EN EN EN 

 
  COMMISSION OF THE E UROPEAN COMMUNITIES 
Brussels, 7.10.2009 
SEC(2009) 1313 
COMMISSION STAFF WORKING DOCUMENT 
accompanying the  
  
COMMUNICATION FROM THE CO MMISSION TO THE EUROPEAN 
PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL 
COMMITTEE, THE COMMITTEE OF THE REGIONS 
AND THE EUROPEAN CENTRAL BANK 
 
Annual Statement on the Euro Area 2009 
  
Annual Report on the Euro Area 2009  
   
{COM(2009) 527 final} 

 
 Annual Report on the euro area - 2009 
 
EUROPEAN ECONOMY 2009 
 
 
ACKNOWLEDGEMENTS 
 
2 This report was prepared in the Directorate-Gene ral for Economic and Financial Affairs under the 
supervision of Marco Buti, Director-General. Exec utive responsibilities lay with Servaas Deroose, 
Director for the Macroeconomy of the euro area and the EU. 
The principal contributors were Lourdes Acedo Montoya, Magnus Astberg, Narcissa Balta, Chris Bosma, 
Anna Corcuera Hotz, Marie Donnay, Roland Eisenberg, Luis Fau, Heinz Feddersen, Jonas Fischer, Mauro Giorgio Marrano, Joern Griesse, Martin Hradisky, Per Iversen, Paul Kutos, Geraldine Mahieu, Aurora Mordonu, Moisés Orellana Peña, Dario Patern oster, Esther Perez Ruiz, Sonia Plecita Ridzikova, 
Valérie Rouxel-Laxton, Andrea Schaechter, Ralph Setzer, Guergana Stanoeva, Michael Thiel, Georges Tournemire, Guntram Wolff and Marcin Żogała. Aurora Mordonu, Guergana Stanoeva, Marcin Żogała 
and Guntram Wolff had special responsibility for Chapters 1, 2, 3 and 4 respectively. 
The cut-off date for the statistics included in this issue was 30 June 2009. The report benefited from comments by staff of the Directorate-General for Economic and Financial 
Affairs, including Matthias Mors and João Nogueira Martins. 
Statistical assistance was provid ed by George-Marian Isbasoiu. 
Secretarial support was provided by Françoise Briard and Elzbieta Kropp. Reinhard Felke and Georges Tournemire edited and coordinated the production of the report. Comments on the report would be grat efully received and should be sent  by mail to the following address: 
Servaas Deroose 
Director – Macroeconomy of the euro area and the EU Directorate-General for Econo mic and Financial Affairs 
Economy of the euro area and EMU European Commission B-1049 Brussels or by e-mail to Reinhard.Felke@ec.europa.eu
 
 
 
3 Introduction 6 
1. Macroeconomic Developments 8 
1.1. ECONOMIC SITUATION AND PROSPECTS 8 
1.2. MONETARY AND FINANCIAL DEVELOPMENTS 12 1.3. FISCAL DEVELOPMENTS 17 
1.4. LABOUR MARKET DEVELOPMENTS 21 1.5. COMPETITIVENESS DEVELOPMENTS 23 
2. Macroeconomic Policies 27 
2.1. INTRODUCTION 27 
2.2. MONETARY POLICY 29 
2.3. FINANCIAL MARKET POLICIES 32 
2.4. THE EUROPEAN ECONOMIC RECOVERY PLAN (EERP) 39 2.5. FIRST ASSESSMENT OF NATIONAL MEASURES TAKEN UNDER THE EERP 45 
3. The External Dimension 52 
3.1. THE GLOBAL NATURE OF THE CRISIS 52 3.2. RECENT DEVELOPMENTS IN THE EURO EXCHANGE RATE 56 3.3. GLOBAL IMBALANCES – AN UPDATE 58 3.4. REFORMING THE INTERNATIONAL FINANCIAL ARCHITECTURE 59 3.5. THE FINANCIAL CRISIS AND THE GLOBAL ROLE OF THE EURO 61 
4. Economic Governance In Times Of Crisis 64 
4.1. THE EMU@10 REPORT IN THE LIGHT OF THE CRISIS 64 4.2. THE BROADENING AND DEEPENING OF MACROECONOMIC SURVEILLANCE 66 4.3. RECENT DEVELOPMENTS IN FINANCIAL MARKETS GOVERNANCE 67 4.4. THE CONTINUING ENLARGEMENT OF THE EURO AREA 71 
 
LIST OF TABLES 
1.1. Industrial production in the euro area (year-on-year change) 9 2.1. Euro-area public interventions in the banking sector (in % of GDP) 36 2.2. First year GDP effects of fiscal stimulus amounting to 1% of GDP 40 2.3. Total fiscal stimulus over 2009 and 2010 by Member State (in % of GDP) 45 2.4. Overview of structural reform measures  relevant to national recovery programmes 46 
3.1. GDP growth in major economies 53 3.2. Current account balances of major economies (as % of GDP) 59 3.3. Countries and territories with exchange rate regimes linked to the euro (as of 30 June 2009) 62 
 
 
4  
LIST OF GRAPHS 
1.1. World trade and manufacturing Purchasing Managers Index (PMI) 8 
1.2. GDP losses across recessions, euro area 9 1.3. Contribution to GDP growth, euro area 9 1.4. Euro-area money market rates (1 Oct 2007 to 30 June 2009) 12 1.5. 10-year government bond yields, euro area (1 Jan 2007 to 30 June 2009) 14 1.6. Euro-area yield curve slope (Jan 2007 to June 2009) 14 1.7. Corporate bond spreads per rating, euro area (1 Jan 2007 to 30 June 2009) 14 1.8. Monetary Financial Institutions lending in the euro area (January 2000 to May 2009) 14 
1.9. Composite Financing Cost Indicators (CFCI) for the euro area (March 2003 to April 2009) 16 1.10. Stock price index and implied volatility (Stock price: Jan 2007 = 100) 16 1.11. Harmonised index of consumer prices (HICP), euro area 17 1.12. Breakdown of euro-area HICP inflation 17 1.13. Headline and structural budget balances in the euro area in 2008 19 1.14. Budget balances in the euro area (2007 levels and 2008 changes) 19 1.15. Structural balances in the euro area 19 1.16. Public debt-to-GDP ratios in the euro area 20 1.17. Cumulated change in public ba lance, euro-area countries (2007-2010) 21 
1.18. Cumulated change in public debt, euro-area countries (2007-2010) 21 1.19. Euro-area employment growth and unemployment rate 21 1.20. Contribution of labour productivity and labour supply components to GDP growth, euro 
area 22 
1.21. Nominal wage indicators, euro area 22 1.22. Compensation per employee, labour productivity and unit labour costs, euro area 22 1.23. Compensation per employee, labour producti vity and unit labour costs by sectors in 2008, 
euro area 23 
1.24. Current account positions, euro area, United States and China (1999-2008) 23 1.25. Compensation per employee, labour producti vity and nominal unit labour costs (1999-2008) 24 
1.26. Changes in intra euro-area Real  Effective Exchange Rate (REER) 25 
1.27. Current account positions, euro-area Member States (1999 to 2008) 25 1.28. Net foreign asset positions, euro-area Member States (1995-2007) 25 1.29. Evolution of current account positions, euro-area Member States (2008 to 2010) 26 2.1. Debt-to-GDP ratios of various economic sectors among select advanced economies 27 2.2. ECB interest rates and Eonia 29 
2.3. Central banks' policy interest rates 32 2.4. Default risks of euro-area financial institutions 34 2.5. Equity prices in the euro area (January 2008 = 100) 34 2.6. Write-downs and capital injections of main euro-area financial institutions 36 2.7. Interest rate spreads (OIS over three-month Euribor, Libor in percentage points) 37 
 
