Public Finance in EMU 2009

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Public Finances in EMU

2009EUROPEAN ECONOMY 5|2009(provisional version)

EUROPEAN COMMISSION


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Europea n Co mm issionDirectorate-General for Economic and Financial Affairs

Public finances in EMU - 2009

EUROPEAN ECONOMY 5/ 2009


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ACKNOWLEDGEMENTS

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This report was prepared in the Directorate-General for Economic and Financial Affairs under thedirection of Marco Buti, Director-General, and Servaas Deroose, Director of the Directorate for theMacroeconomy of the euro area and the EU.

The main contributors were Lucio Pench, Joaquim Ayuso Casals, Salvador Barrios, Roland Eisenberg,Sven Langedijk, Lucia Piana, Andrea Schaechter, Alessandro Turrini.

Specific contributions were provided by Eduardo Barredo Capelot, Marie Donnay, Lars Jonung, JooNogueira Martins, Allard Postma, Jan in 't Veld and Monika Wozowcyk.

The country chapters in Part V were prepared in the Directorates for the Economies of the Member Statesunder the responsibility of Elena Flores and Jrgen Krger. The contributors were Orlando Abreu, Jean-Luc Annaert, Laura Bardone, Paolo Battaglia, Josef Baumgartner, Gerrit Bethuyne, Birgitte Bjornbak,

Piotr Bogmumil, Georg M. Busch, Susanne Casaux, Mateo Cap Servera, Pedro Cardoso, Samuel DeLemos Peixoto, Christophe Doin, Pierre Ecochard, Ivan Ebejer, Gatis Eglitis, Polyvios Eliofotou, CarstenEppendorfer, Balazs Forgo, Malgorzata Galar, Christian Gayer, Agne Genuisaite, Oskar Grevesmuhl,Dalia Grigonyte, Gabriele Giudice, Zoltan Gyenes, Renata Hruzova, Fabienne Ilzkovitz, Lorena Ionita,Laszlo Jankovics, Heinz Jansen, Javier Jareno Morago, Barbara Kauffmann, Neil Kay, Filip Keereman,Julda Kielyte, Jan Komarek, Mitja Komrl, Bohzil Kostov, Bettina Kromen, Robert Kuenzel, StefanKuhnert, Baudouin Lamine, Pim Lescrauwaet, Karolina Lieb, Mart Maivli, Janis Malzubris, CarlosMartinez Mongay, George Moschovis, Maarten Masselink, Alberto Noriega Guerra, Manuel PalazuelosMartinez, Carmine Pappalardo, Balazs Parkanyi, Stefaan Pauwels, Elena Pavlova, Allard Postma, JosLuis Robledo Fraga, Julien Rousselon, Aleksander Rutkowski, Aino Salomaki, Karl Scerri, VladimirSolanic, Siegfried Steinlein, Lotte Taylor, Ingrid Toming, Javier Yaniz Igal, Charlotte Van Hooydonk,Corina Weidinger Sosdean, Peter Weiss, Ann Westman, Ralph Wilkinson, Norbert Wunner.

Sven Langedijk coordinated and supervised the production of the report. Tamas Gabor Szin wasresponsible for statistical and editorial work.

Comments and suggestions by colleagues in the Directorate-General for Economic and Financial Affairsas well as by other services of the Commission are gratefully acknowledged.

Secretarial support was provided by Dominique Prins.

Comments on the report would be gratefully received and should be sent to:

Directorate-General for Economic and Financial Affairs

Unit C2: Public finances in the euro area and the EU

European Commission

B-1049 Brussels

or by e-mail to [email protected] or [email protected]


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CONTENTS

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Sum m a ry a nd m a in c onc lusions 1

Part I: Current develop ments and p rospec ts 9

Summary 111. Financial and economic crisis hits budgetary developments and

prospects 131.1. Times of c risis 131.2. Fisc al stimulus and large auto m atic stab ilisers supp ort ec onom ic a c tivity in

the EU 13

1.3. Short-term dev elopments and prospec ts for the b udge t ba lance and publicdebt 211.4. Government revenue and expenditure 25

2. Imp lementing the SGP - flexibility w ithin the exc essive defic itprocedure 302.1. Introduction 302.2. The exce ssive de ficit proc ed ure 30

3. Plans in the stab ility and conve rge nce programm es ac knowledg ed ifferent roo m for fiscal ma noe uvre 393.1. Introduction 393.2. A significa nt de terioration in pub lic finance s ong oing since 2008 393.3. Fisc al po licy in 2009-2010 reflec ting diffe renc es in room for m an oe uvre 413.4. Consolidation pla nned to be gin in 2010 433.5. Deb t de ve lop ments an d sustainab ility assessments 44

Part II: Evolving budgetary surveillanc e 55

Summary 571. Measuring and assessing fiscal d eve lopm ents in a n env ironm ent of

uncertainty 591.1. Ac co unting for ba nk rescue s 59

2. Disc retiona ry me asures and tax elastic ities in the EU 642.1. Discretiona ry mea sures affec ting ta x reve nues in the EU: how imp ortant a re

they? 642.2. Correc ting the effec ts of discretiona ry me asures on tax ela sticities 662.3. Summ ary and wa y forwa rd 70

3. The quality of public finances: da ta and indica tors 713.1. Introduction 713.2. Develop ing qua lity of pub lic finan ce s indica tors 713.3. Progress on p roviding da ta on g ove rnment expe nditure by function (CO FOG

data) 824. Fisca l rules, indep end ent institutions and med ium-term budg eta ry

frameworks 874.1. Introduction 874.2. Num erica l fisc al rules in EU countries 87

4.3. Indep end ent fisc al institutions 934.4. Me diumterm bud ge tary fram ew orks 94


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4.5. Conclusions 98AII. Mo re d eta ils on d isc retiona ry measures and q uality of public

financ e indica tors 100AII.1. Notes on the d ata collected in the framew ork of the Output Gap Working

Group of the Eco nom ic Policy Com m ittee 100AII.2. Propo rtiona l ad justme nt m ethod 101AII.3. List of ind ica tors used for the illustra tive c alc ulation of qua lity of pub lic

finance s co m po site indica tors 103

Part III: The fisc a l co sts of financ ial c rises: pa st evidenc e a ndimp lic a tions fo r today's c risis 107

Summary 1091. Introduction 1122. Key concep ts for ana lysing financ ial c rises and the ir fiscal costs 113

2.1. Banking c rises 1132.2. Fisc a l costs 113

3. Fisca l costs of financ ial c rises: the evidenc e 1163.1. Direc t fisc al costs an d their de term inants 1163.2. Co mprehe nsive estim ate s of fisc al costs 122

4. Case stud ies 1344.1. Japan 1344.2. Korea 1354.3. Sw ed en 1354.4. Finland 1364.5. Norway 137

5. Ge neral lessons from hand ling banking c rises for fiscal costs 1395.1. Bank resc ue op erations and direc t fisc al co sts 1395.2. Broad principles on the role of fisc al policy supp ort 142

6. The c urrent c risis, policy responses and fisca l implica tions fo r EUMemb er Sta tes 1456.1. What ha ve so far be en the p olicy respo nses b y EU M em be r Sta tes? 1456.2. Key cha rac teristics of the curren t c risis: how do es it c om pa re to p ast c rises? 1486.3. How m uch c an pa st c rises rea lly tell us ab out p olicy respo nses and

implica tions on pub lic financ es? 152

7. Conclusions 157AIII.Mo re deta ils on fiscal costs of financ ial c rises 159AIII.1. Ou tp ut costs of fina nc ial c risis 159AIII.2. Assessing the imp ac t of b an king c rises on go ve rnmen t de b t 163

Part IV: Pub lic finances in boom s and busts 165

Summary 1671. Introduction 168

1.1. Boo ms, bu sts an d pu blic financ es 1681.2. Credit, prope rty p rices and ma croe co nom ic de velopm ents in the EU 168

2. Public financ es during the bo om 1712.1. Rec ent de velop m ents in pub lic finance s 1712.2. Housing m arkets a nd pub lic financ es 172


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2.3. A c loser loo k at ta x reve nue w indfa lls/ shortfalls 1762.4. Mod el simula tions w ith QUEST III 179

3. Public financ es during the bust 1823.1. The fiscal po licy resp onse to the financ ial c risis: fiscal spa ce m at ters 1823.2. Fisc al spa c e and sove reign bo nd sp reads 1863.3. Fisc a l stimulus w ith limite d fisca l space: sim ula tion results with th e Q UESTIII

model 1873.4. Fisc al policy during the bust: the role of fisca l spa ce 188

4. Conclusions 192AIV.Data source and metho ds 194

AIV.1.Dete rmina nts of reve nues wind falls an d sho rtfalls 194AIV.2.Variab les de finition, source s and ca lculation of the fisc al spa ce co m po site

indicator 194

Part V: Membe r Sta te develop ments 197

1. Belgium 1982. Bulgaria 2003. The Czec h Rep ub lic 2024. Denmark 2045. Germany 2066. Estonia 2097. Ireland 2128. Greece 2159. Spain 21710. Franc e 22011. Italy 22312. Cyprus 22613. Latvia 22814. Lithuania 23015. Luxembourg 23216. Hungary 23417. Malta 23618. The Netherlands 23819. Austria 24020. Poland 24221. Portugal 24522. Romania 24723. Slovenia 24924. Slovakia 25125. Finland 25426. Swed en 25627. United Kingdom 258

Part VI: Resources 261

1. Abbrevia tions and symb ols used 2622. Glossary 267


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3. References 2744. Useful inte rnet links 282

LIST OF TABLES

I.1.1. Fisc al stimulus m ea sures in 2009 and 2010 b y Mem be r Sta te (in % GDP) 14I.1.2. Euro area - Gene ral gov ernment bud ge t ba lanc e (% of GDP) 21I.1.3. Bud ge t b ala nc es of EU Mem be r Sta tes (% of GDP) 22I.1.4. Com po sition of c hang es in the gene ral gove rnm ent gross de bt-to-GDP ratio in

EU M em ber Sta tes (% of GDP) 24I.1.5. Euro area - Gov ernment revenue and expe nditure (% of GDP) 24I.1.6.

