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doi: 10.1111/j.1748-3131.2012.01231.x

Asian Economic Policy Review (2012) 7, 180197

Fiscal Challenges in the Euro Zone


Jos Manuel CAMPA
IESE Business School

Fiscal challenges in the Euro zone have been at the center of global economic concern in the last 2 years. Despite lower debt burdens, and higher scal efforts taken by Euro countries, a perception of high scal risk remains. This paper reviews the scal challenges facing the Euro area countries and the measures taken at the Euro area level to manage short-term pressures and to enhance longterm functioning of the area, as well as the main lines of national specic reforms. The paper shows the unique characteristics of the Euro area that still raise concerns to foster stability and the challenges to address them. Key words: economic integration, Euro, debt sustainability, Sovereign debt JEL codes: F36, H63

1. Fiscal Performance and Challenges in the Euro Area The scal performance of the Euro area had not been exceptionally expansionary over the period of the large economic expansion leading up to the economic crisis. In fact, the evidence shows that it had been quite good, at least relative to other developed economies. According to the International Monetary Fund [IMF] (2011b), the debt to gross domestic product (GDP) ratio of the 12 original Euro area members decreased from 71.9% in 1999 to 66.8% in 2007. This amounts to a decrease of 5.1 percentage points in the debt to GDP burden for the Euro area in this period. This compares to increases in the same ratio of 1.5% increase in the USA, 53.9% in Japan, and 0.3% in the UK. Therefore, the Euro area was the only large developed economy, jointly with Canada, to decrease its public debt burden and make it signicantly lower than that of other developed countries. The buildup to the economic crisis increased the potential vulnerability of all developed countries to their scal situation going forward. However, the increase in the debt burdens of the Euro area countries resulting from the crisis was again not particularly different from that of other non-Euro area developed countries. Between 2007 and 2011, the debt to GDP ratio of the 12 original members of the Euro area increased by an estimated 22.4% of GDP, which again compares positively with increases of 36.8% in the UK, 45.5% in Japan, and 37.7% in the USA (see Table 1).
I am grateful to Takatoshi Ito, Sahoko Kaji, and Kazuo Ueda, the Editors of the Asian Economic Policy Review (AEPR), and participants in the Fiscal Policy and Sovereign Debt AEPR Conference for their helpful comments. I also wish to thank Luis Esteve for excellent research assistance. Correspondence: Jos Manuel Campa, Camino del Cerro de Aguila 3, 28023 Madrid, Spain. Email: jcampa@iese.edu
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Table 1 Fiscal decits, debt, and interest burden to GDP 2009 Overall scal balance (%GDP) Spain France Italy Germany UK USA Canada Japan General government gross debt (%GDP) Spain France Italy Germany UK USA Canada Japan Interest expenditure, general government (%GDP) Spain France Italy Germany UK USA Canada Japan 2010 2011 2012 2013

-11.2 -7.6 -5.3 -3.2 -10.4 -13.0 -4.9 -10.8 53.6 79.0 115.5 74.4 68.4 89.9 83.6 216.3 1.8 2.4 4.6 2.7 1.9 2.5 2.6

-9.3 -7.1 -4.5 -4.3 -9.9 -10.5 -5.6 -9.3 60.8 82.4 118.4 83.2 75.1 98.5 85.1 219.0 1.9 2.4 4.5 2.5 2.9 2.6 2.7

-8.0 -5.7 -3.9 -1.1 -8.6 -9.5 -4.9 -10.1 70.1 87.0 121.4 81.5 80.8 102.0 85.5 233.4 2.2 2.6 4.9 2.4 3.1 3.0 2.7

-6.8 -4.8 -2.8 -0.7 -7.8 -8.0 -4.4 -10.2 78.1 90.7 125.3 81.6 86.6 107.6 86.7 241.0 2.4 2.8 5.4 2.3 3.2 3.1 2.7

-6.3 -4.4 -2.3 -0.1 -6.5 -6.4 -3.6 -8.8 84.0 93.1 126.6 79.8 90.3 112.0 84.7 246.8 2.6 3.0 5.6 2.3 3.2 3.3 2.7

Shaded areas indicate IMF estimates. Source: IMF (2012) and European Commission (2011a).

It is also true that European countries, and Euro area countries, in particular, have been much more aggressive than other developed countries in taking measures to tackle their scal challenges from the crisis. This applies not only to countries under an IMF/ Euro nancial support program (Greece, Portugal, and Ireland) or under clear market pressure (Spain and Italy), but also to the core of the area. According to estimates by the IMF (2011b) in September of last year, none of the four large Euro area countries required a scal adjustment to bring down their debt to GDP ratio to 60% by 2030 that is larger than the adjustment required by the USA, the UK, or Japan (see Table 2). In addition, by 2011, the Euro area countries had already taken much larger measures to achieve such a target (60% debt to GDP ratio in 2030) than those of the non-Euro area
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Table 2 Fiscal adjustment: required and performed Fiscal adjustment (% of GDP) required to achieve debt target (60% GDP) in 2030 Estimated performed in 2011 3.1 1.2 0.5 2.4 2.4 3.2 1.6 0.9 0.7 1.3 -1.1 Estimated performed in 2015 5.1 4.8 3.4 7.6 9.6 7.2 3.5 7.6 4.7 5.4 1.8 Remainder perform 3.2 1.5 -0.3 7.9 2.4 2.0 1.2 6.1 11.8