 
5 2.8. Fiscal policy stance in the euro area 42 
2.9. EERP - Measures aimed at supporting househ old purchasing power in the euro area (fiscal 
stimulus as % of country GDP, 2009-2010) 47 
2.10. EERP - Labour market measures in the euro area (fiscal stimulus as % of country GDP, 2009-
2010) 47 
2.11. EERP -Measures aimed at stepping up investment expenditure in the euro area (fiscal 
stimulus as % of country GDP, 2009-2010) 48 
2.12. EERP- Business support measures in the euro area (fiscal stimulus as % of country GDP, 2009-
2010) 49 
3.1. Capital flows to emerging and developing economies, annual flows 52 3.2. World trade and GDP growth (annual average growth rate) 53 3.3. Profiles of GDP growth in major economies (2007-2010) 53 3.4. Changes in EUR cross-rates since 02 Jan 2008 55 3.5. Euro exchange rates (daily data) 57 3.6. Euro real effective exchange rate (41 countries, CPI deflated) 57 3.7. Foreign Exchange Reserves of which cu rrency is known (at constant end-2008 exchange 
rates) 63 
3.8. Total international bonds outstanding, broad measure (at constant end-2008 exchange 
rates) 63 
 
LIST OF BOXES 
1.1. The housing correction in the euro area 10 
1.2. The crash of the US Investment Bank Lehman Brothers 13 1.3. Recent developments in food prices 15 1.4. How large are the risks of deflation in the euro area? 18 2.1. Banking crisis and growth: historical evidence 30 2.2. Unconventional monetary policy measures 33 2.3. Ongoing work on further bond mark et integration in the euro area 38 
2.4. Government accounts and bank rescue schemes 41 2.5. 2008/2009 council recommendations to the euro ar ea in the context of the Lisbon strategy 43 
2.6. The community pillar of the EERP 44 4.1. Activities of the Eurogroup in 2008 and 2009 68 4.2. The three new euro area Member States: Cyprus, Malta and Slovakia 72 
 
 
INTRODUCTION 
 
6 This 2009 issue of the Annual Report on the Euro Area explores in depth the 
global financial and economic crisis that sprang up in the second half of 2008 and rocked the euro-area economy. The r oots of the crisis lay in the gradual 
building-up of macroeconomic imbalances over the past decade. In a context 
of ample liquidity combined with insufficient supervisory oversight, loose lending policies laid the groundwork for the emergence of a housing bubble in the US and other advanced economies. Its extent and duration was prolonged by massive flows of capital from emerging market economies with large external surpluses, notably China. Risk became mispriced and leverage increased for all sectors of the economy , be they households, companies or 
financial institutions throughout the world. Domestic and global imbalances 
fed each other until breaking point. 
Financial markets were at the epicen tre of the crisis. From June 2007 
onwards, interbank interest rates had been tightening considerably. Increasing insolvencies in US subprime lending shattered trust in sophisticated structured products. Fi nancial institutions became saddled with illiquid 
holdings in their portfolio and were in creasingly reluctant to lend to each 
other. The funding of several institutions with risky business models became compromised. Northern Rock, Bear Stearns, Freddy Mac, monoline insurers, and AIG made the headlines in quick succession, while generalised losses began percolating into balance sheets through regular quarterly reporting of 
financial institutions. 
On 15 September 2008, the investment bank Lehman Brothers filed for 
protection in the largest US bankru ptcy case in history. The Lehman 
bankruptcy saw the collapse of a financial institution deemed 'too big to fail'. In the aftermath, interbank markets essentially froze, and banks became 
almost completely reliant on central bank support for short-term financing. The European Union and the euro area  were not spared, with some large 
financial conglomerates on the verge of default. In October 2008, exceptional measures in the EU, spearheaded by euro-area governments, prevented a 
collapse of the banking system. Still, confidence was at an all-time low. 
The real economy bore the brunt of the financial crisis during the fourth 
quarter of 2008. Business surveys, closely followed by hard indicators, such as industrial production and external trade, tumbled to historic lows all around the world. The spectre of a negative feedback loop between banks and the real economy seemed to materialise. It implied that an additional wave of loan losses from companies and households hit by the global recession had the potential to aggravate the already-st retched situation of banks' balance 
sheets. 
Although the euro area was not at the orig in of the current crisis, it has been 
hit hard too. First, euro-area banks had purchased asset classes that eventually became subject to impairment. Second, the episode of acute financial stress in 
the euro area in September and Oc tober markedly affected consumer 
confidence. Third, euro-area exporters,  and especially those of investment 
goods, suffered from the sharp slowdown in world markets. This explains why there are few differences between count ries most directly affected by the 
financial crisis and the euro area as regards current growth prospects. A 
severe contraction in GDP is projected for 2009, with forecasts pointing to a 
subdued recovery in 2010. 
Introduction 
 
7 Although the economic and financial shock was of unprecedented scope, 
policymakers learnt from th e mistakes of the post-1929 period. They quickly 
introduced measures on an unprecedented scale to pr event the recession from 
morphing into a protracted depression and to lay the groundwork for 
economic recovery. 
This Annual Report on the euro area encompasses all key aspects of the 
ongoing economic and financial crisis . Chapter 1 describes how the crisis 
struck and how the economic situation suddenly changed. Chapter 2 explains the economic policy response in the euro area to the crisis, with particular 
emphasis laid on the European Economic Recovery Plan (EERP). Chapter 3 reviews the reaction of major non-EU economic powers and the emergence of the G-20 as the critical forum in global economic governance. Chapter 4 
reflects on euro-area econom ic governance in a period of crisis. The overall 
aim of this report is to shed light on the complex interconnections that sent the world economy into recession and how it affected the euro area. The 
accompanying Annual Statement on the Euro Area contains ensuing policy 
considerations. 
1. MACROECONOMIC DEVELOPMENTS 
 
