Sustainable public finances in a turbulent EU economy

1. Sustainable public finances in a turbulent EU economy Lucio PENCH Head of Unit, Fiscal policies in the euro area and the EU , European Commission, DG ECFIN Federal Planning Bureau «Potential Growth and Fiscal Challenges», Brussels 27 October 2009

2. Outline • Direct costs of the crisis • Indirect effects on growth • Long term sustainability and ageing • Consolidation and policy responses to ensure sustainability

3. The public finance situation in the EUA looser fiscal stance

4. Fiscal costs of the financial crisis Direct fiscal costs and total fiscal costs

5. I. Fiscal costs of financial crises Direct Fiscal costs of past crises Past rescues of the banking sector have often been expensive

6. Fiscal costs of financial the crisis Support to the banking system has focused on guarantees and liquidity measures

7. Fiscal costs of the financial crisis Estimates of direct fiscal costs in the current crisis (net of recovery rates) Risk scenarios for direct fiscal costs 2/ • Upper bound estimate of 13% of GDP is in line with average past direct fiscal crises costs (13% of GDP). • In individual Member States the direct fiscal costs risk to be much higher than this average. • Crisis is costly for the taxpayer. • Policies need to ensure that crises costs are contained and long-term sustainability maintained. (% of GDP) Based on Based on effective approved measures measures A Recapitalisation A.1 As of 21 October 2009 1.7% 2.7% A.1.1 Loss rate (80%) 1.4% 2.2% A.2 Assuming a doubling of recapitalisation needs 3.4% 5.4% A.2.1 Loss rate (80%) 2.7% 4.3% B Liquidity and bank funding support 2.3% 3.2% B.1 Loss rate (10%) 0.2% 0.3% B.2 Loss rate (30%) 0.7% 1.0% Govt. guarantees on bank liabilities and relief of C 8.6% 25.5% impaired assets 1/ C.1 Loss rate (15%) 1.3% 3.8% C.2 Loss rate (30%) 2.6% 7.7% TOTAL net fiscal costs Lower bound (=A.1.1+B.1+C.1) 2.9% 6.3% Higher bound (=A.2.1+B.2+C.2) 6.0% 12.9% Notes: 1/ In percent of 2009 GDP (European Commission Spring Forecast 2009). Includes blanket guarantees (AT, ES, IE, NL) but not the potential shortfalls of deposit insurance schemes nor government guarantees where amounts have not been specified (e.g. BG, IT, PL, UK). Source: Commission services.

8. Fiscal costs of the financial crisis Real economy support EERP: 1.8% of GDP discretionary stimulus measures in addition to large automatic stabiliser effects. Discretionary fiscal stimulus measures in the EU (2009-10) 1/ 1.2 1.1 1.1 EU-27 Euro area 1.0 0.8 0.8 0.7 0.6 0.6 0.5 0.5 0.5 0.5 0.4 0.4 0.3 0.3 0.3 0.3 0.2 0.1 0.0 0.0 2009 2010 2009 2010 2009 2010 2009 2010 Total Revenue Expenditure Public investment Notes: 1/Figures for 2010 include permanent measures taking effect in 2009 plus measures taking effect in 2010. Source: European Commission

9. Fiscal costs of the financial crisis Automatic stabilisers and discretionary policies lead to large deficits Government balances in 2007-10 in the Commission Services’ Spring 2009 Forecasts

10. Large deficits lead to rapid increases in debtChange in debt as a share of GDP – Commission Spring 2009 forecasts

11. The effect of crises on debt Total fiscal costs of past crises Large fiscal deficits contributed to public debt-to-GDP ratios ratcheting them up by 20 points of GDP, on average. This impact has taken a long time to reverse in the past.

12. Case No 1: Full return to earlier path Case No 2: Permanent loss in GDP level Case No 3: Permanent loss on growth rates Potential growth in the aftermath of the crisis Impact of the crisis on potential growth • Critical challenges for the EU are to prevent reductions in potential growth from: • Lower or unproductive investment due to risk aversion, credit constraints or government intervention • Permanent rebalancing of internal demand • Labour market hysterisis • Past crises (e.g. SE and FI) show that policy responses matter • Different scenarios are possible i.e. a full return to earlier path, a permanent loss in level terms only or a permanent loss on growth rates