Gov ernment revenue and expe nditure (% of GDP) 26

I.2.1. Overview EDP step s - Euro area M em be r Sta tes 37I.2.2. Overview EDP step s - Non-e uro area M em be r Sta tes 38I.3.1. Bank rescue pa c kage s 45I.3.2. Budg eta ry develop me nts a c co rding to the 2008-2009 Stab ility and

Convergence Programm e upda tes 46I.3.3. Overview of the Co unc il Opinions on the SCPs Sum mary assessm ents and

po licy invitatio ns 47II.1.1. Ac co unting for ba nk rescue s: a summ ary 63II.2.1. Annua l shares of d isc retiona ry m ea sures in tax reve nue levels: ave rag e 2001-

2007 66II.3.1. Numb er of indica tors used for c om po site ca lculations 74II.3.2. Distribution and c lassifica tion of scores 75II.3.3. Illustrative QPF co m po site indica tors: alternative we ighting m ethod s 77II.3.4. Illustrative QPF indic a tors for sub -dim ension QPF 3 (co m po sition, effic ienc y an d

effec tiveness of expe nditure) 78II.3.5. Rob ustness test for using a lternative w eighting m ethod s: c orrelation co efficients

of results 79II.4.1. Ta rget de finitions b y typ e of rule 90II.4.2. Influence of fisca l rules on the p rima ry CAB (EU-27, 1990-2008) 93II.AII.1. Data co llected on disc retiona ry m ea sures affec ting tax elasticities 101II.AII.2. List of indic ato rs used for the illustra tive c alc ulation of q uality of p ublic finance s

co mp osite indica tors 103III.3.1. Direc t fisc al costs of ba nking c rises 117III.3.2. Crisis m ea sures a nd direc t fisc al costs 119

III.3.3. The de terminants of the fisca l recov ery rate 121III.3.4. Gene ral gov ernment ba lanc es during ba nking c rises (% of GDP) 123III.3.5. Imp lica tions of c rises for gene ral gove rnme nt expend iture a nd reve nue ratios

(% of GDP) 124III.3.6. Prima ry ge neral go vernme nt ba lanc es during b anking crises (% of GDP) 125III.3.7. Breakdo wn of cha nges in prima ry budg etary ba lance 126III.3.8. Cha nge in gross pu blic de bt du ring c rises ep isod es 128III.3.9. The imp ac t of financ ial crises on pub lic de bt 130III.4.1. Jap a n Fiscal pa c kag es, 1992-93 (% of GDP, p rojec t c ost ba sis) 135III.4.2. Sw ed en - Key fiscal indica tors (% of GDP) 136III.4.3. Finland Key fisc a l ind ica to rs (% of GDP) 137III.4.4. Norwa y Key fisc al indicators (% of GDP) 138III.5.1. Experienc e w ith "bad ba nks" (Asset M ana gem ent Co mp anies) during b anking

c rises 142III.6.1. EU pu blic inte rventions in the ba nking sec tor as of end -Ma rch 2009 (in % of GDP) 147


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III.6.2. Fisc al stimulus m ea sures in the EU (2009-10) (% o f GDP) 147III.6.3. EU M em be r Sta tes Key fisc al indic a tors 148III.6.4. External stimulus fac tors to rec ov er from the c risis 153III.6.5. Risk scen arios fo r d irec t fisc al c osts 153AIII.1. Fisc a l costs in system ic b anking c rises (1970-2007) 160AIII.2. Crisis c ontainm ent an d resolution po licies (1970-2007) 161AIII.3. Co rrela tion am ong differen t c rises resolution me asures (1970-2007) 162AIII.4. Exemp lary c alc ulations of outp ut c osts using the grow th and level me thods 162IV.1.1. Key ma croe co nom ic de velop m ents be fore the financia l crisis: 1998-2007 170V.1.1. Bud ge ta ry de ve lop ments 2007-2013, Belg ium (% of GDP) 199V.1.2. Ma in bu dg eta ry mea sures for 2009, Belg ium 199V.2.1. Bud ge ta ry de ve lop ments 2007-2012, Bulg aria (% of GDP) 201V.2.2. Ma in bu dg eta ry mea sures for 2009, Bulga ria 201V.3.1. Bud ge ta ry de ve lop ments2007-2012, Czec h Rep ublic (% of GDP) 203V.3.2. Ma in bud ge tary me asures for 2009, Czech Rep ublic 203V.4.1. Bud ge ta ry de ve lop ments 2007-2015, Denm ark (% of GDP) 205V.4.2. Ma in bud ge tary me asures for 2009, Denm ark 205V.5.1. Bud ge ta ry de ve lop ments 2007-2012, Ge rma ny (% of GDP) 207V.5.2. Ma in m ea sures in the bud ge t for 2009, Germa ny 207V.6.1. Bud ge ta ry de ve lop ments 2007-2012, Estonia (% of GDP) 210V.6.2. Ma in m ea sures in the bu dg et for 2009, Estonia 210V.7.1. Bud ge ta ry de ve lop ments 2007-2012, Irela nd (% of GDP) 213V.7.2. Ma in bu dg eta ry mea sures for 2009, Irela nd 213V.8.1. Bud ge ta ry de ve lopm ents 2007-2012, Gree ce (% of GDP) 216V.8.2. Ma in bud ge tary me asures for 2009, Greec e 216

V.9.1. Bud ge ta ry de ve lop ments 2007-2011, Spa in (% of GDP) 218V.9.2. Ma in bu dg eta ry mea sures for 2009, Sp ain 218V.9.3. GDP effe c ts of fiscal m ea sures 219V.10.1. Increa se in reve nue (in % of GDP) give n a 10% increa se in eq uity and real e sta te

prices 221V.10.2. Bud ge ta ry de ve lop ments 2007-2013, Franc e (% of GDP) 222V.10.3. Ma in bu dg eta ry mea sures for 2009, Franc e 222V.11.1. Bud ge ta ry de ve lop ments 2007-2011, Italy (% of GDP) 224V.11.2. Ma in bu dg eta ry mea sures for 2009, Italy 224V.11.3. Net fina nc ial asse ts (sto c ks - % of GDP) 225V.12.1. Bud ge ta ry de ve lop m ents 2007-2012, Cyp rus (% of GDP) 227V.12.2. Ma in bu dg eta ry mea sures for 2009, Cyp rus 227V.13.1. Bud ge ta ry de ve lop m ents 2007-2011, La tvia (% of GDP) 229V.13.2. Ma in bu dg eta ry mea sures for 2009, La tvia 229V.14.1. Bud ge ta ry de ve lop ments 2007-2011, Lithuan ia (% of GDP) 231V.14.2. Ma in bu dg eta ry mea sures for 2009, Lithua nia 231V.15.1. Bud ge ta ry de ve lop m ents 2007-2010, Luxem bo urg (% of GDP) 233V.15.2. Ma in bu dg eta ry mea sures for 2009, Luxem bo urg 233V.16.1. Bud ge ta ry de ve lop ments 2007-2011, Hung a ry (% of GDP) 235V.16.2. Ma in bu dg eta ry mea sures for 2009, Hunga ry 235V.17.1. Bud ge ta ry de ve lop ments 2007-2012, M alta (% of GDP) 237V.17.2. Ma in bud ge tary me asures for 2009, Ma lta 237V.18.1. Bud ge ta ry de ve lop ments 2007-2011, Nethe rlands (% of GDP) 239V.18.2. Ma in bud ge ta ry mea sures for 2009, Nethe rland s 239V.19.1. Bud ge ta ry de ve lop ments 2007-2012, Austria (% of GDP) 241V.19.2. Ma in bu dg eta ry mea sures for 2009, Austria 241V.20.1. Bud ge ta ry de ve lop ments 2007-2012, Pola nd (% of GDP) 243V.20.2. Ma in bu dg eta ry mea sures for 2009, Pola nd 243


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II.3.6. COFOG II level breakdo wn o f 2007 go vernme nt expend iture on socialprotection 85

II.3.7. COFOG II level breakd ow n of 2007 go vernme nt expe nditure on ed uc ation 86II.3.8. COFOG II level breakd ow n of 2007 go vernme nt expend iture on hea lth 86II.4.1. Fisc a l rules in the EU Mem ber Sta te s b y sub -sec to r 89II.4.2. Fisc al rules in the EU Mem be r Sta tes b y typ e of rule 89II.4.3. Fisc al rule inde x and a verag e p rima ry cyc lica lly-ad justed ba lanc e in the EU-27

in the pe riod 2000-2008 92II.4.4. Develop me nt of the fisc al rule index in the EU 92II.4.5. Develop me nt of the fisc al rule index in selec ted EU Me mb er State s 92II.4.6. Coo rdination, monitoring, co rrec tive m ec hanisms and targe t revisions in

dom estic M TBFs 97II.4.7. MTBF index scores and ranking in the EU27 98II.4.8. Quality of m ed ium-term bud ge tary fram ew orks and fisc al rules, 2008 98III.2.1. Type s of fisc al costs from financ ial c rises 114III.3.1. Gross an d ne t fisc al costs from system ic b anking c rises (1970-2007) 118III.3.2. Net fiscal costs an d ou tpu t costs of financ ial c rises (1970-2007) 118III.3.3. Gene ral gov ernment ba lanc es during ba nking c rises (% of GDP) 123III.3.4. Change in general gove rnment expend iture and revenue during b anking crises