8 1. After almost three years of robust 
growth, economic activity in the euro area 
weakened in the course of 2008, before entering in the last quarter its worst recession in decades.  
The downturn was characterised by an 
extraordinarily rapid and large fall in world trade and industrial output as well as business and consumer confidence, amid a rapidly escalating financial crisis. The euro area was not spared. This 
first chapter provides an assessment of the macroeconomic developmen ts that impacted on 
the euro area during 2008 and the economic outlook. Section 1.1 sets the scene, describing the economic situation in 2008 and prospects for 2009 and 2010. Section 1.2 takes stock of monetary and financial developments, while fiscal developments are covered in Section 1.3. Labour market developments in the euro area are outlined in Section 1.4. Finally, Section 1.5 analyses competitiveness developments within the euro area. 
1.1. ECONOMIC SITUATION AND PROSPECTS 
2. A series of adverse events put a brake on 
economic activity in the first half of 2008.  During 
the first half of 2008 economic activity in the euro area weakened gradually, reflecting an external environment characterised by soaring commodity prices and a deceleration in world growth and trade (following vibrant expansion in 2007), as well as the first repercussions of the financial turmoil. In the second quarter of 20 08, output contracted in 
the euro area for the first time since the early 1990s (-0.3% quarter-on-quarter), in contrast to the robust performance in the first quarter (0.7%). 
3. Financial distress materialised in 
September 2008 and sent the global economy into 
a tailspin.  The financial market turmoil, which 
originated in the US subprime mortgage market in the summer of 2007, intensified sharply in September 2008. The main contagion channels to the real economy were severe deteriorations in financing conditions and confidence effects. Disruptions in money markets led banks to tighten lending conditions. As a result, access to trade finance and insurance was curtailed. Pervasive risk-aversion shattered confidence and led to a reversal of international capital flows away from emerging markets. 4. The impact of the financial crisis fed 
almost instantly into the real economy.  During the 
fourth quarter of 2008, survey indicators of global economic activity dropped  steeply. The OECD 
leading indicator fell to its lowest level since the mid-1970s. This was mirrored by a precipitous decline in world trade, which dropped by some 6% in the last quarter of 2008, a rate not registered since World War II (Graph 1.1). Industrial production was severely affected as well, with double-digit contractions both in the main industrialised regions and in many emerging-market economies. 
Graph 1.1:  World trade and manufacturing Purchasing 
Managers Index (PMI) 
-20-1001020
2001 2002 2003 2004 2005 2006 2007 2008 200930405060
World trade (lhs)
World manufacturing PMI (rhs) 3-month moving average (yoy % change)balance of o pinion
Note: Data for world manufacturing PMI cover the period 
January 2001 to May 2009 
Source:  CPB Netherlands Bureau of Economic Policy 
Analysis, EcoWin, Bloomberg. 
5. With the external environment 
deteriorating significantly, economic activity in 
the euro area fell into recession in the second 
half of 2008. In the third quarter of 2008 GDP 
contracted for the seco nd consecutive quarter, 
falling by 0.4% quarter-on-quarter. However, the full impact of the financial crisis began to be felt in the final quarter of 2008, when GDP dropped by as much as 1.8 %. This drop was the steepest in quarterly terms since the beginning of Economic and Monetary Union (EMU). For 2008 as a whole, GDP expanded by just 0.7% in the euro area, a marked deceleration from  the previous year 
(+2.7%). The carryover for 2009 GDP growth as computed at the end of 2008 was strongly negative (almost 1½ percentage points). Overall, the current recession outstrips by a wide margin past recessions in the euro area (Graphs 1.2 and 1.3). 
1. Macroeconomic Developments 
 
9 Graph 1.2:  GDP losses across rece ssions, euro area 
-6-5-4-3-2-10
1974-1975 1980-1982 1992-1993 currentchange from peak (in percentage points)forecastrealised
Note: Data on past recessions exclude Slovenia and 
Slovakia. 
Source:  Commission services. 
6. Euro-area exports were hard hit by the 
global slowdown.  T h e y  f e l l  b y  m o r e  t h a n  7 %  i n  
the fourth quarter of 2008 (-8% for goods only), the sharpest quarterly cont raction ever (data since 
1970). With the pace of contraction in exports 
exceeding that of imports, the contribution of net exports to real GDP b ecame increasingly negative 
in the second half of 200 8, reaching almost a full 
percentage point in the fourth quarter. The unexpected shock to exports contributed to sizeable involuntary inventory accumulation and translated almost instantly into a steep decline in industrial production (Table 1.1). 
Graph 1.3:  Contribution to GDP growth, euro area 
-5-4-3-2-1012345
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010in percentage points Private consumption Public consumption
Investment Inventories
Net exports GDP growth (yoy%)forecast
Source:  Commission services. 
7. The ongoing deceleration in 
construction investment was amplified by the 
sudden fall in business investment.  Construction 
investment decelerated throughout 2008 in response to moderating and, in some cases, falling house prices (see Box 1.1). This was amplified by the slump in business investment in the fourth quarter. The slump in business investment was the response of firms to missing demand and decreasing profits. Capacity utilisation of 
equipment in place fell to 70.5% in April 2009. It 
was the lowest rate since the beginning of EU business surveys in 1990. In addition, banks' tighter lending standards have reduced the availability of capital. 
8. Private consumption growth also turned 
negative, but only mildly so, in the fourth quarter 
of 2008.  Consumption was subdued in the first 
three quarters of 2008, before falling by 0.4% in the fourth quarter. While nominal compensation remained relatively robust in 2008 (+3.3% year-on-year), the sharp rise in inflation in the first half of the year (peaking at 4%  in the euro area in July 
2008) depressed real incomes. The subsequent sharp fall in commodity prices led to a reversal of inflation dynamics and allowed households to recover some purchasing power during the summer. However, this was eventually offset by the deterioration in labour market conditions in the latter part of the year. Moreover, households’ assessment of their personal financial situation deteriorated during 2008 and in early 2009, mirroring the poor return on investment in financial markets. 
 
