Austerity Cs
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European Economics
After austerity
The European fiscal cliff is largely behind us. Euro area budget deficits fell
again in 2012 and are expected to come down further this year, albeit at a more
moderate pace. Overall, the structural deficit should fall by slightly less than 1pp
this year, after a cumulative 3pp fall in 2011-12, on our estimates. With the
adjustment expected for this year, the euro area, as a whole, has largely
completed its fiscal adjustment, even if that is not true for each country in the
euro area yet.
Phase two of the adjustment is timidly starting. Fiscal retrenchment shouldweigh less on activity going forward, given the above; the European
Commission is showing increasing signs of flexibility in the path of deficit
reduction it has just granted a two-year delay to France and Spain; countries
are announcing (timid) new growth measures at the national level; and, finally,
plans to relaunch the Growth Compact at the European level are making the
news, after the unsatisfactory implementation over the past 12 months.
Debt dynamics will likely remain unfavourable for at least another couple
of years. Overall, the euro area debt ratio is expected to rise further above the
(un)famous 90% level this year and next. However, we do not believe that
focusing on a simple number of the stock of debt of a country makes much
sense. First, because of the distinction between gross and net debt, that can be
important in some countries. Second, because a debt level sometimes says littleabout the sustainability of that debt: the same level of debt in two countries with
very different pension expenditure dynamics is not the same thing, for example.
Third, because other factors are found to be much more relevant in
assessing the true growth potential and the real risk of fiscal stress of a
country.
In this context, we update our index of fiscal stress , which continues to
suggest the possibility of market tensions in Portugal and Cyprus. Spain and
Greece are borderline on our indicator, while relative to our previous
assessment, in January, risks in the UK seem to have increased somewhat, due
to growing external imbalances. At the same time, France, Italy and Germany
(of course) remain at a comfortable or very comfortable level.
Research Analysts
Yiagos Alexopoulos
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Christel Aranda-Hassel
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Steven Bryce
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Violante Di Canossa
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Neville Hill
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Axel Lang
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Giovanni Zanni
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10 May 2013Economics Research
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10 May 2013
European Economics 2
After austerity
The European fiscal cliff is largely behind us. Euro area budget deficits fell again in
2012 and are expected to come down further this year, albeit at a more moderate pace.
The comparison with the other main economic areas remains flattering (Exhibit 1),
although the US in particular is making clear progress, helped by better GDP growth
dynamics. Indeed, the correction in Europe and in the euro area in particular is happening
despite the recession, so that in structural terms corrected for the cycle and other
temporary factors the deficit reduction looks particularly impressive.
Overall, the structural deficit should fall by slightly less than 1pp this year, after a
cumulative 3pp fall in 2011-12. If we take the whole period of retrenchment, the structural
correction amounts to around 4pp, on our calculations, and our estimates suggest that
next year the euro area as a whole should have a broadly balanced budget in structural
terms (Exhibit 2). In other words, the euro area has (largely) gone through its own fiscal
adjustment already.
Exhibit 1: Deficit international comparisons Exhibit 2: Euro area deficits by country
General government budget balance, % of GDP
-14
-12
-10
-8
-6
-4
-2
0
02 03 04 05 06 07 08 09 10 11 12 13 14
Euro area
Japan
US
UK
Structural balance% GDP 2012E 2013E 2014E 2012E 2013E 2014E
Austria -1.7 -1.7 -1.5 -1.5 -1.2 -1.1
Belgium -3.4 -2.4 -2.2 -2.7 -1.2 -1.0
Finland -1.9 -1.5 -1.2 -0.5 0.5 1.0
France -4.7 -4.0 -3.5 -3.4 -2.3 -1.8
Germany 0.2 0.0 0.0 0.0 0.0 -0.3
Greece -6.0 -4.5 -3.5 -0.1 3.4 4.7
Ireland -8.6 -7.5 -4.5 -9.7 -7.9 -4.5
Italy -3.1 -2.9 -2.7 -1.1 -0.4 -0.4
Netherlands -4.0 -3.5 -3.0 -2.4 -1.2 -0.7
Portugal -5.8 -5.2 -4.3 -0.5 1.3 2.2
Spain -7.1 -6.3 -5.5 -4.3 -2.4 -1.3
Euro area -3.1 -2.8 -2.4 -1.8 -0.9 -0.5
Change in the structural balance (pp): 1.7 1.0 0.4
General gov. balance
Source: IMF, Credit Suisse Source: Eurostat, Credit Suisse estimates
Phase two of the adjustment is starting. The pace of adjustment is being reduced, as
illustrated (1) by the estimates of diminished changes in the structural balance highlighted
in Exhibit 2 above; (2) by the European Commissions decision this month to grant two
more years to reach the 3% deficit target to France and Spain; and (3) by the
announcements notably in Italy and Spain of new growth-enhancing measures at the
national level.