20102020 Spain France Italy Greece Ireland Portugal Germany United Kingdom USA Canada Japan 8.3 6.3 3.1 15.5 12.0 9.2 2.3 9.1 10.8 4.3 13.6

Shaded areas indicate IMF estimates. The target of Japan is a net debt of 80% of GDP. Source: IMF (2011c) p. 30 and p. 64.

countries. Furthermore, the Euro area countries had also committed to take further measures until 2015 to close the majority of the gap to reach this target. The case of Italy is particularly interesting. According to the IMF, by September 2011, Italy had already taken more than enough measures to reach the 60% debt target in 2030. In fact, it was the only developed country to have done so. Nevertheless, at that exact moment, Italy was the subject of a major condence crisis in nancial markets on the sustainability of its public accounts. A crisis that led to a large political crisis and to the resignation, 2 months later, of its long-standing Prime Minister. Nevertheless, the challenges facing the Euro area countries appear to be much larger than those of other developed countries. Certainly, Europe, and the Euro area, in particular, has been perceived as the main downside risk to the global economy in the last 2 years. One of the crucial questions faced by analysts is why did the current sovereign crisis focus on the Euro area rather than on other developed countries with apparently just as challenging, if not more challenging, scal difculties going forward? Can these countries learn something from the current Euro tensions to avoid similar tensions in the near future? It is true that the evolution of the aggregate of the Euro area debt burden reects only part of the story, and probably not the most interesting part. In a partially integrated economic union with very limited mutualization of the scal burden, it is not only the aggregate that matters, but also the components. Therefore, the breakdown of the evolution of these debt burdens across member countries within the Euro area is most interesting.
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Three unique characteristics of the Euro area made the region more vulnerable to a sustainability analysis of the aggregate debt burden of the area and of each individual member state. These characteristics were the uneven distribution of the debt burden across the Euro area; the ability to nance that debt burden in the short run; and concerns regarding future growth as a mechanism to dilute the debt burden in the future. These three challenges have confronted the debate among policymakers and nancial analysts during the last 2 years on how to best deal with the crisis in Europe. This paper shows that the Euro area has been struggling to provide convincing answers to the following three related questions to address those challenges. How is the Euro area going to deal with the excessive debt burden in some countries (mainly Greece)? Will countries that are, in principle, solvent but facing increasing nancing costs, be able to nance their debt in the short run (mainly Italy and Spain)? How are some countries facing competitive challenges in the Euro area going to be able to grow in the future (mainly southern Europe)? The rest of this paper is structured as follows. The next section provides a description of the measures that Europe, and, in particular, the Euro area, has been taking to try to address the concerns raised by the previously stated three questions. Section 3 provides an analysis on the relative merits of the progress made and the challenges ahead. Section 4 provides some concluding remarks on the remaining challenges going forward.

2. Measures on Fiscal Discipline Coordination At the time of the creation of the euro, considerable concerns existed on the incentives to pursue cautious scal policies by member states within the currency area. These concerns resulted in the imposition of a number of criteria to enter the union, and of two criteria within the Stability and Growth Pact (SGP) that participant countries needed to comply with in the future.1 These well-known criteria within the SGP were to limit the size of budget decits to less than 3% of GDP, and to put a threshold to the level of public debt of 60% to GDP. Countries made a signicant commitment (a legal commitment at the level of an international treaty) to stick to the rules according to this new arrangement. At face value, the experience with compliance from the rst years of the Euro area was not promising. During the rst 5 years of the Euro area, 8 out of 12 original members did not comply with either the decit criteria and/or had an increase in their debt to GDP ratio despite being already beyond the 60% threshold (see Table 3). However, it would be unfair to say that the rules had no impact at all. The debt to GDP ratio decreased in almost all of the 12 original Euro area countries in the period up to 2007 (see Table 3). In general, the scal behavior of Euro area countries during this period was much more conservative than that of other developed countries. The debt to GDP ratio increased in only four Euro countries: France, Germany, Portugal, and Greece. Only the latter two are currently perceived as being vulnerable. Ironically, the ratio decreased most, by close to 20% points of GDP, in three other countries currently perceived as being scally vulnerable (Ireland, Belgium, and Spain).
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Table 3 Compliance with the Stability and Growth Pact: Euro area