Table 1.1:  Industrial production in the euro area (year-
on-year change) 
August 2008 May 2009
Euro area -1.9 -17.0
Germany 1.5 -17.9
France -1.9 -13.8
Spain -8.4 -20.5
Italy -3.1 -19.8
Source:  Commission services. 
 
9. Activity contracted further during the 
first quarter of 2009. GDP dropped by 2.5% 
quarter-on-quarter, the worst rate of GDP contraction in the post-war era. The contraction was broad-based across euro-area countries. Investment was again one of the main sources of weakness in activity. Gross fixed capital formation fell by 4.1% quarter-on-quarter, subtracting almost one percentage point from GDP growth. Businesses cut their inventories significantly, which reduced growth further by a full percentage point. By comparison, the contraction in private consumption was limited to 0.5% quarter-on-quarter, as both the decline in inflation and measures taken by Member States supported the purchasing power of households. 
European Commission 
Annual Report on the euro area - 2009 
 
10  
Box 1.1: The housing correction in the euro area
The housing cycle has turned and most euro-area Member States are experiencing price decreases in real 
estate. The ongoing correction follows nearly a decade of buoyant housing markets in which, driven by low 
interest rates and –in some cases– dynamic demographics, several EU countries posted double-digit rates of 
house price increases in real terms for several years in a row. Among the largest countries, France and Spain 
were in that position from the turn of the century , while Ireland stood out among the smaller countries. 
While real house price growth was still positive in the firs t half of 2008, in the second half it turned negative 
in most euro-area Member States. In Ireland, real prices declined by about 11% on a year in 2008. This 
compares with an average annual increase of about 7% between 2001 and 2007. A marked reversal in the 
dynamics of house prices could be seen also in Spain, Finland and France. Germany is an outlier, given that 
real house prices remained on a downward trend for most of the last decade.  
In terms of the contribution of housing investment to GDP growth, the correction appears to be particularly 
strong in the countries where the downturn in house prices has been most marked in 2008. In Ireland, 
housing investment subtracted as much as 2.1 percentage points from GDP growth in the first half of 2008, 
against an annual positive contribution of 0.5 percentage point on average between 2001 and 2007. Substantial contractions in housing investment in 2008 were also observed in Spain and Finland. In the euro 
area as a whole, housing investment subtracted 0.23 percentage point from GDP growth in 2008. 
Graph A: Real house prices, selected countries Graph B: Contribution of housing investment to GDP 
growth, selected countries 
-12-9-6-3036912
ES FR IE IT FI NL DE USaverage for 2001-2007
2008yearly change
  -4.0-3.2-2.4-1.6-0.80.00.8
IE ES FR FI IT NL DE EA USin percentage points
average for 2001-2007
2008
 
Source : Commission services.    Source:  Commission services. 
The extent of the correction in house prices will depend,  inter alia, on the degree to which house prices are 
considered to be overvalued. This requires an estimate of an equilibrium house price level, on the basis of its 
fundamental determinants. Typically such estimates vary depending on the estimation technique used, as well as on the sample, data sources and time period considered. The IMF estimates the average 
overvaluation by the end of 2008 at about 20-30% in Ireland and the UK, and about 10-20% in Spain, 
France, Italy and the Netherlands (IMF, World Economic Outlook, 2008). However, the extent of the correction will also depend on the economic environment, the health of the domestic banking system, and 
economic policy responses. Poor growth prospects and the tightening of credit conditions create a difficult 
environment for housing developments in 2009 and 2010. Based on developments in 18 countries over a 
35-year period, an OECD Study
1 suggests that the average housing cycle lasts about 10 years. During the 
expansion phase (lasting about six years) real house prices increase on average by around 45%. In the 
subsequent phase of contraction (lasting around five years), prices correct by about 25%. 
 
(Continued on the next page) 
1. Macroeconomic Developments 
 
11 10. The Commission services' spring 2009 
economic forecast points to the recession 
continuing through 2009, before growth 
stabilises next year.  The GDP forecast for the euro 
area has been revised downward to 4% for 2009. The downturn affects all Member States to varying degrees (depending on their trade openness, exposure to the financial crisis and domestic housing-market developments). It also has an adverse impact on nearly all demand components, with the exception of government consumption and public investment. The latter will contribute positively to growth in 2009-2010, reflecting in part the budgetary stimuli within the framework of the European Economic Recovery Plan (see Chapter 2). In contrast, exports and investment should undergo a marked co ntraction this year, in 
line with the slump in global demand. While private consumption is expected to hold up relatively well, deteriorating labour market conditions and moderating wage growth are likely to dampen real disposable income, though lower inflation in 2009 should have some offsetting effect. However, as external demand improves and measures taken to support the financial system and boost aggregate demand gain momentum, the fall in GDP should level off towards the end of 2009, with modest growth resuming in the course of 2010. For 2010 as a whol e, GDP is forecast to 
broadly stabilise at 0.1%. 
11. Signs of stabilisation emerged in spring 
2009.  The Commission services' Economic 
Sentiment Indicator (ESI) for the euro area picked 
up in April (for the first time since May 2007) and continued to improve in May and June, although it remained well below its historical average. Between the first and the second quarter of 2009, 
all components of the ESI improved, except in the construction sector. The improvement in the ESI 
was also broad based across euro-area countries, with the trough being reached by most countries in March or a month earlier. Conversely, the quarterly manufacturing survey, carried out in 
April 2009, indicates a further fall in capacity utilisation since the last survey in January: it stands at 70.5% in the euro area – the lowest since 1990. According to the six-monthly industrial investment survey which was carried out in March and April, managers in most Member States expect real investment to drop by 20% in the euro area in 2009. All in all, difficult financial conditions and weak confidence are set to continue to weigh on economic activity, but are likely to be gradually offset by the impact of expansionary macroeconomic policies. 
12. The growth outlook for the euro-area 
economy is, however, characterised by 
exceptional uncertainty.  While the ambitious 
policy actions taken by governments and central banks since last autumn have prevented a systemic financial meltdown, financial markets and institutions remain under stress. The world economic situation continues to be exceptionally uncertain. Risks to the forecast are sizeable and remain somewhat skewed to the downside for 2009, but appear more balanced for 2010. Of particular concern is the possibility that the negative feedback loop, from the deteriorating real economy to the still-fragile financial sector, may intensify (e.g. via rising impaired loans or cross-border contagion effects). This may reinforce the deleveraging process, pushing the projected recovery in the real econo my even further into the 
future. There may also be a risk of abrupt exchange-rate movements or the possibility that trade-distorting protectionist measures might be Box (continued) 
A more recent study2 shows that in the aftermath of more severe crises real house price declines average 
35% and stretch out over six years. Given that the magnitude of the housing boom in the last years exceeded by far what had been observed in past cycles, the ongoing corrections might be more severe and protracted 
than before. 
1 Girouard, N., Kennedy M., van den No ord P. and André C., (2006): 'Recent house price developments: the 
role of fundamentals', OECD Working Paper No. 475, 2006. 
2 Reinhart, M., and Rogoff K. (2008): 'The Aftermath of Financial Crises' American Economic Associatio n
meetings in San Francisco, January 3, 2009. 
 
