José Manuel González-Páramo: Fiscal policy and the financial crisis -
the need for an effective exit strategy
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the CFS conference "The ECB and its Watchers XI", Frankfurt am
Main, 4 September 2009.
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Introduction
The economic and financial landscape has changed dramatically since the last ECB
Watchers Conference. Until a year ago, the front line in the fight against the financial market
turmoil had been manned largely by central banks. Then, in the space of a month:
•
Fannie Mae and Freddie Mac were taken into public ownership;
•
Merrill Lynch was taken over by Bank of America;
•
the Federal Reserve extended an extraordinary loan to AIG in return for a majority
stake;
•
and Lehman Brothers filed for bankruptcy.
The financial turmoil became a financial crisis. The US Treasury unveiled a proposal to buy
up to 700 billion US dollars of illiquid mortgage-based assets. And on this side of the Atlantic,
a wave of government interventions to stabilise the financial system and support the broader
economy was set in motion.
The need for policy actions
In September 2008, money markets around the world had come to a standstill. Banks had
stopped lending to each other. Central banks had become the main source of refinancing for
the banking system. Given the situation, the top priority was to restore more orderly market
conditions as soon as possible in order to limit the damage to the real economy. To this end,
in addition to the unconventional measures taken by central banks, vast public funds have
been made available to guarantee bank lending, to recapitalise troubled banks and to
purchase impaired assets.
To what extent have these actions been successful? A useful measure of money market
tensions is the spread between unsecured and secured money market rates. In the euro
area, for the three-month maturity, this spread rose from below 10 basis points before the
onset of the turmoil to 180 basis points at the height of the crisis in autumn 2008. Since then,
it has declined to around 40 basis points. This is still an elevated level, but nonetheless
indicates significant progress towards restoring stable money market conditions. And while
credit conditions in the euro area have weakened significantly over the past 12 months, there
has been no collapse in bank lending to the non-financial private sector.
Even so, economic activity has contracted more sharply than at any time since the Second
World War. In the euro area, output contracted on a cumulated basis by more than 4% over
the third quarter of 2008 and the first quarter of 2009, driven mainly by a sharp fall in
investment and net exports. The latest data indicates a stabilisation in economic activity for
the euro area as a whole in the second quarter of 2009. And most forecasters now expect a
modest recovery in the course of 2010.
But if central banks and governments had not acted as they have done over the past year,
the financial crisis would have been even more intense and the recession would have been
deeper.
The fiscal costs of the crisis
As things stand now, the fiscal costs of the economic and financial crisis are expected to be
considerable. In 2007, euro area general government borrowing amounted to around half a
percent of GDP. In its Spring 2009 forecast, the European Commission projected that
government borrowing in the euro area would rise to 5.3% of GDP this year and 6.5% next
year. The euro area government debt ratio, which stood at 66% in 2007, is projected to rise
to 84% in 2010. 13 out of 16 euro area governments are projected to breach the 3% of GDP
deficit reference value of the Maastricht Treaty. And all are at risk of doing so next year.
These figures reflect the impact on public finances of the contraction in economic activity.
They also reflect the costs of discretionary fiscal stimulus measures adopted in many
countries. But the cost of providing public support to the financial sector is only reflected to a
very limited extent in these projections.
According to information collected within the Eurosystem, the impact of public interventions
on euro area government debt, as recorded in the national accounts this year, is likely to be
something in the order of 3% of GDP. And the impact on the euro area government deficit is
likely to be negligible. But the scale of government support to the financial sector is far
greater than these figures suggest. According to the European Commission, as of the end of
March 2009, the amount of funds made available under approved measures amounted to
around 35% of euro area GDP. Of this amount, around 11% of GDP has already been turned
into effective support, in terms of actual recapitalisations, asset purchases and so on.
The difference between the total amount of funds made available and the impact actually
recorded in government deficit and debt statistics reflects the considerable uncertainty
regarding the true fiscal costs of the bank rescue packages. Roughly speaking, in cases
where governments actually issue debt to finance a loan or an asset purchase, there is an
immediate impact on government debt in the official statistics. But no impact on the deficit
will be recorded unless or until there is clear evidence that the interest on the loan or the
price paid for the asset does not reflect market conditions.
In cases where a privately owned special entity is established to provide loans or purchase
assets, there may be no immediate impact on the government accounts, even if the debt
issued by this entity is backed by a government guarantee. Only if and when this guarantee
is called will the corresponding amount be recorded as government spending. At the current
juncture, it is impossible to assess the amount of the guarantees that will be called or what
the final scale of the losses will be. As Eurostat put it, the cost of the public support to banks
is a large cloud on the horizon, but at the moment we do not know how much it is going to
rain!