184 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 0 0 6 7 7 15 16 16 15 16 18 21 24 5.1 42.5 6.1 6.3 -0.5 55.6 0.9 35.2 -0.2 50.7 0.4 106.5 -1.9 68.1 -1.5 56.9 0.0 66.8 -4.3 51.2 -3.1 59.1 -3.1 108.2 -4.5 103.7 4.1 41.5 2.1 6.3 -0.2 52.6 -0.4 31.9 -2.1 50.5 -0.1 103.4 -2.6 67.9 -3.1 58.8 -0.7 66.2 -2.9 53.8 -3.8 60.7 -3.1 105.1 -4.8 101.7 2.6 44.5 0.5 6.1 -0.3 48.8 0.4 30.7 -3.1 52.0 -0.1 98.4 -3.1 69.1 -4.1 62.9 -1.5 65.3 -3.0 55.9 -4.2 64.4 -3.6 103.9 -5.6 97.4 2.5 44.4 -1.1 6.3 -0.1 46.3 1.4 29.4 -1.7 52.4 -0.3 94.0 -2.9 69.5 -3.6 64.9 -4.4 64.7 -3.4 57.6 -3.8 66.3 -3.5 103.4 -7.5 98.6 2.8 41.7 0.0 6.1 1.3 43.1 1.7 27.2 -0.3 51.8 -2.7 92.0 -2.5 70.1 -2.9 66.4 -1.7 64.2 -5.9 62.8 -3.3 68.6 -4.4 105.4 -5.2 100.0 4.1 39.6 1.4 6.7 2.4 39.6 2.9 24.7 0.5 47.4 0.1 88.0 -1.3 68.5 -2.3 63.7 -1.5 62.3 -4.1 63.9 -1.6 68.1 -3.4 106.1 -5.7 106.1 5.3 35.2 3.7 6.7 1.9 36.2 0.1 24.9 0.2 45.3 -0.3 84.1 -0.7 66.3 -2.7 64.2 -0.9 60.2 -3.1 68.3 0.2 65.2 -1.6 103.1 -6.5 107.4 4.3 33.9 3.0 13.7 -4.5 40.1 -7.3 44.3 0.5 58.5 -1.3 89.3 -2.1 70.1 -3.3 68.2 -0.9 63.8 -3.6 71.6 -0.1 66.7 -2.7 105.8 -9.8 113.0 -2.5 43.5 -0.8 14.8 -11.2 53.9 -14.0 65.1 -5.6 60.8 -5.6 95.8 -6.4 79.9 -7.5 79.2 -4.1 69.5 -10.2 83.1 -3.2 74.4 -5.4 116.0 -15.6 129.4 -2.5 48.4 -0.9 19.1 -9.3 61.2 -31.2 92.5 -5.1 62.9 -3.8 96.0 -6.2 85.3 -7.1 82.3 -4.5 71.9 -9.8 93.3 -4.3 83.0 -4.6 118.6 -10.3 145.0 -0.5 48.6 -0.6 18.2 -8.5 68.5 -13.1 108.2 -4.7 65.2 -3.7 98.0 -4.1 87.2 -5.2 85.8 -2.6 72.2 -4.2 107.8 -1.0 81.2 -3.9 120.1 -9.1 165.3

Years when a scal Maastricht criteria was not accomplished by each country No performing Maastricht criteria (def -3%; debt 60%)

Fiscal Challenges in the Euro Zone

Countries in the Euro area December 2000 Finland Decit EDP 6.9 Debt EDP 43.8 Luxembourg Decit EDP 6.0 Debt EDP 6.2 Spain Decit EDP -0.9 Debt EDP 59.4 Ireland Decit EDP 4.7 Debt EDP 37.5 Netherlands Decit EDP 2.0 Debt EDP 53.8 Belgium Decit EDP 0.0 Debt EDP 107.8 Euro area Decit EDP -0.1 Debt EDP 69.2 (17 countries) France Decit EDP -1.5 Debt EDP 57.3 Austria Decit EDP -1.7 Debt EDP 66.2 Portugal Decit EDP -2.9 Debt EDP 48.5 Germany Decit EDP 1.1 Debt EDP 60.2 Italy Decit EDP -0.8 Debt EDP 108.5 Greece Decit EDP -3.7 Debt EDP 103.4

Jos Manuel Campa

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Shaded areas indicate the years in which the country did not comply with the Stability and Growth Pact. Source: EUROSTAT.

Jos Manuel Campa

Fiscal Challenges in the Euro Zone

But it is also true that complying with the rules did not put countries in any signicant better position to confront the scal challenges arising from the crisis. Portugal and Greece, currently under a program, did not comply with the requirements of the SGP. But, Germany, Austria, and France were in the same league of persistent violators of the rules. On the other side, Ireland and Spain were the only countries, jointly with Luxembourg and Finland, that had fullled the commitments of the SGP since its creation. This compliance, however, did not prevent them from being at the center of concerns about their scal sustainability in the last 2 years. So, committing to the rules did not put countries in a more sound position to confront the crises and violations of the rules were not a good predictor of problems ahead. Over the last 2 years, Europe has taken a large number of reforms that try to respond at least indirectly to the three questions posed at the beginning of this paper. These reforms, particularly in the area of economic governance, are substantial and have signicantly shaped the way in which economic coordination will take place within the member states relative to the original provisions of the SGP. These measures can be classied in three broad areas: mechanisms designed to provide support to member states in the short run; Euro- and/or European-wide measures to strengthen the scal framework and the coordination of economic policies within the area; and country specic measures to enhance the scal framework and growth.