 
European Commission 
Annual Report on the euro area - 2009 
 
12 put in place. On the other hand, policy measures 
may be more effective than anticipated in restoring stability and confidence in financial markets, thereby supporting economic activity. 
1.2. MONETARY AND FINANCIAL 
DEVELOPMENTS 
13. The crisis in financial markets deepened 
substantially during 2008.  The bankruptcy of the 
US investment bank Lehman Brothers in mid-September 2008 prompted a re-evaluation of risks embedded in the financial system (Box 1.2). The global financial system became extremely fragile, reflecting the dislocation of several key credit markets, notably th e markets for interbank 
lending. This derived from the fall in investor confidence, amid pervasive uncertainty about the strength of banks' balance sheets. The combination of this uncertainty and increased risk aversion led to a generalised portfolio reallocation towards safe assets in the second half of 2008. 
Graph 1.4:  Euro-area money market rates (1 Oct 2007 to 
30 June 2009) 
0123456
Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09in %
050100150200
Money market rate (lhs)
Money market spread (rhs)in basis points
Note: The money market rate is the 3-month Euribor. The 
money market spread is the difference between the 3-
month Euribor and the 3-month Overnight Interest Swap rate. 
Source:  EcoWin. 
14. Interbank markets were characterised by 
severe liquidity shortages as banks hoarded cash, 
driving up interbank rates . Spreads on euro-area 
interbank markets, which had already been elevated since the start of the financial market 
turbulence in summer 2007, remained abnormally high throughout 2008 (Graph 1.4). The three-month interbank spread, measured as the   difference between unsecured money market rates 
and risk-free interest rates with similar maturity, peaked at 196 basis points in mid-October 2008. With the interest rate cuts starting in October, interbank money market rates fell perceptibly. By June 2009, the gap between unsecured and collateralised short-term interest rates had decreased substantially to less than 50 basis points, although it still remained higher than prior to the financial crisis. Despite some stabilisation, investor confidence has not fully recovered, given the uncertainties about valuation, counterparty risks and the evolution of the deleveraging process. 
15. Long-term interest rates fell in response 
to the escalation of the crisis . The German 
10-year Bund yield increas ed between January and 
July 2008 by around half a percentage point to 4.66%, amidst growing inflation expectations and still robust economic indicators. The Bund then fell sharply to 2.90% in mid-January 2009, its lowest level since the introduction of the euro. Revisions in respect of growth and inflation as well as interest rate cuts weighed on yields. In the following months, government bond yields increased to 3.72% at the beginning of June owing to improvement in ec onomic sentiment and 
increasing supply of government debt. Renewed uncertainties related to the strength of the recovery triggered a limited easing of interest rates (3.40% at the end of June 2009). 
16. Spreads for government bonds within 
the euro area widened . The spreads of government 
bond yields compared to the German Bund 
benchmark, which were low in the years before 2007, increased steadily throughout 2008 (Graph 1.5). At the beginning of 2008, spreads on 10-year government bond yields stood at 17 basis points for Ireland and 29 basis points for Greece. The widening became significantly more pronounced in the fourth quarter of 2008. In early 2009, spreads peaked at 282 basis points in the case of Ireland and 302 basis points for Greece. The sharp rise in spreads reflected inter alia higher perceptions of credit risk against the backdrop of expectations of higher fu ture borrowing needs, as 
well as the general increase in liquidity premia. Since then, spreads have narrowed markedly, but remain elevated by hi storical standards. 
1. Macroeconomic Developments 
 
13 17. The slope of the euro-area yield curve 
steepened, as the sharp drop in short-term 
interest rates dominated the more moderate 
decline at longer maturities . The slope in the 
euro-area yield curve, measured as the difference between the three-month Euribor and the ten-year German Bund yield, increas ed by almost 400 basis 
points between mid-October 2008 and June 2009 (Graph 1.6). The steepen ing of the yield curve 
reflected the lowering of interest rates by the ECB since October 2008. It also signalled market expectations of positive economic activity and inflation for the future.  
Box 1.2: The crash of the US Investment Bank Lehman Brothers
On 15 September 2008, Lehman Brothers Holding Inc. was filing for bankruptcy. The listing of USD 
639 billion in assets made it the largest bankruptcy in U.S. history. Its failure marked a watershed in the 
global financial crisis. 
Founded in 1850, Lehman had developed into the fourth-largest US global investment bank and a global 
workforce of about 25,000. Until the nineties, the Glass-Steagall Act of 1933 separated commercial banks 
from investment banks. The Gramm-Leach-Bliley Act of 1999 paved the way for Lehman like other investment banks to expand its business into more complex –and riskier– segments of financial markets. At 
the peak of the US housing market in 2007, Lehman had emerged as the biggest underwriter of mortgage-
backed securities. With over USD 600 billion in assets but less than USD 20 billion of common shareholder 
equity, Lehman had the highest gross leverage ratio of all US investment banks, except for Bear Stearns. As 
the housing market deteriorated, Lehman incurred very substantial losses on its holdings of sub-prime and 
other lower-rated mortgage tranches, which it had retained in the process of securitisation. Market analysts 
began to highlight Lehman's high leverage ratio. Even more than other financial institutions, Lehman's share 
price came under heavy selling pressure, with its share price declining from about USD 50 at the beginning 
of 2008 to about USD 9 at the end of August. On 12 September, Lehman's share price fell by a further 42 percent, when a rating agency warned of a possible downgrade of the bank's credit rating. On 13 September, 
the US authorities renewed calls for a private-sector so lution to Lehman's financial difficulties, but reiterated 
their reluctance to use government funds to bail out the bank. On 14 September, Barclays and Bank of 
America withdrew from negotiations to buy Lehman. By 15 September, Lehman filed for Chapter 11 
bankruptcy protection. 
The fall of Lehman led to a global reappraisal of risk in financial markets. The market had been previously 
counting on the 'too-big-to-fail' presumption. In other terms, very large financial entities could be considered 
systemic in the eyes of public authorities. They were supposed to get some form of support at the eleventh hour that would save them. When Lehman failed, the event sent shockwaves within the financial system. 
Counterparty risk became a reality. On 15 September, the Dow Jones Industrial Average was down by 
4.42%. In the credit default swaps (CDS) market, the cost of insuring corporate debt against the risk of 
default rose sharply. Further reflecting an increase in risk aversion, prices of ten-year US government bonds 
had their biggest rally in 20 years, pushing yields lower by about 20 basis points to about 3.5%. Central 
banks took stabilising measures on interbank markets. On 15 September, the US Fed increased its 
emergency lending programme for investment banks to USD 200 billion and announced a further relaxation 
in the types of collateral that financial institutions can  use to obtain loans. Meanwhile, the ECB, the Bank of 
England and the Swiss National Bank all announced meas ures to ease liquidity st rains in their respective 
interbank markets. 
As part of the bankruptcy proceedings, it took some time to value Lehman assets and unwind its trading 
positions with the relevant counterparties, especially those related to derivatives. About 900,000 derivatives 
contracts involving the bank had to be terminated si nce the bankruptcy filings. As a consequence to the 
Lehman case, regulators looked at ways to better protect investors from counterparty risk, possibly through 
recourse to central counterparty clearinghouses. 
 