(% of GDP) 124III.3.5. Selec ted crises episod es: Develop m ents in prima ry general g ove rnme nt

(% of GDP) 125III.3.6. Selec ted crises episod es: Prima ry g eneral gov ernment ba lanc es during crisis

(% of GDP) 126III.3.7. Gross pu b lic de b t in c rises ep isod es (% of GDP) 126

III.3.8. Deb t proje c tions du ring a finan c ial c risis for EU-OECD coun tries 133III.4.1. Jap a n Key fisc al va riab les during the c risis 135III.4.2. Korea Key fiscal va riab les du ring the c risis 135III.4.3. Sw ed en - Key fiscal va riab les du ring the c risis 136III.4.4. Finland Key fisc al va riab les du ring the c risis 137III.4.5. Norwa y Key fisc al va riab les du ring the c risis 138III.6.1. EU M em be r Sta tes Key fisc al indic a tors 148III.6.2. World real GDP grow th du ring m ajo r ba nking c rises 152III.6.3. Real effec tive excha nge rate during ba nking c risis (% c hang e) 152III.6.4. Sov ereign bo nd sprea ds of sele c ted EU Mem be r Sta tes 156AIII.1. Ou tp ut losses of systemic banking c rises (1970-2007) 163IV.1.1. House p rices, mo rtga ge loa ns and othe r c red its in selec ted EU c ountries 168IV.1.2. Annual ave rag e cha nge in current ac co unts and mortgage deb t (1998-2007) 170IV.2.1. Gov ernment revenue s and expe nditure growth in selec ted EU co untries,

1999-2010 172IV.2.2. Ta x reve nue w ind fa lls/ shortfalls in the EU, 1999-2008 (% GDP) 172IV.2.3. Prop erty ta xes in 1999 and 2007 (% of GDP) 173IV.2.4. Prope rty transa c tion ta xes in 1999 an d 2007 (% of GDP) 173IV.2.5. Ta xes on transa c tions in pro pe rty in 1999 and 2007 (% of GDP) 173IV.2.6. Im pulse-respo nse func tion: gov ernment revenues and expen diture vs house

price ch ang es 175IV.2.7. Imp ulse-respo nse func tion: gov ernment reve nues vs house p rice cha nge s with

cred it exoge nous 177IV.2.8. Fisc al p olicy in the c ontext of b uilding-up of imba lanc es in a rep resenta tive

sm all euro area M em be r State (% of po tential GDP) 181IV.3.1. Gov ernment c ontingen t liabilities related to the ba nking sec tor in the EU, 1999-2009 183IV.3.2. Shrinking fisc al space in the EU 185


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IV.3.3. Fisc al spa c e and go vernm ent bo nd sprea ds in the euro area 187IV.3.4. Fisc al spa c e and go vernm ent bo nd sprea ds in non euro-area co untries 187IV.3.5. Fisc a l stimulus and risk p rem ia (% of GDP) 188IV.3.6. Quest III simulations of the unwinding o f imb ala nce s and fisc al p olicy: coun tries

w ith larg e fiscal spa ce (% of GDP) 189IV.3.7. Quest III simulations of the unwinding o f imb ala nce s and fisc al p olicy: coun tries

w ith sm all fiscal spa ce (% of GDP) 190V.6.1. Estonia: Net lending / borrowing (% of GDP) and struc tural ba lanc e (% of GDP) 211V.7.1. Ireland - prope rty-rela ted tax revenue 214V.10.1. Fisc al revenu e an d fiscal reven ue net of discretiona ry m ea sures (in % of GDP) 221V.11.1. Spread 10-year go vernme nt bo nd yield 225V.11.2. Interest rate s on Italian sec urities 225V.20.1. Orthogo nalised imp ulse-respo nse func tions ba sed on vec tor a utoregression for

Poland 244V.20.2. Short-term pla ns an d ou tturns 244V.20.3. The ev olution of pub lic investme nt (ESA95) b y loca l and ce ntral gov ernment in

Poland 244V.20.4. Reg ional GDP per c ap ita a nd pu blic investme nt (non ESA95) in d ifferent

go ve rnmen t sub sec tors, long -term av erag es for 1999-2006 244

LIST OF BOXES

I.1.1. The Europ ea n Econo m ic Rec ov ery Plan 16I.1.2. Fisc al po licy mea sures 18I.1.3. EU ba lan ce-o f-pa yments assista nc e 20I.1.4. The be ha viour of tax reve nues and the finan c ial c risis 27II.3.1. Pros and co ns of co mp osite indica tors 72II.4.1. Key finding s in the 2005 survey on na tiona l fiscal rules 88II.4.2. Ma in fea tures of the new fisc al rules ove r the p eriod 2005-2008 90II.4.3. Criteria used to c alc ulate the index of streng th of fisc al rules 91II.4.4. Key finding s in the 2005 survey on inde pe nd ent fiscal institutions 94II.4.5. Key find ings in the 2006 surve y 96II.4.6. Criteria used to c alc ulate the qua lity index of do me stic M TBFs 97III.3.1. How to m ea sures ou tp ut costs? 120III.3.2. Eco nom etric estimation of the imp ac t of a financ ial crisis on the outp ut ga p 131III.6.1. Financ ial crises in the glob al ec onom y 150

IV.2.1. Dete rmina nts of reve nue w indfa lls/ shortfa lls in the EU 178


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EDITORIAL

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Public finances are a key driver in the EU for economic recovery as the depth of the recession and creditconstraints require fiscal policy action. This has been recognised in the European Economic RecoveryProgramme, which includes an EU-wide, and globally, coordinated effort for discretionary fiscal supportto the EU economy. An even larger support of the EU's economy is coming from automatic stabilisers.Across Member States however, the fiscal policy needs, possibilities and responses have differedstrongly, reflecting notably initial different macroeconomic starting positions and market pressures.

The fiscal support for the economies together with rising interest rates in some countries and heavy publicinterventions in the financial system has led to a sharp deterioration in public finances. And there aresignificant upside risks for further increases in debt levels when considering that the resolution of thebanking sector in the EU is only advancing slowly. But past experiences teach useful lessons on howfiscal costs of banking crises can be contained and which factors can facilitate to eventually bringing thefiscal houses back in order. This includes on the banking crisis resolution side a transparent, resolute and

swift strategy, without regress to regulatory forbearance, as well as a fair and uniform treatment of marketparticipants backed by strong public institutions and legal frameworks. For the fiscal consolidation part,strong fiscal governance frameworks, notably national fiscal rules, are a factor of success.

Today's challenging times have also been a stress test for the Stability and Growth Pact. With the newlybuilt-in flexibility of the reformed Pact in 2005, the EU fiscal framework has allowed on the one hand, toprovide the appropriate support to the EU economies in exceptional times while, on the other hand, set aclear path for future fiscal adjustments. While the fiscal consolidation in the past several years has createdsome buffer in most countries, the need to improve the preventive arm of the Pact needs to be carefullyconsidered when emerging from the crisis. This includes particularly the lack of some Member States touse the "good" pre-crisis times to improve the state of their public finances which would have let thementer the crisis from even more comfortable starting positions. Moreover, past budgetary surveillance hasnot been sufficiently comprehensive in accounting for the role of fiscal policy in allowing the build-up of

internal and external imbalances.This year's Public finances in EMUreport reviews how Member States have tackled the challenges fromthe financial and economic crisis and assesses the prospects for public finances and policy needs ahead.The report follows a well-known and successful formula of past years, essentially consisting of fourmajor elements. The first element is a detailed description and analysis of recent budgetary developments,with a focus this year on the EERP, and an assessment of the outlook. The second element of the report isan examination of the EUs fiscal surveillance framework. This year the main issues are (i) the statisticaltreatment of public interventions in the financial system, (ii) ways to improve the measure of thecyclically-adjusted budgetary balance, (iii) the measurement of the quality of public finances and (iv)developments in Member States' fiscal frameworks. The third element consists of analytical studies. The2009 report assesses in detail the fiscal costs of past financial crises and their determinants, and drawsimportant policy conclusions for handling today's crisis. Moreover, the report studies the link between

house price developments and public finances during booms and busts and the role for fiscal policy inbusts when fiscal space is constrained. The fourth and final element of the report provides an overview offiscal developments in the 27 Member States.

Since the first report was released in 2000, the issues ofPublic Finances in EMUhave sought to raiseawareness and understanding of key fiscal developments and policy challenges. They also reviewed andlaunched ideas on how to strengthen the framework for economic governance and to improve itsenforcement. Given the unprecedented challenging times for public finances, this year's tenth edition ofthe report, as those in previous years, should be an important contribution to the debate on fiscal policy inthe EU and remain a key reference for practitioners and policy-makers.

Marco ButiDirector-General

Economic and Financial Affairs


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SUMMARY AND MAIN CONCLUSIONS

1

Financial and economic crisis hits budgetary developments and

prospects

Public finances in the EU have come under unprecedented stress as they playa central role in overcoming the financial and economic crisis. The EUeconomy has been particularly hard hit by the shockwave of the crisis, whichemanated and quickly spread from the United States, due to the EU's strongexport dependence, its integration and role in global capital markets, andlarge external and internal macroeconomic imbalances that had built up in anumber of Member States. For 2009, the EU's real GDP is projected to fall by4% before stabilising at -0.1% growth in the course of 2010. Due to the depthof the recession and credit constraints, public finances in the EU are

shouldering a particular burden by responding to the crisis with threeobjectives: (i) addressing demand shortfalls in the short run through fiscalstimulus measures and letting automatic stabilisers play, (ii) restoring thehealth of the financial sector and supporting the intermediation function offinancial markets and (iii) contributing to long-term growth prospects, interalia by ensuring sustainable budgetary developments.

