Euro Area Policies: Selected Issues

This 2012 Article IV Consultation—Selected Issues Paper on Euro Area Policies argues that the creation of a common eurozone financial stability architecture is an immediate priority to restore the viability of the Economic and Monetary Union. The paper presents a narrative of the various stages of the banking and sovereign crisis since the Summer of 2011. It also characterizes the downward spirals at play in periphery euro area countries and describes the process of financial de-integration within the euro area.

Abstract

This 2012 Article IV Consultation—Selected Issues Paper on Euro Area Policies argues that the creation of a common eurozone financial stability architecture is an immediate priority to restore the viability of the Economic and Monetary Union. The paper presents a narrative of the various stages of the banking and sovereign crisis since the Summer of 2011. It also characterizes the downward spirals at play in periphery euro area countries and describes the process of financial de-integration within the euro area.

III. Fiscal Consolidation Under the SGP: Some Illustrative Simulations1

A. Introduction

1. The Stability and Growth Pact (SGP) continues to be at the core of European Union (EU) fiscal governance (Figure 1). The SGP was put in place in Maastricht to avoid excessive deficits and debt levels. However, fiscal slippages during the first decade of the Economic and Monetary Union (EMU) led to high vulnerabilities during the crisis (Perez, 2011). To remedy past flaws, EU fiscal governance is being upgraded around a number of reforms focusing on intertwined objectives. These include tighter national enforcement of EU fiscal rules (implementation of the Directive on national fiscal frameworks under the “six-pack” and automatic correction mechanisms under the “Fiscal Compact”); expanded surveillance over internal and external imbalances (through the Excessive Imbalances Procedure introduced under the “six-pack”); and enhanced EU oversight of national budgetary processes (“two-pack”). Underpinned by these complementary processes, the SGP occupies a central role in the EU fiscal framework.

Figure 1.
Figure 1.

Recent EU Fiscal Governance Reforms

Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A003

Note: 1/ Procedures currently in place; 2/ Expected entry into force is autumn 2012 for the two pack; January 2013 for the Directive on National Fiscal Frameworks; and January 2014 for the automatic correction mechanisms mandated by the Fiscal Compact.

2. Both the scale and speed of consolidation in EMU countries are influenced by SGP rules. Bringing debt ratios down to safer levels will require a sustained period of adjustment. The key question is whether the pace of consolidation driven by the SGP is appropriate in the face of a weak outlook.

3. This paper quantifies the output effects from fiscal consolidation implied by the SGP. To this aim, we propose a conceptual framework in three steps. First, we take the April 2012 WEO as our baseline for fiscal consolidation.2 Second, we quantify the gap between fiscal plans under this baseline and the SGP targets (in structural terms) keeping GDP at WEO levels (i.e. no multiplier effects are at play). Third, using the IMF’s dynamic stochastic general equilibrium model—the Global Integrated Monetary and Fiscal model (GIMF)—we simulate the output effects of that fiscal shock. In short:

Step 1: We choose as baseline scenario the April 2012 WEO.

Step 2: We quantify the fiscal shock as

αt=Sbt,SGPGDPt,WEOSbt,WEOGDPt,WEO

where αt represents the change in the structural balance (Sb) to GDP ratio relative to the fiscal consolidation path projected in the WEO, for a given GDP (at WEO values).

Step 3: Shock our model economy with αt and quantify the output decline GDPt,SGPGDPt,WEO when multiplier effects are at work.

4. The rest of this paper is organized as follows. Building on EU legislation and discussions with the European Commission (EC) during the 2012 Article IV Consultation, Section B outlines the order of prevalence between the various SGP benchmarks and quantifies fiscal consolidation needs relative to the April 2012 WEO. Section C subsequently presents the associated output loss under different sets of assumptions. From the different scenarios, it is evident that the effects of fiscal consolidation depend largely on the composition and credibility of fiscal packages, as well as the ability of monetary policy to cushion the fiscal tightening. We therefore conclude with a number of policy recommendations (Section D).