 
European Commission 
Annual Report on the euro area - 2009 
 
14 Graph 1.5:  10-year government bond yields, euro area 
(1 Jan 2007 to 30 June 2009) 
2.53.03.54.04.55.05.56.06.5
Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09in %ELIE
FRES
DEIT
Source:  Source: EcoWin. 
18. Spreads of corporate bond yields also 
increased during the financial crisis . Gloomier 
economic expectations and increasing risk discrimination caused markets for corporate bonds to dry up in 2008. Cred it markets reacted with 
significant increases in corporate bond spreads (Graph 1.7). The spread on ten-year bonds issued by BBB-rated enterprises stood at 462 basis points at the end of 2008, more than 300 basis points higher than at the begi nning of the year. Since 
then, default expectations for the corporate sector 
have receded notably, but concerns over credit quality remained. At the end of the review period, long-term bonds by BBB-rated companies were yielding 5.9%. By contrast, interest rates for the best-rated companies dec lined over 2008, even 
 
Graph 1.6:  Euro-area yield curve slope (Jan 2007 to June 
2009) 
0.00.51.01.52.02.53.03.5
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09in %
Note: Spread between the 10 years and the 3 months spot 
rates.  
Source:  ECB though the risk premium vi sibly increased also for 
these issuers. 
Graph 1.7:  Corporate bond spreads per rating, euro area 
(1 Jan 2007 to 30 June 2009) 
050100150200250300350400450500
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09AAA
AA
A
BBBin basis points
Source:  EcoWin. 
19. Credit growth decelerated sharply after 
September 2008.  Up to the third quarter of 2008, 
the growth rate of credit remained strong, in particular to non-financial corporations (Graph 1.8).  
Graph 1.8:  Monetary Financial Institutions lending in the 
euro area (January 2000 to May 2009) 
-20246810121416
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08Non-financial corporations
Householdsy-o-y change, in %
Source:  EcoWin. 
A significant turn around took place in the fourth 
quarter of 2008. The annual growth rate for loans to the private sector decel erated to 1.5% in June 
2009, down from 11.1% in December 2007. The slowdown was mainly influenced by demand factors such as the moderation of economic activity and the contracting housing market. Nonetheless, supply-side factors have contributed to the moderation in lending as well, as reported by the ECB Bank Lending Surv ey for the euro area. 
1. Macroeconomic Developments 
 
15  
Box 1.3: Recent developments in food prices
Recent years witnessed unusually high volatility of food prices with an important impact on overall 
consumer price inflation and real incomes. After having declined in real terms over  the past thirty years, 
global agricultural commodity prices started to soar around the end of 2006 until early 2008: between 
September 2006 and March 2008 the Dow Jones Agriculture Index (in USD terms) rose by almost 90%. The 
index remained at a high level until July 2008, after which the initial price rise was more than reversed by a 
50% drop in prices until December. In the first six months of 2009, agricultural commodity prices have 
slightly trended upwards without, however, returning to the level of summer 2006. Expressed in euro, the 
price volatility, although considerable, was somewhat mitigated by the appreciation of the euro over the 
same period.  
On 9 December 2008 the Commission – responding to a request by the June 2008 European Council – 
adopted a Communication entitled 'Food Prices in Europe' (1), in which it presented the results of its analysis 
into the causes of the increase in food prices and the differential impact across Member States, as well as an 
analysis of the functioning of the food supply chain. On that basis it presented policy recommendations and 
set out a roadmap for its further work.  
The surge in agricultural commodity prices in 2006-2008 resulted from a combination of structural and 
temporary factors (2): among the former, global population growth, rising incomes in emerging economies 
and the development of new market outlets have contributed to a gradual rise in world demand. Global 
supply was unable to keep p ace due to a slowdown in the growth of f ood crop grain yields and the 
characteristics of world agricultural markets which are thin and typically constrained by the seasonality of 
production. Moreover, increasing production costs, due inter alia to rising energy prices, spilled over on 
agricultural commodity prices. The impact of these structural factors was amplified by large production 
shortfalls resulting from adverse weather conditions and trade restrictions imposed by several exporting 
countries. Exchange rate developments, growing speculative activity in the commodity derivative markets, 
and the close relationship between agricultural and other commodity markets, such as the oil market, also 
affected agricultural commodity price developments. While the global recession has a dampening effect on 
world demand, the underlying structural factors remain. 
Against this background, the Commission proposes in its Communication to: 
– Promote the competitiveness of the food-supply chain to increase its resilience to world price shocks. 
Specific recommendations have in the meantime been issued by the High Level Group on the 
Competitiveness of the Agro-Food Industry (3); 
– Ensure a vigorous and coherent enforcement of co mpetition at EU and national level and target those 
practices and restrictions that are particularly harmful; 
– Review potentially-restrictive regulations at national a nd/or EU level. This exercise is ongoing in the 
context of the retail market monitoring exercise and th e transposition of the Servic es Directive. Regulations 
that restrict the ability to compete on prices should be examined at national level; 
– Ensure the ability of consumers to better compare prices; 
– Examine together with regulators of commodity ma rkets how to discourage excessive volatility in the 
markets that benefits neither producers nor consumers. 
                                                           