2.1 Mechanisms designed to provide nancial support to member countries These mechanisms are the main tool that the European Union (EU), and the Euro area, in particular, have developed to manage the short-term pressures from the crisis. These mechanisms arose from the need to deal with the implications from the tensions observed by individual member states, particularly Greece, to nance their sovereign debt. These mechanisms have evolved and continue to adjust their capabilities as the crisis has shown some of the main weaknesses in their original design. There are primarily four mechanisms: the package of nancial assistance to Greece; the European Financial Stability Facility and the European Financial Stability Mechanism, which have always been conceived as temporary nancial assistance mechanisms; and the European Stability Mechanism (ESM), which was conceived as a permanent mechanism. The package of nancial assistance to Greece was initially established as an ad hoc mechanism on May 2, 2010 to provide, together with the IMF, 110 billion of nancial assistance to Greece in the form of bilateral loans. The program provided ofcial nancing for the next 3 years, with partial access to markets by Greece starting in 2012, an aggressive privatization plan to be executed by the Greek government, and a very large macroeconomic adjustment program. It quickly became clear that this program was insufcient and that Greece was not going to have access to nancial markets in 2012 as expected. In the fall of 2011, a new program was agreed to that provided additional ofcial nancing of up to 130 billion (including the IMF contribution) and a voluntary contribution from the private sector. The private sector would have to agree to a
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reduction of at least 50% in the face value of the Greek debt held by the private sector, extension of maturities, and the lowering of lending rates on new private sector bonds. Temporary nancial backstop mechanisms In May 2011, the Finance Ministers of the European Union (ECOFIN) agreed on the creation of the European Financial Stabilization Mechanism (EFSM) and the European Financial Stability Facility (EFSF). The EFSM is based on guarantees from the Community budget of up to 60 billion and is regulated according to European Union Legislation. In contrast, the EFSF is an intergovernmental body providing up to 440 billion in guarantees from the Euro area member states. The IMF decided at the same time to complement these mechanisms with a potential nancial support to Euro area countries of up to 250 billion. The launch of the EFSF quickly faced some important difculties that needed to be confronted. First, there was the unwillingness of the member countries to enter in joint and several guarantees of the amounts issued by the EFSF. This limitation in the joint guarantees implied that, given the different credit quality of the Euro sovereigns, the effective borrowing capacity of the EFSF was substantially lower than the initial 440 billion. Furthermore, the range of activities for which the EFSF had been originally designed, mainly providing lending to a member state with a full range of macroeconomic conditionality, was too narrow to deal with the needs arising from the crisis. In particular, in July 2011, the EFSF was reformed to enhance the amount guaranteed by each member state to guarantee an overall borrowing capacity of 440 billion; provide lending for primary and secondary purchases of sovereign debt; and allow the facility to enhance its leverage capabilities. Ireland and Portugal have been granted 85 billion and 78 billion in assistance, respectively, by these funding mechanisms. It has also been agreed that the additional Euro area contribution for the new nancial package for Greece explained earlier will be provided by the EFSF. Permanent nancial mechanism The ESM agreed to by the members of the Euro area is meant to be a permanent mechanism that will supersede the existing EFSF and the EFSM, and will provide a permanent solid basis for emergency lending to member states confronted with nancial needs. The ESM became operational on July 1, 2012. It will have an effective lending capacity of 500 billion with a paid-in capital contribution of 80 billion. Despite the institutional differences among these mechanisms, and the changes over time in their operational capabilities, three fundamental principles have guided their design and usage during the crisis. These guiding principles are (i) all these mechanisms have always been used jointly with IMF involvement; (ii) the use of nancial resources provided to a member state has always come with strong and broad conditionality; and (iii) the mechanisms are used exclusively as a means to provide nancing directly to a member state, originally on nonpreferential terms. A fourth principle has been also fundamental for the establishment of most of these mechanisms: the intergovernmental approach. An intergovernmental approach in the EU applies when the implementation
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of the agreed policy decisions is done via international agreements established in parallel but outside of existing European legislation by a subset of the member countries. With the exception of the EFSM which is engrained in the existing legal framework of the EU, the other three mechanisms have been developed in parallel to the existing European legislation via a new international agreement among the signatory member states. This approach leads to large institutional complexity and confusion. Furthermore, it also leads to the opportunity by member states to pick and choose which specic proposal they are going to participate in.2