B. A Characterization of SGP Regimes

5. Since its introduction in Maastricht, the SGP system has become increasingly complex (Table 1). Countries are: required to converge to the 60 percent of GDP debt benchmark; prohibited from breaching the 3 percent of GDP deficit threshold; and mandated to improve the structural deficit to GDP ratio at an average rate of 0.5 percent per year. In addition, government spending is constrained to grow in line with trend GDP. This raises the question of the order of prevalence between the existing rules, complicating the task of quantifying the fiscal shock implied by the SGP.

Table 1.

EU Fiscal Rules from Maastricht to the Fiscal Compact

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Sources: Staff, based on the EU treaty, SGP secondary legislation and the Fiscal Compact intergovernmental treaty.

6. To disentangle the order of prevalence between rules, we assume the strictest criteria apply. EU regulations and discussions with the EC suggest that where there is an overlap between rules, countries would be subject to the strictest benchmark. This rules out the possibility of over-determination and makes it possible to calculate SGP consolidation paths in an unambiguous manner.

7. Over the WEO horizon, we assume compliance with the rules follows a three-stage process. All fiscal commitments, independently of their nature, are translated into deviations from the WEO in terms of the structural deficit to GDP ratio.3 Two regime switches operate during the WEO projection period, from the overall to the structural deficit benchmark; and from the latter to the debt reduction criterion. The relevant fiscal regimes can be summarized as follows:

  • EDP phase. Countries currently under Excessive Deficit Procedures (EDP) are expected to deliver structural adjustments needed to meet the 3 percent of GDP deficit target by the requested deadlines (between 2012 and 2015, see Table 2).

  • Grace period. An exemption from the ½0th debt reduction rule will apply over the three-year period following the closure of the EDP. During this period, countries are expected to improve structural balances by at least 0.5 percent of GDP each year until they reach their respective medium-term objectives (MTOs).4

  • ½0th debt benchmark. Three years after exiting the EDP, structural balances will improve by 0.5 percent of GDP per year or more, if so required by the ½0th debt benchmark. This benchmark ensures an annual pace of debt reduction no less than 5 percent of the gap between the observed debt level and the 60 percent of GDP target. EU authorities will first verify compliance with the debt rule in a backward-looking manner and then in a forward-looking manner for countries breaching the first criterion (Figure 2).

Table 2.

EDP Deadlines

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Source: European Commission.
Figure 2.
Figure 2.

Translating SGP Regulations into a Fiscal Shock

Fiscal Regimes under the SGP

Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A003

Sources: IMF, April 2012 WEO; SGP regulations; and Staff calculations.1/ The benchmark is given by Bt/Yt=60+(0.95/3)*(Bt;-1/Yt-1-60)+((0.95^2)/3)*(Bt-2/Yt-2-60)+((0.95^3)/3)*(Bt-3/Yt-3-60).2/ The formula specified in 1/ is applied to projected debt-to-GDP ratio up to t+i+3+2.3/ The “adjusted debt measure” is given by Bt/Yt=Bt+Σ02Ctj/Yt3Π02(1+Ytj*) with C the cyclical budget and Y* the growth rate of nominal potential GDP.4/ To place a country under EDP, the report assesses risk factors such as the structure of debt, implicit liabilities related to ageing, or private indebtedness.5/ The High Debt group comprises Belgium, Greece, Ireland, Italy, Portugal and Spain. The Low Debt group includes the rest of Euro area countries.

8. Overall, planned fiscal efforts in the EA fall significantly short of SGP requirements. For the euro area as a whole, the additional consolidation amounts to 1 percent of GDP over 2012-17, nearly half of which would be frontloaded over 2012-13 (Figure 2). For the analysis here, we split euro area countries into two blocs: those countries with acute fiscal sustainability issues (high-debt5 or HD), comprising Greece, Ireland, Italy, Portugal, Spain and Belgium, and those countries with less acute fiscal sustainability issues (low-debt or LD), comprising the rest of the euro area. Additional consolidation needs in the HD bloc (at around 2.2 percent of GDP over the WEO horizon) are five times as large as in the LD bloc (at 0.4 percent of GDP over 2012-17). Across countries, the additional fiscal effort is the highest in Spain, mainly as a result of requirements under the EDP. In contrast, Germany, Cyprus and Estonia have no additional adjustment as the WEO path is consistently more demanding than requirements under the SGP. Among the larger euro area countries, additional consolidation is particularly frontloaded in Spain and the Netherlands.