(1) COM(2008) 821. 
(2) See also Communication COM(2008) 321, Tackling the challenge of rising food prices - Directions for EU action, 20 
May 2008. 
(3) Re port on the Com petitiveness of the Euro pean A gro-Food Industr y, 17 March 2009.  
(Continued on the next page) 
European Commission 
Annual Report on the euro area - 2009 
 
16 Graph 1.9:  Composite Financing Cost Indicators (CFCI) 
for the euro area (March 2003 to April 2009) 
3456
Mar-03 Mar-05 Mar-07 Mar-09Non-financial corporations
Householdsin %
Source:  Commission services. 
20. The overall cost of  finance for both 
euro-area non-financial corporations and 
households climbed during 2008.  While this 
increase was mainly driven by higher costs of equity finance for non-financial corporations, the costs of bank loans and market debt increased as well (Graph 1.9). For households, as measured by the Commission services Composite Financing Cost Indicators (CFCI), th e cost was on average 
0.35 percentage points higher than in 2007, while financing costs for non-financial corporations were 0.93 percentage points higher. The CFCI for non-financial corporations and households has been declining in the first months of 2009, above all as bank lending rates were reduced, but also on account of lower costs of market-based debt. 
21. Stock market prices decreased 
substantially in 2008 on the back of negative 
prospects for earnings.  The Dow Jones Euro 
Stoxx 50 declined in several waves, and most markedly after the above-mentioned failure of Lehman Brothers in September 2008 (Graph 1.10).  Graph 1.10:  Stock price index and implied volatility (Stock 
price: Jan 2007 = 100) 
020406080100120
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09index
050100150200
Eurostoxx 50 (lhs)
Implied volatility (rhs)in %
Source:  EcoWin. 
From March onwards, stock markets regained 
some ground, but volatility remained elevated reflecting uncertainty about the impact of economic policy actions. Still, as of end-June 2009, the Euro Stoxx 50 had declined by 45% compared to end-2007. Wh ile the value of some 
troubled financial stocks tumbled (especially those of financial institutions with significant exposure to Central and Eastern European countries), the decline in equity markets was broad-based across sectors and countries. 
Price developments 
22. Surprising commodity price rises during 
the first half of 2008 caused upward pressure on 
inflation.  Headline HICP inflation averaged 3.3% 
in 2008, about one percentage point higher than during the previous year  (Graph 1.11).The increase 
was chiefly driven by energy and food sub-components (Box 1.3). They contributed as much as 2.4 percentage points to the average inflation figure of 3.6% in the first eight months of   Box (continued) 
Furthermore, the Communication notes that to keep the balance in the global supply and demand for food, 
continued efforts are needed to ensure that agricultural production responds to market signals and to 
promote an open trade policy. By agreeing the Health Check of the CAP, the European Union has taken 
decisive steps to facilitate farmers' responses to changing market conditions. Moreover, the Doha Round of 
WTO trade talks aims to open up agricultural markets to developing countries. Incentives and assistance to 
raise the production potential in developing countries could also contribute to increasing global food 
security. 
 
 
1. Macroeconomic Developments 
 
17 2008. The contribution had been much weaker in 
the same period of 2007 (0.5 percentage point out of 1.8%). As a result, possible second-round effects remained under close scrutiny during the first half of 2008. 
Graph 1.11:  Harmonised index of co nsumer prices (HICP), 
euro area 
01234
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09Headline HICP
HICP excluding energy & unprocessed foody-o-y change, in %
Source:  Commission services. 
23. Headline inflation eased considerably 
after September as commodity prices tumbled.  
HICP inflation fell from a peak of 4.0% in July 
2008 to -0.1% in June 2009 (Graph 1.12). HICP sub-categories food and energy contributed only 1.3 percentage points to the 2.6% average inflation figure for the period Se ptember-December 2008. 
The contribution of services to headline inflation remained stable, but at a relatively high level (around one percentage point in 2008). The contribution from non-energy industrial goods to headline inflation also rema ined stable in 2008 at a 
low level (around ¼ percentage point). 
24. Core inflation remained contained in 
2008. Though much less pronounced, the pattern 
for core inflation (defined here as HICP inflation excluding energy and unprocessed food) followed the changes observed in headline inflation (Graph 1.12) (
1). It accelerated to 2. 4% in 2008 from 2.0% 
in 2007 and markedly decelerated in the first months of 2009 to reach 1.3% in June 2009. 
                                                          
 
(1) Core inflation is a measure of  inflation that excludes or 
reduces the weight of the more volatile components of 
headline inflation. Different statistical methods are available to compute core inflation (i.e. trimmed means, 
weighted median and HICP excluding energy and 
unprocessed food). Graph 1.12:  Breakdown of euro-area HICP inflation 
-2-1012345
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09-2-1012345
Non-en. ind. goods Energy
Unproc. food Processed food
Services Headline HICP
Source:  Commission services. 
25. Inflation is expected to remain subdued 
in 2009.  Prices are likely to continue declining 
throughout most of 2009 on the back of weakening economic activity and moderating commodity prices. As a result of strong base effects (
2) year-
on-year inflation has turned negative in June 2009 (-0.1%), possibly remaining in negative territory for a few months. However, the risk of a deflationary scenario at the euro-area level, i.e. a persistent and self-reinforcing decline in a broader set of prices, appears limited at the current juncture (see Box 1.4). Inflation expectations remain anchored at levels consistent with price stability, whereas wage growth is expected to remain positive and capacity utilisation is at very low levels. According to the Commission services spring 2009 forecast, HICP inflation is expected to 
reach 0.5% in 2009. A gra dual rebound in inflation 
to around 1¼% can be expected in 2010. 
1.3. FISCAL DEVELOPMENTS 
26. The fiscal situation had benefited from 
years of successful consolidation.  By 2007, fiscal 
positions in the euro area had evolved favourably. The headline deficit was down to 0.6% of GDP while the reduction in the structural deficit was somewhat smaller (1¾% from 2½% in 2005). The debt ratio had decreased to 66% from 70% in 2005. No euro-area Member States ran an excessive deficit. 
                                                          
 
(2) A base effect occurs when the evolution of a variable's 
annual rate from month t to month t+1 varies because of the evolution of the variable's  level twelve months before 
and not because of the variation of the variable's level 
between month t and month t+1. 
European Commission 
Annual Report on the euro area - 2009 
 