2.2 Euro- and/or European-wide measures to strengthen the scal framework and the coordination of economic policies within the area In the last 2 years, the EU has also been aggressively reforming its institutional framework so as to enhance its economic governance, the integration of its institutional capabilities, and the coordination of major economic policies across member states. Again, a large part of this effort has focused on Euro area countries, but parts of these changes also affect all 27 EU member states. As with the design of the mechanisms for nancial assistance, the legal framework used for these reforms differs across the reforms. This implies that some reforms apply to all EU member states, others just to the Euro area, and some others to different subsets of both groups. This pick-and-choose approach again adds to the complexity in the design and implementation of the reforms approved. These reforms started at the beginning of the crisis with a strong push to reform the institutional setting of the working of the nancial markets within the EU. The initial impetus came from the response to the nancial crisis in the fall of 2008 that resulted in an agreement on the coordination of deposit guarantee schemes across all European member states so as to avoid unfair competition among different national regimes in moments of panic.3 This was followed by the Larosire Report issued in February of 2009 by a high-level group on nancial supervision in the EU, headed by Jacques de Larosire (Larosire, 2009), on reforms of nancial supervision in the EU. The main changes proposed in this report implied the creation of four new pan-European bodies: the European Systemic Risk-Board for assessing macro-prudential risk assessment, and three industry-specic European supervisory bodies: one for banking, one for insurance, and one for securities. A quick agreement was reached on the creation of these supervisory bodies, and all four started their operations in January 2011. Although the jury is still out on the overall effectiveness of this institutional structure in the nancial industry, the momentum for reform in this area on the part of the European countries was admirable. These reforms have been followed in June 2012 with a move toward supranational supervision by the ECB of Euro area banks. To give further impetus to the governance reforms, several proposals were sequentially approved in line with the development of the crisis starting in May 2010. These proposals can be grouped in three different areas: reforms of European legislation to enhance the working of the SGP and the coordination of macroeconomic policies;
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reforms to national legislation particularly in the area of scal discipline and coordination; and country-specic commitments to enhance economic coordination, competitiveness, and convergence. The reforms of European legislation have been directed to address some of the failures observed in the application of the SGP, mainly, the tendency for the recommendations arising out of the Pact to arrive too late and not be sufciently binding on affected member states. The reforms implied a more automatic application of recommendations and sanctions for noncompliant countries, put a larger emphasis on the preventive stage, and a more strict application of the correction of excessive debt ratios in member countries. Additionally, the legislation also tried to complement some of the gaps left in the original SGP that had proven crucial. Mainly, a new procedure to address the appearance of macroeconomic imbalances in the Euro area was put in place so as to enhance recommendations to those countries with policies that may result in imbalances affecting the stability of the overall Euro area. The third area of reform is a signicant increase in the coordination of short-term scal policies and long-term more structural policies at the national level in what has been termed the European Semester. Preventing and correcting macroeconomic and competitiveness imbalances is a crucial aspect of this set of reforms as the Euro area moves beyond the crisis. Over the past decade, member states had made economic choices which have lead to competitiveness divergences and macroeconomic imbalances within the EU. This new surveillance mechanism should aim to prevent and correct such divergences in the future and help correct those that have accumulated. The procedure will rely on an alert system that uses a scoreboard of indicators followed by more detailed country studies. The second area of reform has been the establishment of new binding commitments by member countries in the functioning of their national scal policies. The main part of this reform has been articulated around a new international agreement, named the Fiscal Pact, that has been recently negotiated. This Fiscal Pact is expected to be ratied during 2012 by all countries of the EU, including, of course, Euro area members, with the notable exception of the UK, and a reservation by the Czech Republic. This agreement commits member countries to impose in their national legislation a set of rules on the functioning of their scal policies. Most visible among these commitments is the agreement to insert in each countrys constitution, or a similar ranking legal instrument, the so-called golden rule, that is, the commitment to a structural scal balance in the operation of scal policies at the national level. The third area of reforms has been an increase in the number of national commitments to even stronger economic coordination for competitiveness and convergence in areas of national competence by member countries. The objective of these commitments is mainly to increase growth and the stability of future growth patterns within Europe. The challenges in this area are great because the required policies in many ways affect issues (labor markets, regulated industries, nontraded sectors in the economy, and parts of the so-called social state) that have long been difcult to include in any meaningful agenda of coordination and integration at the European level. The recent experience is
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also disappointing on this front. The previous attempt to pursue these types of reforms, the so-called Lisbon Agenda, proved to be a big failure. The Lisbon Agenda was supposed to be a program for reforms at the European level introduced a decade ago with the laudable objective of making the EU one of the most competitive areas in the world by 2010. Europe has decided to try again, and within the new set of reforms expected to be put in place, it has created the Europe 2020 agenda. This is mainly the continuation of the Lisbon agenda, and will face the same difculties for success faced by the former attempt. Finally, an attempt to make these reforms easier to monitor led to another set of commitments in the same area: the Euro Plus Pact. This Pact is an agreement by 23 member states, including six outside the Euro area (Bulgaria, Denmark, Latvia, Lithuania, Poland, and Romania), signed in March 2011. This Pact is expected to make these reforms more operational by committing its signatories to the concrete goals agreed on and reviewed on a yearly basis by the Heads of State or Government. The annual review process should make these commitments more operational. However, both the areas of commitment and the specic commitments are the decision of each member state. Therefore, the space for coordination remains weak.

