Session 2: How is Europe coping with the current phase of the crisis

Jul 2nd, 2010 | Category: Session 2

June 11 2010

The session looked at the current phase of the crisis focusing on the evolution of sovereign debts and on intra-EMU real and nominal divergences. In particular, the discussion revolved around the following themes:

• The breath and nature of the sovereign debt crisis

• The divide between North and South and the need for internal adjustment

• The risks ahead with special reference to fiscal consolidation

• The solutions to improve surveillance as well as the enforcement procedures

Greece is not an isolated case. Most European countries have displayed disappointing public accounts after the financial crisis with debt to GDP ratios increasing by about 20 pp of GDP in three years. Not only were all budgets affected but EU countries were also exposed to other countries’ risks. The exposure of French and German banks to the four periphery countries, for example, amounts to around 15% of their GDP. The cross-country exposure through banks was such that the direct and indirect risk of contagion was present. The rescue package agreed on 9 May had indeed the main objective of muting contagion risks. The measures adopted are substantial considering the annual financing needs of Greece, Ireland, Portugal and Spain, which are estimated to be about €200bn, or €145bn excluding Greece.

Macroeconomic imbalances and the prospects for internal adjustment. Not all problems are fiscal or not only fiscal. The countries with the highest debt ratio to GDP also had high private indebtedness, sharp losses in competitiveness, and resulting large current account deficits. In this respect, the divide between South and North is clear-cut with the former highly indebted to the latter. Here, the most worrying aspect consists of the persistence of external imbalances, which the crisis has only partially reduced. True, in the crisis, current accounts have somehow converged due to a fall in domestic demand in deficit countries and a fall in exports in surplus countries following the global trade slump, but this effect is likely to be only cyclical in nature.

As for the prospects of internal adjustment, equal attention should be devoted to Greece, other deficit countries and surplus countries.


• It was suggested was suggested that debt write-down might be in the end necessary. The IMF/euro area bail-out is not a bail out of Greek citizens, but a bail-out of the lenders. The burden is passed to taxpayers in other euro-area countries and the IMF, but the programme may not work without economic growth. Debt write down would be necessary, but not enough, because gain in competitiveness is needed.

• There was a debate whether private sector wage cuts should be enforced to improve competitiveness. Some argued that the Asian financial crisis clearly demonstrates that recovery from financial crises and successive fiscal retrenchment can only come from real exchange rate depreciation and export-led growth. Considering Greece, perhaps a 30% wage cut may be necessary. To achieve that, Greece needed a new social contract to allow for changes in the wage-setting process.

• But others suggested that after considering carefully the Greek situation, it was not at all a mistake that the lending conditions to Greece have not required measures to foster private sector wage cuts (in addition to public sector wage cuts, which were an integral part of the programme), such as abolition of bonuses or the 14th month salary, change in overtime remuneration or in the minimum wage. Reasons: 1. there is already a large disruption in economic activity and with a general private sector wage cut fiscal consolidation would have been even more difficult; 2. the oligopolistic nature of several sectors of the Greek economy would have implied that private sector wage cuts would have been absorbed by increased mark-ups with little impact on external competitiveness; 3. forced private sector wage cuts would have affected the income distribution negatively. 4. Wages in the private sector tend to be lower than in the public sector and generally more flexible than the latter, which speaks in favour of a differentiated approach to wage developments depending on the sector. Instead of forced cuts in private sector, the programme focuses on the strengthening of the wage-setting mechanism that will support adjustment through normal market forces. Also, greater coordination may be required across sectors so that if a wage cut is agreed in the public sector, the private sector will soon follow suit resulting in some real depreciation. The remark was made that coordination is important but that it does not necessarily equate with an across-the-board cut.

Other deficit countries. Other deficit countries such as Spain and Portugal should also devise measures to improve their competitiveness, mainly through structural reform on labour markets. However, the entire burden of adjustment is imposed upon deficit countries, as aggressive wage cuts and retrenchment may risk undermining the very notion of the European welfare state.

Surplus countries. Some adjustment would be also needed in surplus countries. Countries such as Germany would need to find ways to boost domestic demand or to convert financial savings to investments. Germany is the centre of the euro area and all country watch its spread against Germany. But Germany did not behave as a leader, but as a ‘normal’ country following its self-interests.

The risks that lie ahead. In the short-term, synchronized fiscal adjustment across Europe is likely to put the recovery at risk. First, retrenchment should be gradual as the evidence suggests that large fiscal adjustments take at least two years. Second, because explicit devaluation is not an option in the monetary union, the euro area must find ways of i) engineering an internal devaluation for those countries in need of competitiveness gains, and ii) getting the support of the euro area and the rest of the world demand, to compensate somewhat for the decline in domestic demand. Additionally, it is important that a strict fiscal policy stance is accompanied by a relatively loose monetary policy. Third, a crucial political decision will concern the composition of fiscal adjustment as it will determine on what categories the burden of adjustment is expected to fall on.

Enforcement procedures. The following solutions were put forward for improving enforcement:

• Shorter time span between assessment of fiscal positions and decisions

• Stronger incentives should be provided, such as administrative support or easier payment of funds

• Some suggested more automatic sanctions, but others emphasized that when the budget balance can move from a two percent surplus to a 10 percent deficit in two years time, sanctions can not work Instead, private sector imbalances and their risk to the government budget should be scrutinised.

Surveillance. The following solutions were put forward for improving surveillance:

• Closer look at imbalances also in the private sector by extending the analysis to include a larger set of indicators pointing towards imbalances.

• Budgetary positions should be evaluated by a body other than the Council

Rapporteur: Benedicta Marzinotto and Zsolt Darvas, Bruegel

• Laurence Boone,“Euro Area Sovereign Crisis”

• Nikos Christodoulakis, “North South Asymmetry in the Eurozone”

• Guntram Wolff, “Surveillance of Intra-Euro-Area Competitiveness and Imbalances”

• David A. Vines,“Internal adjustment in the euro-zone. Greece and the vulnerability of the European Monetary Union”