With its European Economic Recovery Programme (EERP) the EU hasdefined an effective framework for addressing the economic downturncombining active fiscal stimulus with structural reforms. The programme,endorsed by the European Council in December 2008, calls for discretionaryfiscal support of at least 1.5% of GDP. This EU-wide, and also globally,

coordinated response is a crucial contribution to tackling the global economiccrisis in which all countries with sufficient fiscal space need to play a role infilling short-term demand gaps. Model simulations by the Commissionservices clearly indicate that a coordinated policy response has a considerablylarger impact on output and is thus eventually less costly, since leakages arecontained, than those undertaken by a single country. Overall, Member Stateshave adopted or announced fiscal stimulus measures totalling 1.1% of GDPin 2009 and 0.7% of GDP in 2010. Of the total, 1% of GDP is on the revenueand 0.8% of GDP on the expenditure side. These stimulus measures areestimated by Commission services to contribute to about % of real GDPgrowth in 2009 and about % in 2010.

The fiscal support packages adopted under the EERP have broadly followed

desirable general principles but some risks on their effectiveness remain. Theset of principles includes the well-known "three Ts" (timely, temporary andtargeted) in addition to the need for a coordinated approach taking intoaccount cross-country differences in fiscal space. As regards the timeliness,there were initially concerns that under the projected growth path the impactof the EERP could take effect relatively late in the cycle. But with thematerialisation of the downward risks to the projections this concern hasevaporated. As regards the targets of measures, to a large extent they havebeen geared toward those with the highest multiplier effects and therefore thegreatest potential to mitigate the impact of the crisis on economic activity.However, the support of individual industries in some Member States, whilesuccessful in filling short-term demand gaps, needs to be weighed against its

potential longer-term distortionary effects. As regards temporariness, this isassured for the majority of measures (e.g., frontloading of public investmentand tax relief for which discontinuation has been announced). However, there

Unparalleled

ch alleng es in fac e of

the c urrent c risis

make p ublic

finances a key driver

for econo mic

rec ove ry

... through

coo rdinated EU fisc alstimulus pa c kag es


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Pub lic finances in EMU - 2009

2

remains a risk that especially some of the revenue measures becomeentrenched.

In addition to discretionary measures, an even larger support of the EU'seconomy is coming from automatic stabilisers. The larger size ofgovernments in the EU than in the United States, particularly the moreextensive social security systems explains the greater importance of thischannel of support to economic activity in the EU compared to the UnitedStates. As a consequence, the average budget deficit in the EU alreadyworsened in 2008 to 2.3% of GDP from 0.8% in 2007 (1.9% in 2008 and0.6% in 2007 in the euro area) and is expected to widen further by 5.0% ofGDP by 2010 (4.6% of GDP deterioration for the euro area).

Taking into account that some Member States have been particularly hard hitby the crisis and some had difficult initial macroeconomic starting positions,fiscal policy needs and possibilities differ across the EU. Even though theoverall level of interest rates has fallen substantially to before crisis levels,the significantly higher risk premiums that financial markets are requestingon sovereign bonds for some Member States can be very costly andcounteract fiscal stimulus policies, in particular if risk premia spread to thewider economy. Thus, Member States need to carefully manage their fiscalspace in light of sustainability concerns. The Commission services latestassessment of long-term sustainability, using the conventional indicators andclassification (albeit not accounting for the impact of the crisis on potentialgrowth) has already evidenced a strong increase in sustainability risks,independently of the potential materialisation of contingent liabilities linked

to the banking sector.

Across EU Member States, the financial and economic crisis is sharplyratcheting up public debt-to-ratios, not only as a consequence of fiscalsupport to ailing economies but also due to direct public interventions inbanking systems. The public debt-to-GDP ratio in the EU which justsurpassed the 60% mark in 2008 (from 58.7% in 2007) is expected to jumpby 21 percentage points to 79.4% of GDP until 2010. For the euro area theincrease is projected to be somewhat smaller at about 18 percentage pointsbetween 2007 and 2010. So far, about 3 percentage points of the increase inthe public debt-to-GDP ratio until 2010 in the EU (5 percentage points in theeuro area) is attributed to stock-flow adjustments, which in turn reflect

predominantly the acquisition of financial assets and are recorded "below-the-line" (i.e., affecting public debt but not the deficit). However, accuratelyaccounting in fiscal statistics for these and other operations in support of thefinancial sector is not unproblematic as representative market prices may notbe available during a financial crisis and a measure of fair value may only beinferred indirectly. Eurostat is in the process of drawing up guidance on thestatistical treatment of public operations to support the financial sector. Sofar, Member States have supported their banking sectors with measuresamounting to about 13% of GDP and have approved funds worth another31% of GDP. The largest share (7.8% of GDP in terms of measures taken;24.7% of GDP in terms of measures approved) are guarantees on bankliabilities, which do not affect public debt and deficits unless they are calledupon. The rest pertains to relief of impaired assets, liquidity support and

capital injections. To what extent these operations risk eventually adding to

and the functioning

of automa tic

sta b ilisers.

But responses differac ross countries

acc ounting for

differenc es in fisc al

spa ce .

inc luding from

pub lic inte rventions inthe financial systems.

Public d eb t ratios are

quickly shooting up


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Summ ary and ma in conc lusions

3

the fiscal bill is still uncertain, but some lessons can be drawn from pastfinancial crises.

Experiences with past crises yields some lessons on potential fiscal costs

for resolving the current crisis

Past financial crises have generally been very costly. When analysing asubset of 49 crisis episodes from the 122 systemic financial crises thatoccurred since 1970 around the world, one finds that net direct fiscal outlaysto rehabilitate the banking system averaged 13% of GDP but were muchhigher, over 50% of GDP, in some emerging market economies. Thesefigures already account for the values recovered (until six years after thecrisis broke out) from assets acquired by the public sector. Recovery rates

were rather low at only 20% on average with few notable exceptions, such asSweden.

Increases in public debt ratios, the most comprehensive measure to capturefiscal implications from financial crises, went far beyond the direct costsattributable to tackling the financial sector problems and amounted to, onaverage, 20% of GDP during the crisis, which lasted on average 4 years.That these increases were linked to the crisis is corroborated by theCommission services' econometric evidence. Most of the ratcheting up ofdebt ratios occurred in the first two crisis years and was rooted in theexpenditure side, including crisis-related budgetary outlays ensuing from theoperation of automatic stabilisers and substantially higher interest paymentsfor some emerging market economies. These reflect the sizeable economic

slowdowns as output gaps are estimated to have widened by on average by1% per annum during past financial crises. To some extent, increaseddiscretionary fiscal stimulus to counter the economic downturns also added tothe overall budgetary deterioration of on average 2% of GDP during the fulllength of the crisis. However, country case studies indicate that active fiscalstimulus was not as widespread as one might expect, since countries' fiscalspace was frequently constrained due to rapidly weakening marketconfidence in the public sector. In the few cases of relatively largeexpansionary fiscal activism, such as Sweden and Japan, there are manyindications that the success of policies put in place in the wake of a financialcrisis was rather limited. Overall, the process of rising debt ratios has proveddifficult to reverse. Even a decade after the start of the crisis, most

governments ran public debt-to-GDP ratios above pre-crisis levels.Experience shows that some factors have contributed to containing the levelof direct fiscal costs, i.e. outlays from rescuing and rehabilitating thefinancial sector. Lower direct fiscal costs and higher recovery rates wereachieved notably, taking into account of the severity of the crisis, when thebank resolution strategy was implemented swiftly, was transparent andreceived broad political support, backed by strong public institutions andlegal frameworks, consistent in terms of fair and uniform treatment of marketparticipants, and included a clear exit strategy. Within this broad framework,econometric results show that some individual measures have beenassociated with higher recovery rates. This includes recapitalisation andliquidity support, presumably reflecting that they were extended to viable

institutions that recovered after the crisis. Moreover, the econometric analysisshows that the use of asset management companies was linked to

In past c rises pub lic

intervention wa s

expensive ...

lead ing to high a nd

difficult to reverse

debt levels.

Large fisc a l stimulus

wa s less c om mo n.

Som e me asures have

limited the taxpayers'

b ill of c risis

intervention.


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significantly higher recovery rates only when the government effectiveness,i.e. the quality of public administration as well as the legal and judicialsystem, was strong. The size and complexity of the asset portfolio also seemsto have impacted the effectiveness of asset management companies. Thus,experience suggests that they can be a useful tool in managing non-performing assets, when certain conditions are in place, but are not a panacea.

What do these experiences imply for the direct fiscal costs of today's crisis?The global nature of the current crisis adds to the factors of fiscal risks andreduces the policy options. This includes first the much larger sizes ofbanking systems in the EU today than in past crises and consequently thelarger size of impaired assets and recapitalisation needs. Second, recoveryvalues of today's impaired assets may be much lower than of those in the past

due to several factors. The complicated nature and high leverage of manyfinancial assets makes them more difficult to manage, unwind and recoverthan in the case of past crises, when assets included predominantly real estateand other loans. Moreover, a protracted slowdown of the economy, given theglobal nature of the crisis, compared to many V-shaped output developmentsin earlier crises supported by sharp real depreciations of the currencies andexport-led growth, is likely to depress recovery values including throughlesser availability of foreign and, more generally, private investors. Andfinally, delays in the implementation of a comprehensive strategy for theresolution of the banking system across the EU and the use of regulatoryforbearance may add to the fiscal bill. Against this background today's crisisincludes only few aspects that allow a more optimistic view on containingfiscal implications. This regards foremost the generally stronger legal andjudicial systems and the greater transparency and more uniform applicationsof national bank resolution policies than in the past, even though in the EUsignificant differences in institutional strengths remain. These factors couldpositively impact recovery rates and help contain fiscal costs.