C. The Output Effects from Fiscal Consolidation under the SGP

Assumptions

9. The impact of fiscal tightening on economic activity will depend on the underlying simulation assumptions. First, the composition of the fiscal adjustment makes a big difference, with multipliers being typically larger for spending-based consolidations. Second, the monetary policy reaction function is an important factor as multipliers are higher when interest rates are constrained by the zero lower bound. Finally, the credibility of fiscal packages also affects multipliers through anticipation of the future benefits of consolidation. This last effect may be substantial in some cases.

10. In practice, however, there is considerable uncertainty surrounding these assumptions. Information on the composition of the adjustment on a country basis is not readily available and it is difficult to predict over which time horizon monetary policy in the euro area will be constrained by the zero lower bound. Also, governments’ credibility in delivering fiscal commitments is at stake and risk-premium effects are inherently difficult to quantify when spreads are very volatile and an increasing number of countries face punitive yields.

11. Faced with these uncertainties we carry out a number of illustrative simulations. These are intended to illustrate the possible response of the economy under three different scenarios rather than aiming at an accurate representation of the economic reality (Table 3):

  • Scenario 1: Myopia and growth-friendly consolidation. Under this scenario, the consolidation package is tilted towards measures that have strong effects on households’ current disposable income, but little negative impact on factor supply and potential output. We further assume fiscal plans are not credible per se, but rather that credibility needs to be established by action. In particular, agents do not perceive the government’s commitment toward consolidation as permanent but rather expect measures to revert back to baseline levels in each period. However, they change their beliefs ex post, once they verify past fiscal measures remain in place. This is meant to portray an economy where, due to a general lack of confidence in the future, agents base their decisions on short-term considerations. With regards to monetary policy, the zero-interest floor is assumed to bind over the 2012-17 period. To gauge the magnitude of spillovers, we run two variants of this scenario featuring joint and stand-alone consolidation (i.e. undertaken by the HD or LD groups separately).

  • Scenario 2: Credibility and growth-friendly consolidation. The assumptions mimic scenario 1 except that agents are not myopic, i.e. changes in the structural balance are perceived as permanent as of the year of implementation. As a result, agents incorporate the long-term benefits of the consolidation already undertaken (lower real interest rates and future debt service costs) in their expectations. However, fiscal changes are not anticipated and do not affect behavior until they actually occur (i.e., absence of full Ricardian equivalence).

  • Scenario 3: Credibility and growth-unfriendly consolidation: A variant of scenario 2, this is intended to illustrate the sensitivity of the results to the composition of the fiscal consolidation, with a package biased towards high-multiplier measures. In particular, fiscal efforts are switched (i) from consumption to corporate taxes; (ii) from government consumption to public investment; and (iii) from general transfers to transfers targeted to households with a high marginal propensity to consume. As empirical evidence shows (see, e.g., OECD, 2010 and the references therein), corporate taxes have the highest distortionary effects amongst revenue measures; on the other hand, government investment shrinks potential output and cuts in targeted transfers reduce the income of households whose marginal propensity to consume is equal to one.

Table 3.

Assumptions Underlying SGP Simulations

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Source: Staff.

Simulation tools and Output Effects from Additional Fiscal Consolidation

12. The simulations are conducted for the two euro area country groupings with the GIMF model.6 The analysis uses a general equilibrium framework applying a six region version of GIMF, with the euro area split into the HD and LD blocs, the US, Japan, emerging Asia, and a bloc encompassing the rest of the world. GIMF models both liquidity constrained and finite-planning horizon households. This provides non-neutrality in both spending- and revenue-based measures, which makes the model particularly appropriate to analyze the stabilization role of fiscal policy in the short term.

13. Country-specific effects are examined using the G35 model.7 The G35 model is an estimated structural macroeconometric model of the world economy, disaggregated into 35 national economies, including 11 euro area countries.8 Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages.