The fiscal exit strategy
Faced with the prospect of large deficits in the coming years and uncertainty regarding the
final costs of bank rescue packages, the priority for fiscal policy must be to set out a clear
and credible plan for restoring order to the public finances over the medium term. Just as
central banks are mulling their exit strategy from non-standard monetary policy measures,
governments need to develop their exit strategy too.
* * *
In this respect, the first hurdle to overcome is to be honest and transparent about the scale of
the problem. As I already mentioned, much of the support given by governments to the
banking sector will not be reflected, for the time being, in the government accounts. But this
does not mean it can be overlooked. Eurostat has announced that it intends to establish a
supplementary reporting table to collect data on guarantees, liquidity support measures, and
the operations of special purpose entities relating to the financial crisis. This reporting must
be taken seriously. Public authorities cannot call on banks to be more transparent about the
scale of their liabilities, if they exploit statistical conventions themselves to keep debt off of
their balance sheets.
Beyond this, there is a risk that the increase in government borrowing during the crisis is
viewed as being purely the consequence of the operation of the automatic stabilisers and
fiscal stimulus packages. Cyclical effects should cancel out over time. Stimulus measures
are supposed to be largely temporary. So once the crisis is over and the stimulus measures
unwind, we should be more or less back where we started.
This is wishful thinking. The sharp contraction in economic activity brings with it a permanent
output loss. This is reflected in significant downward revisions to estimates of potential output
and potential output growth. These revisions imply a reassessment of the spending that
governments can afford given a lower structural level of tax receipts. The European
Commission's estimate is that the "cyclical component" of the euro area government deficit
will amount to about 1.4% of GDP this year and 1.9% next year. This is less than one third of
the overall projected deficit!
Assuming that fiscal stimulus measures can be easily unwound may also prove a little
optimistic. Even if a tax cut or a subsidy is announced as temporary, this does not mean that
cancelling it will be less unpopular. And even when stimulus measures are unwound, the
resulting impact on the deficit will be limited. Even net of stimulus measures, the projected
structural deficit for the euro area would still be almost 4% of GDP in 2010 according to the
European Commission.
The most reasonable assumption is that, for the most part, the sizeable government deficits
that are likely to build up this year and next will not be self-correcting. Instead, they will need
to be corrected through policy actions.
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The challenge for fiscal policy at this juncture is to appropriately calibrate the timing and
speed of this adjustment. In this respect, we should not forget that fiscal policies in EMU do
not operate in a vacuum. Governments are bound by their obligations under the Treaty and
the Stability and Growth Pact. All the more so now, as monetary authorities consider their
exit strategy from the crisis, it is essential that fiscal policies are conducted within a
predictable, medium-term oriented framework.
The Treaty and the Stability and Growth Pact provide for a degree of flexibility under the
current, special circumstances. The European Commission has expressed its view that
Member States incurring excessive deficits due to the crisis should be allowed to implement
corrective action in a time frame consistent with the recovery of the economy. But this should
not lead to corrective action being unduly delayed. Fiscal adjustment needs to start with and
not later than the economic recovery. And when more normal economic conditions return,
consolidation efforts will need to be substantial.
Just how substantial these efforts need to be can be illustrated by way of a simple, numerical
example. Let us assume that the current projections of the European Commission until 2010
turn out to be correct. Let us assume that from 2011 onwards annual output growth is equal
to 21⁄4 percent. This might be considered a generous assumption. And let us also assume
that government revenues keep pace with economic activity so that the revenue ratio is
unchanged. Under such assumptions, a complete freeze on government spending would
reduce the euro area government deficit by around 1% of GDP each year, bringing it close to
balance no sooner than 2016. A more timely fiscal adjustment would require the adoption of
corrective measures already in 2010, absolute spending cuts in real terms or additional tax
increases.
Concluding remarks
To conclude, the scale of the challenge for fiscal policy is considerable. Over the past 12
months, governments, like central banks, have taken unprecedented action to restore
stability to the financial system and to tackle the largest recession in post-war history. This
action was largely justified. But most governments will come out of this crisis with the highest
debt levels, as a proportion of GDP, ever to have been experienced in modern history. And
this at a time, lest we forget, when the fiscal burden associated with population ageing looms
ever larger over the horizon. If confidence in future stability is to be ensured, now is the time
to set out an effective fiscal exit strategy.