Thus, on balance there are considerable risks that rehabilitating the EU'sbanking system would require substantial public outlays. Of the total publicresources approved for the support of the EU banking system (about 44% ofGDP so far) most are guarantees that may not be called upon. In a benignscenario much of those outlays may either be recovered or not evenmaterialise. However, in a more adverse scenario net direct fiscal costs couldadd up to about 16% of GDP. This broadly matches the average bank

rescue costs from past systemic crises. This cost estimate is derived byassuming that capital injections would be doubled from the currentlyapproved amount of 2.6% of GDP, which appears rather small in comparisonto recent estimates of impaired assets in Europe. Moreover, the scenariocalculation uses the already approved amounts for other public bankinterventions (including guarantees) and applies to this the lower end of arange of recovery rates in line with past crises.

Some lessons can also be drawn for the effectiveness of fiscal support of theeconomy whose likelihood for the success is intertwined with that of bankresolution policies. Experience suggests that without a resolute clean-up ofbank balance sheets, the impact of fiscal policy can be muted as long asuncertainty and constraints to providing loans and stimulate private demand

prevail. Thus, in the EU any lagging behind of bank resolution policies risksto add to the fiscal bill. Going forward, efforts to restoring the health of the

Tod ay's g lob alised

c risis risks to be a t le ast

as expensive as past

c rises

pa rtic ularly, if bank

resolut ion e ffo rts are

not stepp ed up .


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financial sector need to be stepped up, even when it implies high upfrontfiscal outlays, so as to ensure the full effectiveness of fiscal measures insupport of an economic recovery.

Budgetary surveillance to anchor exit strategies and long-term

adjustment

The expected sharp budgetary deteriorations and increases in publicexpenditure-to-GDP ratios, in addition to pressures on many Member States'public finances from rising age-related spending, will eventually requiretough choices with a view to maintaining long-term sustainability. While theEU's fiscal framework provides the appropriate anchor for futureadjustments, some areas of improvement have emerged.

The Stability and Growth Pact contains the sufficient flexibility to cope withthe unprecedented challenges of the crisis while at the same time providing aframework for future consolidation strategies. In particular, while the openingof the excessive deficit procedure (EDP) when breaching the 3% of GDPdeficit threshold is in all but exceptional cases a requirement, the deadline forthe correction of the excessive deficits takes into account the relevant factorsin the economy. In particular, in the existing and newly opened excessivedeficit procedures, the pace of adjustment recommended to Member Statestakes explicitly into account their different room for fiscal manoeuvre. Sincethe Public Finance Report 2008 release, a new recommendation has beenissued for the United Kingdom, which was already in excessive deficitprocedure. For Hungary, the deadlines for the deficit correction were

maintained while they were extended until 2013 for the United Kingdom toaccount for the sharp deterioration of public finances due to the crisis.Moreover, following deficits in excess of 3% of GDP in 2008, new excessivedeficit procedures were opened for France, Greece, Ireland and Spain in thefirst half of 2009. Deadlines for the correction of the excessive deficits rangefrom 2010 to 2013. Given the rapid and strong worsening of public financesin 2009 also for a number of other Member States, including notably Latvia,Malta, Poland and Romania, the opening of further EDPs is expected in thecourse of this year.

While the immediate focus for countries with sufficient fiscal space is still onsupporting the economy, credible exit strategies are a precondition for theeffectiveness of this support. The absence of a roadmap for the future courseof policies may exacerbate uncertainty and risk-aversion, and thereby makethe crisis more persistent. A majority of Member States envisaged, undertheir Stability and Convergence Programmes, already some structuralimprovements of their budget positions in 2010 and a further withdrawal offiscal stimulus from 2011 on. However, the SCP consolidation plans appearto have been built on rather optimistic economic assumptions risking anewdriving a gap between plans and outcomes as already witnessed under morefavourable circumstances.

In addition to the European fiscal framework, national fiscal frameworks canprovide credible and transparent commitments for fiscal adjustment paths.The past has taught useful lessons in that respect. Strong fiscal frameworks

have been success factors for consolidation, including after the financialcrises in Finland and Sweden in particular. National fiscal rules and medium-

In sto rmy time s, the

SGP provide s a

compass.

EDPs ha ve be en

opened for many

Mem ber Sta tes

allowing flexibility

and provid ing

orientat ion for exitstrategies.

Strong na tiona l fisc al

governance

reinforces the EU

framework.


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term budgetary frameworks can provide credibility, transparency andmedium-term orientation to fiscal policy making in times when difficultchoices need to be made. Moreover, fiscal institutions can play useful roles inmonitoring and advising on fiscal plans as well as providing underlyingmacroeconomic assumptions for the annual budget preparation. Thus, exitstrategies for EU Member States could benefit strongly from commitments toimproving and/or adhering to existing fiscal rules and medium-termframeworks. Examples of countries where fiscal framework offer substantialroom for improvement are Hungary, Latvia and Romania, which havereceived balance of payments assistance from the EU, and who are seeking tostrengthen their fiscal governance frameworks, with the support of theEuropean Commission and the IMF, as part of their adjustment processes.Going forward, Member States have confirmed the importance of fiscal

governance frameworks and committed to step up their efforts to report onthem as a contribution to improve budgetary surveillance and for exitstrategies.

Generally, a review of fiscal governance frameworks across EU MemberStates by the Commission services confirms their rising importance but alsoidentifies remaining shortfalls. In recent years, in particular some newMember States have introduced fiscal rules and other Member States planfurther revisions and strengthening of their rules in particular in light of thecrisis experience. Overall, current weaknesses of fiscal rules relate mostly totheir enforcement and monitoring mechanisms as well as media visibility,which could serve as an informal enforcement device. Moreover, revenuerules, which pre-define how excess revenues should be used, are not yetwide-spread. Their use might have helped particularly in pre-crisis "good"times to keep the spending of revenue windfalls in check and improve fiscalpositions.

Strong fiscal governance is one avenue to better quality of public finances(QPF) which has gained new urgency as Member States' public finances havecome under unprecedented stress. This also includes more effectivelycollecting and using scarce public resources with a view not only to creatingadditional fiscal space but also to backing the long-term economic growthpotential of the economy and ensuring sustainability. For example, a numberof Member States' initiatives under the EERP, including higher and "greener"investment, go in this direction while also regional policies provide a tool for

more effectively targeting resources for investment. Thus, since raising thequality of public finances will be an important contribution to consolidationand exit strategies the Commission services have made progress inidentifying and developing indicators that would contribute to moresystematically analyse and compare the status and development of QPF inMember States. This includes also the provision by Eurostat on first andsecond-level government expenditure data (COFOG), at least partially, for allMember States.

Despite the usefulness of the anchor that the EU budgetary surveillanceframework has provided, the current crisis has also exposed someweaknesses. These include the following areas for which improvements needto be made. First, some Member States have not sufficiently used the "good"

pre-crisis times to improve the state of their public finances which wouldhave let them enter the crisis from much more comfortable starting positions.

Som e p rogress ha s

been ac hieved.

Better qua lity of p ublic

financ es ca n be

another p illar for exit

strategies.

Go ing forwa rd

budgetary

surveillanc e should b e

strengthened.


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7

In particular, revenue windfalls during asset price boom periods are oftenmisread as durable improvements in the underlying budget position. Creatinga sufficient safety margin to accommodate debt increases during bust phases,can avoid amplification of booms, and assure greater resilience duringdownswings. Countries with limited fiscal space i.e., a high public debt, ahigh share of non-discretionary expenses and potential large tax revenueshortfalls together with competitiveness challenges threatening medium-termgrowth perspectives need to engage in particularly cautious fiscal policiesin booms to avoid adverse financial market reactions and constraints on thefiscal stabilisation tool during busts, leading to deep recessions.

Second, past budgetary surveillance has not been sufficiently holistic inaccounting for the role of fiscal policy in allowing the build-up of internal

and external imbalances. Broader surveillance based on a wider set ofindicators could provide a useful signalling device for the capacity ofcountries to meet their financial obligations. A broad definition of fiscalspace, covering a wider set of variables would facilitate early indication ofrisks of budgetary stress and, by the same token, of the ability to conductcounter-cyclical fiscal policies when favourable conditions revert sharply.Such monitoring also needs to be consistent with a deeper analysis ofunderlying fiscal positions during booms, when revenues may be swollen bytemporary factors not captured in cyclical adjustment calculations. Inaddition to the usual indicators of government debt and deficit, particularattention could be given to external and domestic imbalances, includingcontingent liabilities related to private sector credit, foreign currencyliabilities and current account developments. A regular competitivenesssurveillance exercise within the euro area which was already initiated by theEurogroup on the basis of a first Commission report and follows up onfindings in the Commission's EMU@10 Report would also be useful in thisrespect.

And third, in the past most deviations from Member States' fiscal plans, aslaid out in their SCPs, were rooted in expenditure overruns. Thus, budgetarysurveillance should devote more attention to developments of the expenditureside, while Member States could tackle this issue with stronger fiscalframeworks.


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Part ICurrent deve lop ments and prospec ts


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SUMMARY

11

The EU economy is in the midst of its deepest andmost widespread recession in the post-war era.Playing a central role in overcoming the financialand economic crisis, public finances in the EUhave come under unprecedented stress. As theeffectiveness of monetary policy has been stuntedin the financial crisis, public finances in the EU areshouldering a particular heavy burden byresponding to the crisis with three objectives: (i)addressing demand shortfalls by letting automaticstabilisers play and through fiscal stimulusmeasures, (ii) restoring the health of the financialsector and supporting the intermediation function

of financial markets and (iii) contributing to thelong-term growth prospects.