2.3 Country-specic measures to enhance scal credibility, sustainability, and growth The third area of active reforms has been the country-specic measures taken by individual countries in response to the challenges facing each one of them. Despite the measures described in the previous two sections both for short-term nancial support and medium-term scal sustainability and economic coordination, the reality of European economic policy is that national decision making remains at the core of the process of reforms. Countries have been engaging in active measures to deal with the challenges of the crisis primarily according to their perceptions of what was needed and feasible. Let me here focus on three areas which I nd particularly illustrative: scal consolidation, nancial sector, and growth adjustment. On the scal front, countries remain primarily responsible for establishing their scal objectives. The degree of coordination at the European level remains very small beyond setting objectives for scal decits. Coordination on expenditure obligations or tax coordination remains very small. Despite the existence of the valued added tax with a fair degree of coordination at the European level, the core of direct taxation (personal income, corporate tax) continues to be a national matter. Recent debates on the coordination of the establishment of a possible nancial tax on banks (either a nancial transaction tax or a tax on other components of the activity of the nancial sector) and on progress in the harmonization of the corporate income taxes show the difculties in making progress on any meaningful coordination on this front. On the expenditure side, coordination may be even harder. The social component of expenditure and the core of expenses on health, education, pensions, and income subsidies, linked to the situation in the labor market (unemployment subsidies, training programs, income support programs), are at the core of the political debate in all countries. A slightly more positive role for coordination exists in relation to productive expenditures on infrastructure,
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support for innovation activities, and other enterprise-related programs from the public sector. Nevertheless, issues of nationalism, transfer and risk sharing among countries, and national bias still remain. Countries have been active, however, in establishing country-specic measures to enhance their scal sustainability in the long run. Despite the dominance of national priorities in these policies, some common features are beginning to appear. There is a considerable convergence in the functioning and adjustments in pension reforms (increasing retirement ages toward 67, and rules linking the legal retirement age to the evolution of life expectancy), and in the management of scal policy as discussed earlier (the golden rule, the use of independent forecasts, and multiyear budgeting). This convergence, however, is still way short of fostering a strong sense of integration and facilitating the mobility of the population, and the labor force within the Union. In the nancial sector, despite the establishment of supervisory authorities at the European level, a highly integrated nancial market prior to the crisis, and a single monetary authority, the regulation and resolution of the nancial challenges remain a country-specic issue. Countries had pursued individual strategies that highlight important differences in the mechanisms used by member countries to deal with banking crises. The degree of restructuring involved differs substantially. The lack of mechanisms at the European level to deal with individual institutions and the resort to the national sovereigns of the home base whenever nancial support is needed have led to an increasing vicious circle between the perceived solvency of the banking industry of vulnerable countries, and the increase in the cost of nancing of the sovereign, which in turn worsens the growth prospects for the economy and the solvency of the banking system (Gerlach et al., 2010). Furthermore, this vicious circle between the vulnerability of the national sovereign and its banking system has also led to a substantial increase in the fragmentation of the European nancial industry. 3. Addressing the Specic Challenges Facing Euro Area Countries As indicated in the rst section, the scal challenges facing the euro as a whole were large but not unique in the context of other developed economies. Furthermore, in aggregate, the scal challenges confronting the euro were substantially lower. Nevertheless, there have been several questions confronting these challenges in the Euro area: How is the Euro area going to deal with the excessive debt burden of some countries (mainly Greece)? Will countries that are, in principle, solvent but facing increasing nancing costs, be able to nance their debt in the short run (mainly Italy and Spain)? How are some countries facing competitive challenges in the Euro area going to be able to grow in the future (mainly southern Europe)? Europe has been addressing these questions over the last 3 years. Probably the dominant perception among the international community on the form and content of the decisions taken so far is that these have been too little, too late (see, e.g. Pisani-Ferry, 2011). The perception continues today that Europe has not put enough resources into dealing with the short-term challenges; that there is too much cacophony among
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political leaders on what could be done; and that there is a lack of a clear perspective on the long-term future for the Euro area. The most obvious part of the story on the too little, too late actions has been the way Europe has dealt with an assistance package to deal with Greeces excessive debt burdens. The Euro area member states set up an ad hoc mechanism on May 2, 2010 to provide, together with the IMF, 110 billion of nancial assistance to Greece in the form of bilateral loans. The original terms of these loans, in terms of the interest rates, maturity, and the conditionally required, quickly became the subject of across-the-board skepticism on its likelihood of providing any kind of long-term sustainability to Greece. Additional measures taken afterward lengthen the maturities of the loans, reducing interest rates, and most importantly, the agreement reached in March 2012 to decrease the Greek debt burden with the private sector holders of Greek bonds jointly with an additional ofcial package of nancial support still appear insufcient. The demands for economic reform and scal consolidation to be implemented by the Greek government continue to be extremely challenging. The sense of weakening political support, and specially citizen support, for the program is clearly increasing in Greece and in other parts of the Euro area. As this paper goes to press (August 2012), Greece has formed a new government after having had to call for a second round of general elections in mid-June that resulted in sufcient support to form a coalition government among the parties that support the implementation of the reform measures agreed with its European partners in the context of the program. For other Euro area countries confronting high debt burdens and/or a lack of credibility from nancial markets, the crucial questions they need to address continue to be this: how can they maintain nancing at a reasonable cost in the short-run, and how do they expect to grow to decrease their debt burdens and, in particular, their scal burdens? The answers to these two questions are obviously interrelated. If a country can convincingly show that it has the capability of sustained economic growth in the future, it will generate the necessary condence to nance itself at reasonable cost in the nancial markets. This logic congured the essence of the approach taken initially by the Euro area (and the IMF) in dealing with the crisis. The logic was as follows: the country at stake should commit to a set of structural reforms and scal consolidation that will provide condence in both its scal sustainability and its economic growth in the long term. The ofcial sector will complement this program by providing all the necessary nancing for a sufcient time. Initially, sufcient time was estimated to be in the range of up to 3 years, so that the country is taken out of the market and does not rely on nancial markets for its nancing needs (at least for maturities beyond a year). This line of reasoning underlines the structure of all the assistance programs agreed so far.4 This strategy has proven to be of limited success. The strategy basically followed the long-standing experience of IMF programs. However, several shortcomings quickly arose when applied to the Euro area context. First, the short-term recovery of output in such a program is likely to be much slower within the euro than in the traditional program involving a nominal exchange rate depreciation. The lack of a quick adjustment in