14. Even with a growth-friendly consolidation package, the output effects are sizable (Figure 3). Under scenario 1, output in the euro area is 1 percent lower than baseline by 2017. This implies a cumulative output loss of 3½ percent throughout 2012-ainly reflecting the scale of th17. The fairly large multiplier stems from negative spillovers (around 40 percent of the loss) and the inability of monetary authorities to ease the policy rate (20 percent of the loss). As expected, the HD bloc experiences the largest losses—1.4 percent of GDP by 2017 (cumulatively 5 percent over 2012-17)—mainly reflecting the scale of the additional fiscal adjustment required. On the other hand, losses among the LD bloc of 0.8 percent by 2017 (cumulatively 3 percent over 2012-17) are largely caused by spillovers from the HD bloc (given their relatively high propensity to import from the LD countries).

Figure 3.
Figure 3.

Output Effects from SGP Rules: Myopia and Growth-friendly Consolidation

Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A003

Sources: IMF, April 2012 WEO; and Staff simulations carried out with GIMF (first three charts) and G35 (fourth chart) models.1/ The High Debt bloc comprises Belgium, Greece, Ireland, Italy, Portugal and Spain. The Low Debt bloc includes the rest of Euro area countries.

15. The aggregate results conceal considerable cross-country heterogeneity. Due to contractions in domestic demand, cumulative output losses are highest in Spain (at around 10 percent), closely followed by Portugal (at almost 8 percent), largely caused by substantial spillovers from fiscal tightening in its neighboring country. Negative spillovers are also sizable in small open economies like Belgium, Finland and Ireland. Somewhat surprisingly, Greece experiences positive spillovers from fiscal adjustment in other euro area countries. This is because a joint consolidation in the euro area reduces the world demand for commodities and improves Greece’s terms of trade. As Greece is a relatively closed economy, this improvement in the terms of trade outweighs the reduction in its external demand, yielding a positive net spillover.

16. Multiplier effects dramatically change with credibility and fiscal composition assumptions (Figure 4). With myopia (scenario 1), private households and firms are so concerned with the short-term impact of fiscal retrenchment that they neglect the positive income effects arising from future lower tax liabilities when making their consumption, employment and investment choices. For a given composition of adjustment and the zero lower bound constraint, the 2017 GDP loss in the euro area is considerably reduced if fiscal plans are credible (scenario 2), falling from 1 percent to 0.3 percent of GDP. On the other hand, the multiplier effect is more than doubled when consolidation remains credible but becomes growth-unfriendly (scenario 3). In this case, the 2017 GDP loss in the euro area relative to the WEO amounts to 0.8 percent, against 0.3 under credible but growth-friendly consolidation. Cumulative losses in the euro area throughout 2012-17 amount to -1.5 percent under scenario 2 and -3.1percent under scenario 3.

Figure 4.
Figure 4.

Comparing Output Losses across Scenarios

(Percent Deviations from WEO, 2017)

Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A003

Sources: IMF, April 2012 WEO; and Staff simulations carried out with the GIMF model.1/ High debt comprises the following countries in the Euro area: Belgium, Greece, Ireland, Italy, Portugal and Spain. Low debt includes the rest of Euro area countries

17. The output decline might be higher than implied by our simulations because of the current state of the economy. Recent empirical work suggests that fiscal multipliers are larger when there is excess capacity (see, for example, Batini et al, 2012; and Baum et al, 2012). This could arise from tighter credit constraints, the need to repair balance sheets, and higher precautionary savings.

D. Policy Perspectives: How Can the Output Loss from Additional Fiscal Consolidation Be Mitigated?

18. The SGP rules should be applied flexibly to accommodate unexpected events. The appropriate pace of consolidation should depend on the state of public finances and growth, and the monetary policy stance. Given uncertainties surrounding these developments, consolidation strategies that adjust for new information can be welfare improving. In this context, the recent shift of focus towards structural targets under the SGP is very appropriate.

19. Where financing conditions permit, the pace of fiscal consolidation should take into account the current adverse conditions. With limited scope for monetary policy to mitigate output losses from fiscal tightening, negative output gaps, and joint consolidation efforts, multipliers are likely to be larger than normal. Furthermore, multipliers might increase with the size of consolidation.9 Hence, in the current context, to the extent that market financing remains available at reasonable rates, adjustment should occur at a steady pace defined in cyclically-adjusted terms and should avoid heavy front-loading.

20. The composition of fiscal adjustment should be tilted towards growth-friendly measures. Where adjustment needs are very large, countries will have to act both on the revenue and spending side. However, given the high spending levels prevailing in many European countries, consolidation should focus on the spending side, targeting in particular those areas where multipliers are low or where spending is most inefficient.