With its European Economic RecoveryProgramme (EERP) the EU has defined aneffective framework for combating the economicdownturn. The programme, endorsed by theEuropean Council in December 2008, calls fordiscretionary fiscal support of at least 1.5% ofGDP. Model simulations indicate that acoordinated policy response, such as the EERP,has a considerably larger impact on output and is

thus eventually less costly, since leakages arecontained, than those undertaken by a singlecountry. Overall, Member States have adopted orannounced fiscal stimulus measures totalling 1.1%of GDP in 2009 and 0.7% of GDP in 2010. Of thetotal, 1% of GDP is on the revenue and 0.8% ofGDP on the expenditure side. The fiscal supportpackages adopted under the EERP have broadlyfollowed the well-known "three T principles" foreffective fiscal stimulus (timely, temporary andtargeted), in addition to the need for a coordinatedapproach taking into account cross-countrydifferences in fiscal space. The stimulus measures

are estimated to contribute to about % of realGDP growth in 2009 and about % in 2010.

In addition to discretionary measures, an evenlarger support to the EU's economy is coming fromthe operation of automatic stabilisers, which isamplified by the reversal of previous revenuebuoyancy. As a consequence, the average budgetdeficit in the EU already worsened in 2008 to 2.3%of GDP (from 0.8% in 2007) (the euro area budgetdeficit was 1.9% of GDP in 2008 compared to0.6% in 2007) and is expected to widen further by

5.0% of GDP until 2010 (4.6% of GDPdeterioration for the euro area).

Rising deficits, low growth and subdued inflation,as well as implemented support to the financialsector, feed through in debt developments. Fromits low (58.7%) in 2007, the public debt-to-GDPratio in the EU surpassed the 60% mark in 2008and is expected to jump by 21 percentage points to79.4% of GDP until 2010. For the euro area theincrease is projected to be somewhat smaller atabout 18 percentage points between 2007 and2010. The high deficit levels, which are to asignificant extent structural considering the natureof the economic and financial shocks, suggestfurther rising debt ratios in the years beyond 2010.

Coupled with the perspective increases in age-related expenditure, a slow-down in potentialgrowth and possible calls on governmentguarantees extended in the context of financialrescue packages, failure to achieve a timely returnto sound budgetary positions might have adestabilising effect on public finances in severalcountries. Looking forward, a desirable fiscalstance needs to weigh appropriately stabilisationand sustainability considerations. While theimmediate focus for countries with fiscal space is

still on supporting the economy, credible exitstrategies are a precondition for the effectivenessof this support. The absence of a roadmap for thefuture course of policies, can exacerbateuncertainty and risk-aversion, and thereby makethe crisis more persistent. A majority of MemberStates envisaged, under their Stability andConvergence Programmes, already some structuralimprovements of their budget positions in 2010and a further withdrawal of fiscal stimulus from2011. However, the SCP consolidation plansappear to have been built on rather optimisticeconomic assumptions risking anew driving a gap

between plans and outcomes as already witnessedin calmer economic times in the past.

Since the Public Finance Report was last issued in2008, a new recommendation was issued for theUnited Kingdom, which, like Hungary, wasalready in excessive deficit procedure. Thedeadlines for the deficit correction were extendeduntil 2013 for the United Kingdom to account forthe sharp deterioration of public finances due tothe crisis. Moreover, following deficits in excessof 3% of GDP in 2008, new excessive deficit

procedures were opened for France, Greece,Ireland and Spain in the first half of 2009.Deadlines for the correction of the excessive


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deficits range from 2010 to 2013. Given thatvirtually all Member States (ex. Bulgaria, Cyprus,Denmark, Luxemburg, Finland and Sweden) areprojected to have deficits in excess of 3% of GDPby 2009, the opening of further EDPs is to beexpected. In the existing and newly openedexcessive deficit procedures, the pace ofadjustment recommended to Member Statesconsiders their different room for fiscalmanoeuvre.

The EU's fiscal framework provides the anchor forfuture adjustments. The Excessive Deficit

Procedure (EDP) of the Stability and Growth Pact(SGP) is flexible enough to allow corrective actionto be implemented in time frames consistent withthe recovery of the economy, with rapid fiscalconsolidation being called for only in cases ofimmediate sustainability risk e.g. as reflected inhigh sovereign risk premia. The 2005 reform hasintroduced the possibility of revising therecommendations for the correction of theexcessive deficit including an extension of thedeadline in case of adverse economicdevelopments with major unfavourable

consequences for public finances. This possibilityis meant to cater for budgetary outcomes fallingshort of targets on account of the deterioration ofthe underlying economic scenario. The reasons forthe deviation and the overall economic andbudgetary situation should be carefully consideredwhen deciding on the revised recommendations.


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1. FINANCIAL AND ECONOMIC CRISIS HITS BUDGETARYDEVELOPMENTS AND PROSPECTS

13

1.1 . TIM ES O F C RISIS

The economic situation and outlook remainsuncertain as the world faces its worst crisis sincethe Second World War. The initial shocksstemming from the financial market developmentshave been followed and amplified by the negativefeedback-loops between the real economy and thefinancial markets. In addition, the legacy ofaccumulated imbalances in the world economy

may lead to a painful adjustment process, thusfurther extending the period of weakness ineconomic activity. The Commission services'spring 2009 forecast projects real GDP growth forboth the EU and the euro area at -4.0 % in 2009.

The downswing is broad-based across countries,although sizeable differences exist. Some EUMember States will be subject to a morepronounced and/or protracted downturn,depending on their exposure to the financial crisisand the global manufacturing cycle, domestic and

external imbalances, including a substantialhousing-market correction or other country-specific factors. Part IV of this volume discussesthese country differences and their implications forfiscal space and fiscal policy. In the large MemberStates, GDP is expected to fall by between -1.4%and -5.4% this year, with the downswing beingparticularly marked in Germany and the UnitedKingdom, and more protracted in Spain. In somesmaller EU economies the output loss could be inexcess of 10% of GDP.

GDP would shrink for seven consecutive quarters,

from late 2008 to mid-2010, and would only verygradually recover thereafter. While the EUeconomy is expected to return to positive growthrates on a quarterly basis from the third quarter of2010, GDP growth is expected to be slightlynegative for the year 2010 as a whole (at -0.1%).The outlook remains exceptionally uncertain, butupside and downside risks are broadly balanced.

The economic downturn is increasingly visible inthe labour market. From the low of 6.7% in early2008, the EU unemployment rate has increased

rapidly. In March 2009 it already stood at 8.3%.Reacting with some lags to GDP growth,

unemployment is likely to rise notably during thisand next year, reaching an annual average of morethan 10% in the EU by 2010. Reversing this trendwill be a major policy challenge for the EUeconomy, as the worsened outlook also impactspublic finances.

1.2 . FISC A L STIM ULUS A ND LA RG E

A UTO M A TIC STA BILISERS SUPPO RT

EC O NO M IC A C TIVITY IN THE EU

As the financial and economic crisis began tointensify after the summer of 2008, the EuropeanCommission published a Communication inNovember 2008, outlining a European EconomicRecovery Plan (EERP; Boxes I.1.1 and I.1.2) tocombat the economic downturn. This plan waslater affirmed by the European Council. Given theextent of the crisis, the plan called for animmediate and co-ordinated effort to boostdemand, suggesting a fiscal policy responseequivalent to 1.5% of EU GDP. This figure

includes actions at the EU as well as the MemberState level. The fiscal stimulus comes on top of theimportant role that automatic stabilisers play in theEU and public support to the financial sector. Over2009-2010, the additional support to economicactivity as measured by the change in the budgetbalance is estimated to amount to 5.0% of GDP.This section provides an overview and analysis ofthe budgetary support to the EU economy. (1)

(1) In addition to support of the economy there have beenmassive public interventions in financial systems. Overall,governments have approved support totalling 35% of GDP,most of which are guarantees. How these are treated infiscal statistics is reported in Part II.1. More details on therescue measures and their fiscal implications are providedin Part III.


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Since autumn 2008, governments of a vastmajority of Member States have taken action inline with the EERP (Table I.1.1). Overall, MemberStates have adopted or announced fiscal stimulusmeasures in response to the economic downturnamounting to a total of 1.1% of EU GDP for 2009and 0.7% of EU GDP for 2010. The scale of themeasures varies strongly from one Member Stateto another. In 2009 the largest fiscal stimulus in theeuro area is being run in Spain, and is of the orderof 2.3% of GDP; other sizeable stimuli areundertaken by Austria (1.8% of GDP), Finland

(1.7%), Malta (1.6% of GDP), Germany (1.4% ofGDP) and Luxembourg (1.2% of GDP) . Outsidethe euro area the largest fiscal stimuli come

notably from the UK (1.4% of GDP) and Sweden(1.4% of GDP). Since these are countries facing asharp economic slowdown, their budgetarypositions are deteriorating fast.

A similar picture of the distribution of fiscalstimuli across EU Member States is expected for2010 (Table I.1.1). Only few Member States,including notably Spain, will already next yearstart to reverse their earlier stimulus measures.