After having legislated to repay public administrations arrears to the tune of 40bn (2.5%
of GDP) over the next 12 months, Italy has announced it will at least postpone the
payment of the real estate tax on first homes, that was due in June, and is planning to find
the means to avoid the 1pp VAT increase due in July while also providing funds to supportunemployment benefit plans. Funding should come via lower-than-expected interest
payments and some tax expenditure cuts, most probably. In Spain, on top of the two-year
postponement for reaching the 3% target, the government also presented measures to
support the creation of new enterprises and investment in R&D, cut corporate taxes for
small businesses and eased liquidity constraints of SMEs via later VAT repayments.
Giovanni Zanni
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Yiagos Alexopoulos
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10 May 2013
European Economics 3
Wind of change.The change of philosophy is also quite evident in the debate at the
European level, with European Commission President Barroso, for example, declaring last
month that austerity in Europe has reached its limits in terms of political support:
Growth based on unsustainable public or private debt is artificial growth and what
we need is to have growth that is sustainable, namely based on increased
competitiveness in Europe. This is what we need. This is the greatest lesson to
draw from the crisis.[While addressing the unsustainable debt problem] is fundamentally right, I think it
has reached its limits in many aspects, because a policy to be successful not only
has to be properly designed. It has to have the minimum of political and social
support.
And indeed, the risk is that too much adjustment in too short a period can ultimately
damage the effort itself with a social and political backlash undoing what has been
achieved over the past couple of years.
Recent suggestions to revive a more positive idea of Europe include relaunching the
Growth Compact. The latter was announced last year but has so far had little visible
impact on activity. The announcement of new measures including new instruments to
support countries reforming their economies and helping the unemployed across Europe
could also be announced in the coming months. The aim is to show that Europe can
provide positive interventions, associated with an improvement in citizens personal
situation, too. We have highlighted in the past how this is crucial, in light of rising social
and political protest (European Economics Crisis, meet the electorate). The rise of euro-
scepticism and of a protest vote in general (Exhibit 3) is a worrying sign.
Exhibit 3: Share of non-mainstream votes
%
0
10
20
30
40
50
60
70
GER FRA ITA SPA BEL NET AUT GRE IRE POR FIN
Pre-crisis election
Latest election (if held during crisis)
Latest polls
Source: Wikipedia, Credit Suisse
More policy coordination is of the essence. We mentioned above that France and Spain
will be granted two more years until 2015 to bring their deficit below the 3% threshold.
Ideally, France and Spain should have corrected their imbalances earlier but, ideally as
well, a stronger boost to growth in the euro area should have come from German domestic
demand. This did not happen, also as a consequence of policy decisions in that country.
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European Economics 4
Correction in imbalances is difficult without a symmetric correction on the other side of the
equation in other words, it is difficult to ask France and the periphery to correct quickly
while Germany appears too timid on the opposite front. Germany has consistently beaten
its deficit reduction targets, has disappointed on the domestic demand growth front and
has maintained an extremely high current account surplus. All these elements suggest that
the country could have done and could still do more to support growth and rebalancing in
the euro area.
Exhibit 4: Germany is consistently beating its deficitprojections
Exhibit 5: while building a large current accountsurplus
% %
-6
-5
-4
-3
-2
-1
0
1
2
3
4
00 01 02 03 04 05 06 07 08 09 10 11 12 13
Government balance
Apr 10 proj
Apr 11 proj
Apr 12 proj
-2
-1
0
1
2
3
4
5
6
7
8
00 01 02 03 04 05 06 07 08 09 10 11 12 13 Source: European Commission, Credit Suisse Source: Eurostat, Credit Suisse
Debt dynamics still unfavourable, driving debt ratios higher. Although interest rates have
come down across the board, the effective cost of funding for governments is still higher
than the growth rate of the economy, leading to rising debt ratios even despite the
stabilizing effect of the primary balance. This phenomenon, the so-called snow-ball effect
(Exhibit 6) can be reversed only with stronger nominal GDP growth dynamics in the short
term. Exhibit 6 also shows that stock-flow adjustments have contributed to the increase of
the debt ratio in recent years; these factors include, predominantly, contributions to the
European financial support facilities such as the EFSF and the ESM.