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relative prices in the economy implied that the positive contribution to the recovery from the tradable sector is likely to be very small in the short term, and the resulting drop in short-term output substantially larger. As a result, the likelihood of a short-term recovery that will boost condence in nancial markets is less likely. This made the underlying assumption of taking a country out of the nancial markets for a prespecied period more risky and did not guarantee in any way the timing when the country would be capable of returning to the market in any signicant manner. This shortcoming became clear in the Greek case about a year ago, and was the triggering factor for the design of a new program. Currently, voices are already beginning to raise a similar concern on the likelihood that Portugal may be able to access the market to nance itself according to the schedule of its existing program. A second concern was the negative feedback loop between the sovereign solvency and the solvency of the banking sector in the country involved. This negative loop made the necessary adjustments and the estimated nancing needs even larger. This became quite clear in the case of the program for nancial support for Ireland. Most of the required funding in that program was to capitalize the banking sector. It has also become an important issue currently in the second Greek program.5 Third, the strategy of directly guaranteeing by the ofcial sector all nancing needs for a signicant period of time was a strategy that could work only for sufciently small countries. Belonging to a monetary union meant that domestic savings had plenty of alternative opportunities to nancing their sovereign. The ability to perform nancial repression in the context of the euro is very limited.6 Once the concerns on the nancing capability of sovereign needs moved to larger countries, such as Spain and Italy, the shortcomings became more important. The amounts of money necessary to provide such support from the point of view of the creditors become so large that it made it politically very difcult to nd sufcient support domestically for such packages. Investors could read through these difculties and did not have the guarantee that the support will exist. The rollover risk of these countries become a major source of concern. A standard response to this concern exists in the policy world, namely, the national central bank should act as the lender of last resort. In fact, this traditional response has been applied to a large degree by the developed economies in response to the crisis over the last 4 years. However, the institutional and public restrictions faced by the European Central Bank to engage in this type of activity were large. There was an explicit no bail out clause of any member state by other member states in the treaty of the EU. A crucial condition for the participation of Germany in the creation of the euro was to eliminate the possibility of the monetization of debt from a member state by the new European Central Bank (ECB). Despite these restrictions, the ECB decided in May 2010 to engage in a program of purchases of sovereign bonds in the secondary market in those cases in which it felt that the appropriate transmission of monetary policy was at risk. It started purchases of bonds from Greece, Portugal, and Ireland, and extended its purchases to Spanish and Italian bonds in August 2011. The results were temporary at best. Market participants quickly understood that the determination of the ECB to engage in considerable
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purchasing was limited. At the same time, the decision to engage in purchases of a particular sovereign implied a negative signal that some participants perceived as increasing the vulnerability of those sovereign markets. The result was that the ECB held just over 2% of the outstanding sovereign debt from the Euro area countries in October 2011, while the Bank of England held 22% of the stock of UK sovereign debt, and the US Fed held over 15% of US sovereign debt.7 Despite the limited amounts of sovereign bonds purchased as a percentage of all sovereign debt issued by Euro sovereigns, the perception of nonmarket interest rates in Euro sovereigns relative to those of other countries was widespread.8 The ECB announced in November 2011 the provision of a new long-term renancing operation to provide liquidity to the banking sector in unlimited supply for up to 3 years. This new renancing operation had the impact to provide much-needed liquidity to the European banking system and aborting an imminent credit crunch.9 It also increased the relative attractiveness to certain banking systems in the Euro area of holding sovereign bonds (particularly of their home country) that were yielding very appealing rates. As a result, the increase in demand for Euro sovereign bonds was signicant. Yields adjusted considerably, especially in the short-term part of the yield curve up to 3 years, and the ECB could scale back in its secondary market purchases of bonds from Euro sovereigns. These actions helped address in the short term the concerns to the answer of the second question on the ability to nance the short-term needs of potentially solvent countries. Nevertheless, the relief has only been temporary. The main reason has been the vicious circle in the Euro area between banking sector vulnerability and sovereign vulnerability (see Standard & Poors, 2012). The actions by the ECB have not led to an increase in international borrowing and lending within the euro. Rather the opposite has happened, the additional liquidity has led to an increase in purchases of sovereign bonds by the national banking systems in the vulnerable countries, while decreasing the amount of interbank borrowing and lending within the euro. In fact, the interbank market across Euro area countries has essentially disappeared, and most of the borrowing and lending is being done through the National System of Central Banks (i.e. through the national central banks). As a result, the national banking system, and in turn the access to nancing in national economies, has become more dependent rather than not less dependent on the perceived credibility of the sovereign (see Darvas 2011 and Von Hagen et al., 2011). Private rms and consumers in similar lines of business and credit quality, but located in different Euro area countries, face signicantly different nancing costs depending on the perceived risk of their sovereign. Put simply, the single currency is currently not capable of providing a single reference interest rate for agents across the Euro area. This malfunctioning of the monetary policy transmission mechanism imposes an even higher toll on countries under pressure to trigger growth. All Euro countries under pressure have engaged in important structural reforms to boost their competitiveness and productivity. The challenges for growth differ by country, but they all share a need to recoup part of their price competitiveness lost during the initial 10 years of the creation
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Figure 1 Changes in intra-Euro real effective exchange rates (REER) 20072011. Source: EUROSTAT. Note: Intra refers to the REER relative to 16 Euro zone trading partners. CPI, consumer price index; ULCs, unit labor costs.