However, given the limited room for fiscal

manoeuvre in some Member States, theyeffectively contribute hardly or not at all to theEERP. Within the euro area Cyprus, Greece, Italy

Table I.1.1: Fiscal stimulus measures in 2009 and 2010 by Member State (in % GDP)

2010*

Total

Ofwhichin

autumnforecast

Ofwhichin

budget2009

Expenditure

Revenue

Measuresaimed

athouseholds

Increased

spendingon

labourmarket

measures

Measuresaimed

atbusinesses

Increasedpublic

investment

Ofwhichpublic

infrastructure

Total

AT 1.8 0.2 1.6 0.4 1.4 1.1 0.2 0.3 0.2 0.1 1.8

BE 0.4 0.0 0.0 0.2 0.2 0.1 0.1 0.0 0.2 0.1 0.4

BG** 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

CY 0.1 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0

CZ 1.0 0.0 0.9 0.5 0.5 0.0 0.5 0.1 0.4 0.4 0.5

DE 1.4 0.3 1.4 0.6 0.8 0.9 0.1 0.0 0.4 0.0 1.9

DK** 0.4 0.0 0.0 0.3 0.1 0.0 0.0 0.1 0.3 0.2 0.8

EE 0.2 0.0 0.1 0.2 0.0 0.0 0.2 0.0 0.0 0.0 0.3

EL 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

ES 2.3 1.2 1.2 1.0 1.3 0.3 0.0 1.1 0.9 0.0 0.6

FI 1.7 0.9 0.9 0.6 1.1 0.9 0.2 0.2 0.3 0.0 1.7

FR 1.0 0.0 0.0 0.7 0.3 0.2 0.1 0.4 0.3 0.1 0.1

HU** 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IE 0.5 0.5 0.5 0.3 0.2 0.5 0.0 0.0 0.0 0.0 0.5

IT** 0.0 0.0 0.0 0.2 -0.2 0.2 0.0 -0.2 0.0 0.0 0.0

LT** 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

LV** 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

LU 1.2 1.2 1.2 0.1 1.2 1.2 0.0 0.0 0.0 0.0 1.4

MT 1.6 0.0 1.6 1.3 0.3 0.3 0.0 0.1 1.3 0.7 1.6

NL 0.9 0.3 0.3 0.4 0.5 0.3 0.1 0.1 0.4 0.2 1.0

PL 1.0 0.8 1.0 0.3 0.7 0.6 0.0 0.1 0.3 0.3 1.5

PT 0.9 0.1 0.1 0.9 0.0 0.1 0.2 0.3 0.4 0.3 0.1

RO 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

SE 1.4 1.0 1.0 0.6 0.8 0.6 0.5 0.0 0.3 0.2 1.6

SI 0.6 0.0 0.0 0.5 0.1 0.0 0.1 0.3 0.2 0.0 0.5

SK 0.1 0.0 0.0 0.1 0.0 0.0 0.0 0.1 0.0 0.0 0.0

UK*** 1.4 0.1 1.4 0.4 1.0 1.2 0.0 0.0 0.2 0.0 0.0

EU-27 1.1 0.3 0.7 0.5 0.6 0.5 0.1 0.2 0.3 0.1 0.7

EA-16 1.1 0.3 0.6 0.5 0.5 0.4 0.1 0.2 0.3 0.1 0.8

2009

* Figures for 2010 represent changes with respect to 2008, i.e. include permanent measures taking effect in 2009 plus the net effect of measures takingeffect in 2010.**Measures in Bulgaria are conditional on the improvement in macro-economic imbalances. Overall, a neutral fiscal stance is assumed. Denmarkrecently decided to postpone the reintroduction of a mandatory special pension contribution by one year. Since the pension scheme is outside thegeneral government sector but the contribution is tax-deductible this postponement will improve the general government balance. Hungary, Italy,Lithuania and Latvia have adopted fiscal packages in response to the downturn, but their net impact is either neutral or deficit-reducing.*** The measures announced by the UK are affecting the financial years 2008/09 and 2009/10. These measures have been reattributed, to the extentpossible, in accordance with their impact on the calendar years 2009 and 2010.The latest UK measures, announced in April 2009, are not included inthe calculation.Source: Commission services.


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and Slovakia belong to this group. Outside theeuro area they include Bulgaria, Estonia, Hungary,Lithuania, Latvia and Romania. (2) In fact, givenstrong market pressures, in light of great stress onpublic finances as well as, in part, large externaland internal imbalances, several new MemberStates have requested balance-of-payments support(see for details Box I.1.3).

The EERP comprises broadly equally in sizerevenue and expenditure measures (Box I.1.2).They pursue different aims: support to household'spurchasing power, increased spending on labour

market policies, reduction of taxes, social securitycontributions and other measures directly aimed atbusiness, increased public investment.

The fiscal support packages adopted under theEERP have broadly followed desirable generalprinciples but some risks on their effectivenessremain. The set of principles includes the well-known "three Ts" timely, temporary and targetedin addition to the need for a coordinated approachtaking into account cross-country differences infiscal space. As to the timeliness of the stimulus,

reductions in social security contributions andsupport measures in favour of lower incomebrackets and families appear promising and thesame applies to the frontloading of payments suchas VAT to enterprises. Conversely various tax cutsare likely to take much longer to have any impact,and so do additional infrastructure projects. Thestimulus packages are generally well-targetedtowards the sources of the economic challenge,giving support to credit-constrained householdsand enterprises, supporting employment anddirectly increasing demand. A large part of themeasures in support of households is targeted at

low-income earners, who are expected to beespecially hard hit by the slowdown. The increasedpublic infrastructure investment is mainly targetedat the ailing construction sector. By contrast,reductions in various taxes often do notdiscriminate between the particularly vulnerablegroups and others. As to the temporariness of thestimulus, the measures in support of labourmarkets, the stepping-up of public infrastructure

(2) In fact, some of these countries, both within and outside theeuro area, have designed fiscal stimulus packages.However, as these are being offset by other plannedmeasures, the net effect on budget balances is either neutralor deficit-reducing.

investment and a large part of the measures aimedat enterprises are of a temporary nature, with theirnegative impact on government finances beingreversible. On the other hand, a large part of therevenue related measures, particularly tax cuts andreductions in social security contributions, mayprove difficult to reverse and hence have a morepermanent character (possible exceptions are VATcuts which are explicitly designed as temporarymeasures).

The effectiveness of the measures implemented inthe context of the EERP is being confirmed by

simulations with the Commission's QUEST IIImodel (Box I.1.2). Here the overall impact of afiscal stimulus of 1% of GDP in 2009 and 0.5% ofGDP in 2010 is estimated to provide a real GDPgrowth stimulus of about percentage points in2009 and percentage points in 2010.

In total, i.e. also accounting for the effect ofautomatic stabilisers, fiscal policy is providingsupport to the economy in the region of 5.0% ofGDP over the period 2009 and 2010, equivalent tomore than 600 billion. (3) The largest share of

this overall support comes from the operation ofautomatic stabilisers which are particularly strongin the EU. The estimated impact of the automaticstabilisers is around 3.2% of GDP over 2009-2010.In contrast to the budgetary impact of newexpansionary measures, automatic stabilisers donot provide a short-term boost to the economy, butrather produce a stabilising effect on the economyover the cycle without requiring discretionaryinterventions by fiscal authorities. The twoelements most frequently stressed to exert thiseffect are progressive tax systems andunemployment benefits. (4) However, the bulk of

automatic stabilisation originates not from thosetwo factors but rather from the size of government.In particular, it is the inertia in adjusting the levelof non-cyclical expenditure the majority ofpublic spending that produces the largeststabilising effect. In other words, the

(3) This 5.0% of GDP estimate does not include guaranteeschemes, which do not require upfront funding, but whichnevertheless could result in significant budgetary outlays incase of default on the guaranteed liabilities.

(4) Tax revenues increase more than proportionally when GDPrises and similarly expenditure for unemployment benefitsdrop in economic good times, which improves the fiscalposition and produces a countercyclical effect.


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Box I.1.1:The Europe a n Ec onom ic Re c ove ry P la n

In response to the current economic crisis, the European Economic Recovery Plan (EERP) was officially

launched with the Commission Communication of 26 November 2008, which was later affirmed by the

European Council of 11 and 12 December 2008. (1) Against the background of the scale of the crisis, and

given that most economic policy levers, and especially those which can affect consumer demand in the short

term, are in the hands of the Member States, such a co-ordinated approach is needed. The fact that Member

States have very different starting positions, in terms of fiscal room for manoeuvre in particular, makes

effective coordination all the more important.

Apart from delivering a short-term economic stimulus, the strategic aims of the EERP also are: to help

Europe to prepare to take advantage when growth returns; speed up the shift towards a low carbon economy;

lessen the human cost of the economic downturn and its impact on the most vulnerable. Indeed the Recovery

Plan is supposed to be implemented against the backdrop of the fundamental principles of solidarity and

social justice. It has two key pillars, and in addition also covers monetary and credit aspects, and external

action (the latter in order to work towards global solutions to global economic challenges).

The first pillar is a major injection of purchasing power into the economy, to boost demand and stimulate

confidence. On a proposal from the Commission Member States and the EU have agreed on an immediate

fiscal impulse amounting to at least 200 billion (1.5% of GDP), in order to boost demand. This consists of

a budgetary expansion by Member States of 170 bn (around 1.2% of the EU's GDP), and EU funding in

support of immediate actions of the order of 30 bn (around 0.3% of EU GDP), and occurs in full respect of

the Stability and Growth Pact.

Apart from being accompanied by structural reform measures in the context of the Lisbon strategy (see next

paragraph below), the fiscal stimulus should be based on several principles. First, it should be timely,

temporary, targeted, and co-ordinated. Second, it can combine a mix of revenue and expenditureinstruments, such as public expenditure; guarantees and loan subsidies to compensate for the unusually high

current risk premia; well-designed financial incentives; lower taxes and social contributions. Last but not

least, it is conducted within the Stability and Growth Pact. Extraordinary circumstances combining a

financial crisis and a recession justify a co-ordinated budgetary expansion in the EU. This may lead some

Member States to breach the 3% of GDP deficit reference value. However, for Member States considered to

be in an excessive deficit, corrective action will have to be taken in timeframes consistent with the recovery

of the economy. The Stability and Growth Pact is therefore applied judiciously ensuring credible medium-

term fiscal policy strategies. Member States putting in place counter-cyclical measures have normally

submitted an updated Stability or Convergence Programme by the end of December 2008. This update

spelled out the measures that will be put in place to reverse the fiscal deterioration and ensure long-term

sustainability. The Commission then has assessed the budgetary impulse measures and Stability and

Convergence Programmes based on updated forecasts and has provided guidance on the appropriate stance.