Exhibit 6: Euro area debt dynamics
average 2004-08 2009 2010 2011 2012 2013F 2014F
Gross debt ratio (% of GDP) 69.1 80.0 85.6 88.0 92.7 95.5 96.0
Change in the ratio 0.2 9.8 5.6 2.4 4.7 2.8 0.5
Contributions to the change in the ratio:
1. Primary balance -1.1 3.5 3.4 1.1 0.6 -0.2 -0.3
2. "Snow-ball" effect(*) 0.3 5.3 0.6 0.8 2.5 2.1 0.5
of which:
Interest expenditure 3.0 2.9 2.8 3.0 3.1 3.1 3.1Growth effect -1.4 3.2 -1.5 -1.2 0.5 0.5 -1.2
Inflation effect -1.3 -0.7 -0.6 -1.1 -1.1 -1.4 -1.4
3. Stock-flow adjustment 1.0 0.9 1.6 0.5 1.5 0 .9 0.4
(*) The "snow-ball effect" captures the impact of interest expenditure on accumulated debt, as well as the impact of real GDP growth andinflation on the debt ratio (through the denominator). The stock-flow adjustment i ncludes differences in cash and accrual accounting,accumulation of financial assets and valuation and other residual effects.
Source: European Commission estimates, Credit Suisse
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European Economics 5
Forget about the 90% debt level fairytale. Overall, the euro area debt ratio is expected to
rise further above the (un)famous 90% level this year and next. However, we would stress
that theres nothing special, no non-linearities at that level of debt, in our view. The
scaremongering that started with the Rogoff-Reinhart paper1
on this point was partly
demystified by a recent paper from Herndon-Ash-Pollin2, with the authors stressing some
incorrect use of the database in the Rogoff-Reinhart paper. The point we make, however, is
that fixating on a level of debt doesnt make a lot of sense also for other reasons first, due
to the distinction between gross and net debt that can be important in some countries.Second, because a debt level sometimes says little about the sustainability of that debt. For
example, the same level of debt in two countries with very different pension expenditure
dynamics or where the maturity of that debt is very different should not be judged
equivalently. Third, because our research suggests that other factors than fiscal indicators
are key to assess the true growth potential and the risk of fiscal stress of a country.
Exhibit 7: Average debt maturityExhibit 8: Projected increase in pension expenditure2010-60
Number of years % of GDP
0
2
4
6
8
10
12
14
16
18
GRE
UK
IRE
POR
AUS
BEL
FRA
NET
GER
ITA
JAP
FIN
SPA
US
-4
-2
0
2
4
6
810
12
14
BEL
IRE
NET
SPA
FIN
GER
AUS
UK
GRE
FRA
ITA
POR
2009 projection
2012 projection
Source: the BLOOMBERG PROFESSIONAL service, IMF, Credit Suisse Source: European Commission, Credit Suisse
Debt dynamics and fiscal stress indices. As we stress in a recent paper (European
Economics: An early-detection index of fiscal stress), what really matters for the
sustainability of public finances but also to some extent for the future growth potential of
a country, we believe is real economy and financial variables, more than fiscal ones. In
our work we highlight several relevant conclusions, summarised below:
Based on past fiscal stress events, the predictive power of financial/competitiveness
variables (e.g., private sector credit, the yield curve, current account) appears higher
than indicators based on fiscal ones (e.g., debt, deficit). Moreover, in several instances,
financial/competitiveness variables have been a leading indicator of future fiscal
problems and fiscal crises. To simplify, the current account and credit dynamics are
often a better indicator of future fiscal problems than the deficit and the debt.
While in 2009 almost two thirds of the EU countries were above the threshold that theindex associate with a significant likelihood of fiscal stress in the following year, since
then risks have been progressively reduced. Most peripheral countries (although not
Italy and not Ireland) are still in a fragile zone, though. For Spain, full implementation of
the planned adjustment would reduce the risk for fiscal stress in the short term, although
a more serious chance to fall below the fiscal stress threshold will likely take more time
and more reforms.
1 Growth in a Time of Debt, C.M. Reinhart & K.S. Rogoff, American Economic Review, 2010
2 Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff, T. Herndon-M.Ash-R.Pollin, 2013
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European Economics 6
The indicator for the UK has deteriorated since our last assessment, although it still lies
below the stress threshold. The reason behind the worsening situation is the
deterioration of some competitiveness variables. Still, the fact that the UK runs an
independent monetary policy (which is not fully captured by the index) provides more
flexibility in addressing any potential problems.
The absence of a political variable highlighting political credibility and social
discontent issue in the stress indicator is a shortcoming and suggests that the risk of afiscal crisis might be underestimated in some countries. For example, Italys track record
in terms of fiscal and financial/competitiveness variables was good and the fiscal stress
index did not signal the episode that happened in 2011.
At the same time, innovations at the euro area level, in terms of for example ESM
and OMT instruments should reduce the chances of an episode of fiscal stress in the
future relative to the previous period.
Exhibit 9: Fiscal stress index, selected countries
S0 composite index. The horizontal line is the threshold that signals risks of fiscal crisis in the year ahead
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
GER AUS FIN NET FRA BEL ITA SLO IRE SPA UK GRE POR CYP
2012 2013
Fiscal stress threshold
Source: European Commission, Credit Suisse
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