13. The path of actual and potential output in previous financial crises in Japan, Sweden and Finland

14. Hypothetical GDP trajectory for Belgium Pre-crisis: average annual growth of 2.3%Post-crisis: average annual growth of 1.4%By 2020 and going forward: GDP 11% lower

15. Fiscal sustainabilityRequired consolidation to bring debt to 60% by 2020

16. Developments in debt up to 2020

17. Some background figures on demographics

18. Budgetary costs of population ageing Costs set to increase substantially but with wide variation between countries

19. Fiscal sustainabilitySustainability gaps (S2 in percent of GDP)(latest available unpublished, data)

20. Fiscal sustainability Decomposition of the S2 indicator IBP: required adjustment given the initial budgetary position LTC: required adjustment given the long-term change in age-related expenditure

21. Fiscal sustainability Comparing the sustainability gaps in 2009 and 2006

22. Examples of debt and consolidation in BelgiumTrajectory of debt as a share of GDP based on different levels of consolidation

23. Time to design exit strategies? • EU Council - 17 September “Exit strategies need to be designed now and implemented in a coordinated manner as soon as recovery takes hold, taking into account the specific situations of individual countries.” • Pittsburgh Summit – 24-25 September “We will prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a cooperative and coordinated way, maintaining our commitment to fiscal responsibility.” • Informal ECOFIN – 1-2 October “In order to anchor expectations and reinforce confidence, it is necessary to start designing and communicating credible exit strategies, even if implementation will have to wait.” • IMFC Statement – Istanbul 4 October “As the recovery takes hold, we are committed to work together in articulating and implementing credible and coordinated exit strategies for the withdrawal of public support for the financial sector, orderly unwinding of monetary policy support, and fiscal consolidation needed to underpin long-term sustainability.” • ECOFIN Council – 20 October “The Council agrees that preparing a coordinated exit strategy for exiting from the broad-based policies of stimulus is needed.... The Council underlines that an early design and communication of such a strategy would contribute to underpinning confidence in our medium-term policies and to anchor expectations”

24. ECOFIN Council 20 October 2009Designing fiscal exit strategies • Withdrawal of stimulus should be timely. Consolidation should start in 2011 at the latest, with some countries needing to consolidate earlier. • Consolidation will need to go well beyond the benchmark 0.5% of GDP per annum. • Important additions: • Strengthened national budgetary frameworks to underpin credibility of consolidation. • Measures to support long-term fiscal sustainability • Strengthening of structural efforts to enhance productivity and support long term investment

25. What do we know about how to consolidate successfully? • Extensive literature on the subject including Alesina and Perotti (1995), Public finances in EMU 2007, Kumar et al. (2007). • Consolidations based on expenditure cuts tend to be longer lasting • Especially true if also focus on structural reforms increasing work incentives and public sector efficiency • Tax based consolidation tends to work better if it is gradual and starts from a lower level • Gradual adjustments have proven more effective (Public finances in EMU 2007) • Often accompanied by structural reforms • Improvements in the fiscal institutions can be important complements to consolidation • Countries with existing strong institutions consolidate more effectively • Difficult macroeconomic and public finance starting points can be catalysts for successful consolidations

26. The quality of the public finances in Belgium Note: a higher value indicates outcomes more conducive to long-term growth

27. Belgium – what choices are available? • Reducing expenditure? • Government spending is high, so possibility to reduce it • Efficiency gains also possible • Increasing tax? • Tax and SS revenues high and relatively inefficient • Increasing them further could be costly and hard • Structural reforms? • The tax system has strong disincentives to work in it • Pension changes for the long term? • Scope to change the pension system but can only be a part of the answer

28. How to reduce the cost of ageing over time • Stockholm strategy from the 2001 European Council • Reduce debt to allow pre-financing • Would need to be in addition to reversing debt increases due to crisis • Could only be achieved very gradually • Might add to global imbalances • Increase employment rates and productivity • Can accompany fiscal consolidation • May not reduce the cost of ageing much due to accrual of pension rights • Reform pension, healthcare and long-term care systems • Shifting to private provision also has risks • Adequacy of provision must be ensured to make any changes effective • Raising retirement ages is a serious consideration

29. Exit ages from the labour market

30. How can changes to the labour market or pension structure aid sustainability?

31. Conclusions • Crisis has had both a direct and indirect impact on public finances • Increase in government debt substantial and worrying • The existing challenge of ageing looms large over the future • Exiting the crisis will be a delicate exercise • Measures addressing both medium-term deficits and long-term increases in the cost of ageing are required