of the euro relative to Germany. Spain, Portugal, and Ireland have approved major overhauls of their labor market regulations. Reductions of severance payments, increased exibility at the rm level to opt-out from collective bargaining agreements, and mechanisms to enhance wage adjustment are at the core of these reforms. These reforms have begun to result in some signicant progress. Ireland and Spain have adjusted the real effective exchange rates with a signicant depreciation relative to the Euro area average (see Figure 1). The real exchange rate, measured by unit labor costs, has adjusted in these two countries since the beginning of the crisis by around 70% of its appreciation relative to the Euro area since the creation of the euro. These two countries had also been able since the creation of the euro to enhance their tradable sector. The market share of exports from these two countries relative to world trade were, jointly with Germany, among the best performers of all Euro area (and large European) countries. This ability to continue to perform in world markets despite a persistent real exchange rate appreciation during the boom points to a signicant part of the adjustment as having been driven by BalassaSamuelson convergence effects. Furthermore, the adjustment in unit labor costs since the crisis in these two countries also points to a relatively more exible economy. In contrast, Portugal, Greece, and to a lesser extent Italy, have not been able to considerably grow their tradable sector since joining the Euro, and their corrections in terms of real appreciation during the crisis have also been slow (see Figure 1). Nevertheless, the challenges are still large for all these countries. The most important challenge is growth. Growth has to be driven by the external sector; however, it is not
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clear where the additional demand will be coming from. So far, since the crisis, most of the adjustment of internal imbalances within the Euro area has taken place in the vulnerable countries. Euro countries running large current account surplus prior to the crisis continue to do so. Aggregate demand in the Euro area needs to substantially increase to absorb the increase in unemployment and to promote growth in the vulnerable countries. Furthermore, the strength of the euro as an international currency, despite the apparent concerns on Euro area stability, reduces the contribution to growth from external demand. A second challenge is the ability of these countries to engage in the necessary sectoral adjustment of factors of production within their economies. This adjustment requires exibility not only in labor markets, but also on other areas of the economy such as labor mobility, training, entrepreneurship, red tape, and deregulation in many parts of the service sector. Countries have started to make progress in this direction. Italy has announced a very ambitious reform of professional services, the elimination of restrictions on opening hours for retail outlets, and facilitating new business creation. Nevertheless, both the breadth of reforms and the time needed for them to lter down into real enhancements of productive capacity raise uncertainty on how much of it will reect in increases in growth in the short and medium term. 4. Concluding Remarks Europe has been confronting serious challenges to the perceived sustainability of its scal situation by nancial markets. These challenges have been questioning the viability of the euro project. This paper shows that the scal trajectory of the Euro area over the last decade was at least as prudent as that of other developed economies. The measures taken by Euro area countries since the crisis to tackle their scal challenges have been more aggressive than those of many other developed countries. The paper shows the institutional changes and reforms that Europe has been engaging in to address concerns about its long-run viability. The measures taken point in the direction of the concerns raised. However, the assertiveness in taking those measures and the methods used increased the complexity of governing the EU. At the same time, large challenges remain to provide strong condence to investors concerns in two particular areas. The commitment of Euro area countries to support each other in nding a way to restore scal credibility and the determination of all countries to engage in the necessary macroeconomic adjustment policies to restore growth in the area and decrease internal macroeconomic divergences. Notes
1 A vigorous discussion existed among academics that strong institutions and scal rules were necessary for the well functioning of the euro going forward (see, e.g. Alesina & Bayoumi, 1996; Von Hagen, 2010). 2 For instance, the Slovak Republic did not participate in the original program of support for Greece, and Finland requested additional guarantees for participating in the second program of support for Greece.
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3 An agreement was reached to harmonize the provision of deposit guarantees to 100,000 per customer in an institution. 4 See for instance European Commission (2010; 2011b) or International Monetary Fund (2010a,b; 2011a) for a description of the rst two adjustment programs, that is, for Greece and Ireland. 5 The ofcial sector provided 23 billion for bank recapitalization, and 35 billion to provide additional guarantees to the ECB to support the discounting activities of the Greek banks, while the debt exchange with private sector investors took place and Greek bonds were on special default status. 6 Reinhart and Rogoff (2009) show that nancial repression was the most common way to reduce the debt burderns of developed countries in the twentieth century. 7 These estimates were published by Credit Suisse, and were in line with broad industry estimates. 8 Given that the ECB only purchased debt from a subset of Euro sovereigns, the percentage of sovereign bonds purchased by the ECB from specic countries relative to the outstanding debt of those member countries was signicantly higher. 9 The results of the two auctions performed in December 2011 and February 2012 resulted in an allocation slightly above 1 trillion.

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