21. Reforms that underpin credibility are essential to limit output losses from fiscal tightening. Our findings suggest that, by raising agents’ expectations about the positive (future) income effects of consolidation, credible policies can reduce multipliers in the short term and act as a substitute for heavy frontloading. Anchoring adjustment in well-specified medium-term plans is key. A responsible implementation of automatic correction mechanisms under the Fiscal Compact will be important to safeguard durable fiscal efforts.

22. Finally, monetary policy should accommodate the consolidation. The simulations suggest significant output losses if monetary policy does not provide support. When the zero bound is binding or if conventional interest rate cuts are less effective than normal, this implies unconventional monetary policy stimulus may be needed.

E. References

  • Batini, N., G. Callegari and G. Melina, 2012, “Successful Austerity in the United States, Europe and Japan,IMF Working Paper forthcoming (Washington: International Monetary Fund).

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  • Baum, A., M. Poplawski-Ribeiro, and A. Weber, 2012, “Fiscal Multipliers and the State of the Economy,IMF Working Paper forthcoming (Washington: International Monetary Fund).

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  • Carlson, S., J. Hatzius, S.J, Stehn, and D. Wilson, 2011, “The Speed Limit of Fiscal Consolidation”, GS Global Economics Paper No. 207, August 2011.

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  • Erceg, Christopher J., and J. Lindé, 2010, “Asymmetric Shocks in a Currency Union with Monetary and Fiscal Handcuffs,” NBER Chapters, in: NBER International Seminar on Macroeconomics 2010, pages 95135 National Bureau of Economic Research, Inc.

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  • Kumhof, Michael, D. Laxton, D. Muir and S. Mursula, 2010, “The Global Integrated Monetary and Fiscal Model (GIMF)—Theoretical Structure,IMF Working Paper 10/34 (Washington: International Monetary Fund).

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  • OECD, 2010, “Tax Policy Reform and Economic Growth”, OECD Tax Policy Studies, No. 20.

  • Pérez, Esther, 2011, “Strengthening Governance in the Euro AreaIMF, Euro Area Policies, Selected Issues Paper, 2011.

  • Vitek, Francis, 2012, “Policy Analysis and Forecasting in the World Economy: A Panel Unobserved Components Approach,IMF Working Paper 12/149 (Washington: International Monetary Fund).

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1

Prepared by Derek Anderson (RES), Marialuz Moreno Badia (FAD), Esther Perez Ruiz (EUR), Stephen Snudden (RES), and Francis Vitek (SPR). We are grateful for comments from DG ECFIN staff during the seminar held in Brussels, June 4, 2012.

2

The shock and simulation results presented in this paper take into account the fiscal plans adopted or specified in sufficient detail at the time of the elaboration of the April 2012 WEO forecasts. Since then, some countries have announced additional measures.

3

We keep GDP at WEO levels and use OECD budgetary semi-elasticities to break down the overall deficit into the structural and cyclical components.

4

MTOs are country-specific and updated each 3 to 4 years. Current MTOs are 0.5 for Belgium, Finland, and Luxembourg; 0 for Austria, Cyprus, Estonia, Greece, France, Italy, Malta, and Spain; -0.5 for Germany, Ireland, Netherlands, Portugal, and Slovak Republic; and -1 for Slovenia.

5

For the purposes of the simulation the high-debt group includes countries with debt projected to be above 85 percent of GDP by 2017.

6

For further details on this model, see Kumhof and others (2010).

7

For further details, see Vitek (2012).

8

The list comprises Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, and Spain.

9

See Stehn and others (2011), Erceg and Linde (2010).

Euro Area Policies: 2012 Article IV Consultation: Selected Issues Paper
Author: International Monetary Fund
  • View in gallery

    Recent EU Fiscal Governance Reforms

  • View in gallery

    Translating SGP Regulations into a Fiscal Shock

    Fiscal Regimes under the SGP

  • View in gallery

    Output Effects from SGP Rules: Myopia and Growth-friendly Consolidation

  • View in gallery

    Comparing Output Losses across Scenarios

    (Percent Deviations from WEO, 2017)