:30 Claimant Unemployment Mar 5.0% — 5.0% — -UK 09:30 Average Earnings - Headline Rate Feb — +1.2% 3m/yoy — +1.4% 3m/yoy -

Thurs 19th AprilEuro area 15:00 Consumer Confidence Apr — — — –19.1 4

Fri 20th AprilGermany 09:00 IFO Business Survey Apr — — 109.8 — 3UK 09:30 Retail Sales - Ex Autos Mar +0.2% +1.1% –0.8% +1.0% 3

Forecast* Previous

Source: Bloomberg, GS Global ECS Research. Economic data releases are subject to change at short notice in calendar. Complete calendar available via the Portal — https://360.gs.com/gs/portal/events/econevents/. * In the case of the PMIs, the Forecast is simply the Flash estimate where available (Flash PMIs are published by Markit for the Euro area, Germany and France 1-2 weeks before the end of the reference month).

Fiscal Consolidation in Europe

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