In this context the following criteria have been relied upon: ensuring the reversibility of measures increasing

deficits in the short term; improving budgetary policy-making in the medium term through a strengthening

of the national budgetary rules and frameworks; ensuring long-term sustainability of public finances, in

particular through reforms curbing the rise in age-related expenditure.

The second pillar is grounded in the Lisbon strategy and rests on the need to direct short-term action towards

implementing structural reforms aimed at raising potential growth, promoting resilience, and reinforcing

Europe's competitiveness in the long term. Indeed at the operational level there should be a close connection

between the fiscal stimulus and action in the four priority areas of the Lisbon Strategy (people; business;

infrastructure and energy; research and innovation). In order to achieve this, the EERP sets out a

comprehensive programme to direct action to 'smart' investment, which means investing in the right skills

(1) COM (2008) 800 final, 'A European Economic Recovery Plan'. The thrust of this Recovery Plan was confirmed in th

Commission Communication 'Driving European Recovery' of 4 March 2009. See COM (2009) 0114 final.

(Continued on the next pa ge)


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Box (continued)

for tomorrow's needs, in energy efficiency and clean technologies, and in infrastructure and inter-connection

to promote efficiency and innovation. Some of these actions are designed to frontload EU funding directly to

contribute to the fiscal stimulus and assist Member States with the implementation of their policies, while

others are intended to improve the framework conditions for future investments, reduce administrative

burdens and speed up innovation. Specifically, ten actions are included in the Recovery Plan: to (1) launch a

major European employment support initiative; (2) create demand for labour; (3) enhance access to

financing for business; (4) reduce administrative burdens and promote entrepreneurship; (5) step up

investments to modernise Europe's infrastructure; (6) improve energy efficiency in buildings; (7) promote

the rapid take-up of green products; (8) increase investment in R&D, innovation and education; (9) develop

clean technologies for cars and construction; (10) provide access to high-speed internet for


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Box I.1.2:Fisca l po l ic y m ea sures

The European Economic Recovery Plan (EERP; Box I.1.1) also provided broad guidelines on the types of

measures which, if adopted in a coordinated way, are likely to result in cross-country synergies and positive

spill-over effects. (1) Within the framework of a common approach country-specific measures to support

demand should aim at producing immediate results, be of limited duration, and target the most important and

most affected sectors of the economy. A distinction can be made, on the one hand, between expenditure and

revenue related measures and, on the other, between the different aims of the measures.

The EERP encouraged choosing the instruments from a range of options depending on country-specific

circumstances, thus including both revenue and expenditure instruments. Given that discretionary public

spending is in general considered to have a stronger positive impact on demand in the short run than tax

cuts, as consumers might prefer to save rather than consume, a higher share of expenditure-related measures

often has been wished for. However, provided that tax cuts are (expected to be) limited in time, thereby

avoiding neutralising anticipatory effects of larger tax liabilities in the future, and delivered directly and

upfront, the effect on consumption could still be substantial. In addition, a number of operations that do not

affect the general government balance have also been taken by Member States. The measures which can be

considered pursue the following aims:

Support to households' purchasing power. Reduction in taxes and social security contributions and

direct aid aimed at households, such as income support for households, lowering taxes for

households (including energy subsidies), supporting housing or property markets and decreasing

VAT. In this category, the great majority of Member States have adopted measures.

Increased spending on labour market policies, such as wage subsidies and intensifying activelabour market policies. Only few Member States have adopted noteworthy measures in this area.

Reduction of taxes, social security contributions, and other measures directly aimed at business,

such as tax breaks, earlier payment of VAT returns, facilitating company financing, state aid and

stepping up export promotion were adopted in almost half of all Member States.

Increased public investment, such as public investment in infrastructure, supporting investment

aimed at greening the economy, and/or improving energy efficiency were adopted in close to half

of all Member States.

This menu of options can be assessed on the basis of the three criteria: timely, targeted, and temporary:

As to the timeliness of the stimulus, reductions in social security contributions, social measures in favour of

lower income households and families with children can provide early support to household purchasing

power. Regarding cuts in indirect taxes, however, necessary adaptations in retailers' pricing strategies are

likely to entail a time lag before the effect feeds through. The timeliness with which income tax cuts impact

on household purchasing power depends crucially on the administrative modalities. On the business side,

while the frontloading of payments such as VAT to enterprises should have a rather immediate stimulus

effect, other supporting measures may impact only gradually. Given the inevitable implementation lag of

additional infrastructure projects, their direct stimulating effect will probably not materialise before the

second half of the year. Lower social contributions paid by employers should have an immediate positive

impact on job retention throughout the economy.

(1) The box draws largely on European Commission (2009), 'A first horizontal assessment of National Recover

Programmes in response to the European Economic Recovery Plan', Note for the Economic and Financial Committee.(Continued on the next pa ge)


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Box (continued)

The stimulus packages are generally well-targeted towards the sources of the economic challenge, giving

support to credit-constrained households and enterprises, supporting employment and directly increasing

demand through public investment. The increased public infrastructure investment is mainly targeted at the

ailing construction sector. As for the measures in support of households, a large part is targeted at low-

income earners who are expected to be especially hard hit by the slowdown. By contrast, reductions in direct

and indirect taxes often do not discriminate between the particularly vulnerable groups and others. Capital

injections and direct guarantees with the purpose of increasing lending to credit constrained private

enterprises are often targeted at small and medium and export-oriented enterprises.

As to the temporariness of the stimulus, one has to distinguish between different types of actions. The

measures in support of labour markets, the stepping-up of public infrastructure investment and a large part

of the measures aimed at enterprises are of a temporary nature, with their negative impact on government

finances being reversible. On the other hand, a large part of the revenue related measures, particularly tax

cuts and reductions in social security contributions, appear to be of a permanent nature and may provedifficult to reverse. (Exceptions are VAT tax cuts explicitly designed as a temporary measure with a fixed

reversal date.) Overall, given that revenue based measures represent the majority of the total, a significant

part of the stimulus measures does not seem to be of a temporary nature.

Finally, regarding empirical evidence, the Commission services have performed simulations on the impact

of discretionary fiscal policies on economic activity under conditions of a financial crisis by including credit

constraints in the QUEST III model. (1) The main results of these simulations suggest that: (i) while the

introduction of credit constraints raises the multiplier for transfer and tax shocks, government consumption

or investment shocks continue to have a relatively higher impact on GDP; (ii) a permanent shock is much

less effective in supporting economic activity than a temporary shock as the anticipation effects of larger tax

liabilities weigh more negatively on current consumption and investment; (iii) the introduction of credit-

constraints also raises the multiplier for permanent transfer and tax shocks, but its size remains much smaller

than that for transitory shocks. Overall the large difference between the multipliers for temporary andpermanent fiscal shocks underscores the importance that budgetary measures should be credibly contingent

on the foreseen duration of the downturn: private agents need to believe the expansionary measures will be

timely reversed and not become permanent. Non-reported results also show that cross-country spill-over

effects of fiscal shocks are positive and effects of a joint fiscal stimulus are larger than when acting alone.

The Table below displays the simulation results for the measures announced by the Member States in their

fiscal stimulus packages grouped according to their broad area of impact. The overall result is that the

stimulus measures (estimated at 1% of GDP in 2009 and 0.5% in 2010) will have a positive impact on GDP

growth of around 0.8% in 2009 and about 0.3% in 2010 for the EU as a whole.

Graph 1: Model simulation of the impact of fiscal stimulus packages in the EUFiscal measures as % of GDP 2009 2010

Supporting household purchasing power 0.5 0.2

Labour market 0.1 0.0

Measures aimed at companies (excl. inves tment incent ives ) 0.2 0.1

Increasing/bringing forward investment 0.3 0.1

Total 1.0 0.5

GDP growth impact 0.8 0.3

Source: Commission services based on QUEST III model.

(1) The results of the simulations reported are based on a DGSE model consisting of two regions: the European Union an

the rest of the world (ROW). The results concern the EU economy and assume that both the EU and the RO

undertake simultaneously a 1% of GDP fiscal stimulus in 2009. The regions are differentiated from one another btheir economic size and calibrated on bilateral trade flows. The EU is characterised in the model by relatively hig

transfers and unemployment benefits, high wage taxes, high price rigidities and labour adjustment costs, and a loelasticity of labour supply. Multipliers are generally smaller in the EU due to higher nominal and real rigidities and t

benefit and transfer generosity. The model allows for housing investment and includes credit constrained householdalong the lines suggested by the recent literature on the financial accelerator mechanism. For more detail on th

Commission services' QUEST model see Ratto et al. (2008).


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implementation of discretionary expenditure levels

in line with plans leans against the current declinein aggregate output. Because of the significantly

larger government sector in the EU (in 2008 theaverage expenditure-to-GDP ratio in the EU was46.8%, compared to 39.1 % in the US), automatic

stabilisers play a more important role than in theUS.

Box I.1.3:EU ba la nce -o f -pa ym e nts a ssista nce

In the ongoing financial and economic crisis, some EU Member States outside the euro area have come

under external financing stress and sought financial assistance. The Community can provide balance-of-

payments support to non-euro area Member States through its medium-term financial assistance facility

under Article 119 of the Treaty. The assistance (1) aims to overcome short-term liquidity constraints while,

through policy conditionality, supporting the correction of underlying macroeconomic and financial

imbalances. The funds for the loans under the Facility are raised by the Commission (on behalf of the

Community) on financial markets, and are on-lent to the recipient country at the same conditions (i.e., the

borrowing country benefits from the AAA credit rating of the Community).

While the facility is in principle a free-standing instrument, in practice the Community financial assistance is

provided in the context of broader

Public Finance in EMU 2009

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