18  
Box 1.4: How large are the risks of deflation in the euro area?
While a reduction in prices – e.g. as a result of competition or efficiency-induced cost-savings – is generally 
considered desirable when affecting individual products, it may lead to adverse effects when it is broad-
based. Deflation essentially refers to a decline in prices that is generalised, persistent and expected. 
'Generalised' implies that overall price aggregates are falling and that the decline is broad-based across items 
and products. Within a currency area, it also implies th at the price decline is geographically spread out and 
not restricted to a limited set of Member States. 
'Persistent' indicates that the price decline is stretched out over a prolonged period of time. A one-off 
downward price adjustment as a result of an external shock (e.g. a sharp drop in oil prices), would thus not 
fall under deflation. There is no agreed definition as to how long prices have to fall in order to technically 
qualify as deflation. 
'Expected' means that, as economic agents' inflation expectations turn negative, the perceived relative cost of 
future spending with respect to current spending falls. It follows that deflation should be distinguished from 
a deceleration in the inflation rate (disinflation), which may also involve spells of negative price changes, 
without however causing expectations to turn negative. 
All currently-available forecasts do not foresee a prolonged period of negative price growth in the euro area, 
and deflation risks appear limited. Several factors contribute to this. 
First, the price decline is not generalised since it la rgely results from price falls in two items: energy and 
food. As shown in Graph A, only 17% of HICP items (at the 4-digit level), accounting for a combined 
weight of about 20% in the HICP, recorded negative price growth in May. Items making up about 70% of 
the HICP basket registered price growth above 1%. 
Second, base effects, mainly explained by energy and food price movements, will contribute positively to 
annual inflation from August 2009 onwards (see Graph B). 
Third, market-based measures of inflation expectations appear to be well-anchored around the ECB price 
stability objective. The ten-year spot break-even inflati on rate stands at 2.2% in June 2009. Finally, the 
monetary and fiscal policy response to the crisis is likely to have a pre-emptive effect with respect to 
deflation by supporting demand.  
Graph A . HICP items sorted in ascending   Graph B. Contribution of base effects to euro area  
growth order (year-on-year change, May 2009) HICP inflation (in percentage points, January 2009 to 
 April 2010) 
 
 0510152025
< -4%
-4% to -3%
-3% to -2%
-2% to -1%
-1% to 0% 0% to 1%
1% to 2% 2% to 3%
3% to 4%>4%051015202530
No of categories
Combined HICP weight
 -0.6-0.4-0.20.00.20.40.6
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 
Source:  Commission services. Source:  Commission services.   
 
1. Macroeconomic Developments 
 
19 27. The financial crisis hit public finances 
hard and budgetary positions deteriorated for the 
first time in five years in 2008 . The euro-area 
average headline deficit r eached 1.9% of GDP, up 
by 1.3 percentage point of GDP from 2007 (Graph 1.13). Due to the economic downturn, the development in the headline deficit was matched by a smaller deterioration of the euro-area average structural balance, i.e. the budget balance net of 
cyclical factors and one-off and other temporary measures (Graph 1.15). Its deterioration was of the order of 1% of GDP, thus putting the structural balance at 2¾% in 2008. The result seems to suggest that the rise in the headline deficit was primarily of a structural nature. However, current 
estimates of the structural  balance are likely to be 
affected by the volatile behaviour of tax revenues. While they were exceptionally buoyant in 2007, tax revenues dropped sharply as a result of the economic and financial crisis. 
Graph 1.13:  Headline and structural budget balances in 
the euro area in 2008 
-8-404
BE DE IE EL ES FR IT CY LU MT NL AT PT SI SK FI EA16% of GDPStructural budget balance
Headline budget balance
Source:  Commission services. 
28. Dispersion in fiscal balances increased 
in 2008. Member States with initial budget 
surpluses exhibited different patterns over 2008 (Graph 1.14). In Ireland a minor surplus turned into a large deficit of more than 7% of GDP. In Spain the public balance swung from surplus (2.2%) to deficit (-3.8%). In Cyprus the large surplus shrank considerably (from 3.4% in 2007 to 0.9% in 2008). Conversely, the Netherlands increased its surplus from 0.3% to 1.0% of GDP. The large surpluses of Finland and Luxembourg were trimmed down, but remained strong in 2008 (respectively 4.2 and 2.2 percentage points). In Germany, the fiscal position remained almost unchanged and very close to balance. In countries still in deficit in 2007, a further deterioration was 
witnessed, but remained relatively contained, especially in Portugal  and Slovakia. A more 
substantial deterioration in numbers was recorded in Malta, Italy and France. For France, the deficit deteriorated from 2.7% of GDP to 3.4%. On this basis, in April 2009, the Council decided that excessive deficits existed in France, Spain and   
Graph 1.14:  Budget balances in the euro area (2007 levels 
and 2008 changes) 
BEDE
IEEL
ESFRIT
CYLU
MTNL
ATPT
SISK
FI
EA16
-8-6-4-202
- 4 - 20246
Public balance in 2007 (in % of GDP)Change in public balance in 2008
Source:  Commission services. 
Ireland. For Greece, EDP pr oceedings were started 
in 2008 on the basis of the 2007 outturn. In July 2009, on the basis of the Commission services' Spring 2009 Economic Forecast, the Council 
decided that Malta was in excessive deficit. 
Graph 1.15:  Structural balances in the euro area 
-8-7-6-5-4-3-2-101234
AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SKin % of GDP
Structural balance in 2008
Medium term objective
Source:  Commission services. 
29. Progress towards medium-term 
budgetary objectives was limited in the first half 
of 2008.  At that time, policymakers were still 
mainly concerned with individual countries' speed of structural fiscal adju stment. With a view to 
European Commission 
Annual Report on the euro area - 2009 
 
20 speeding up adjustment towards the medium-term 
budgetary objective (MTO), the Commission adopted a so-called policy advice on economic and budgetary policy for France in May 2008. The situation changed in the second half of the year, when the euro area was hit by the effects of the financial crisis, which led to a rapid deterioration in tax revenues. 
30. Government debt bounced back in 2008, 
partly due to public interventions in the financial 
system. In the euro area, the debt to GDP ratio rose 
by 3.3 percentage points to 69.3% in 2008 (Graph 1.16). Ireland witnessed a particularly steep increase in its debt level, by 18 percentage points in 2008. In Belgium, the government debt ratio rose in 2008, after havi ng remained on a steady 
downward path for almost a decade. Overall, the increase in debt reflected largely the acquisition of financial assets in the framework of financial rescue plans, most notably in Ireland (10.5 points out of a total increase of 18 percentage points), the Netherlands (12.6 points out of 15.7 points), Luxembourg (10.4 points out of 7.8 points) and Belgium (6.8 points out of 5.6 points). 
Graph 1.16:  Public debt-to-GDP ratios in the euro area 
020406080100120
AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SKin % of GDP2007
2008
2010Maastricht 
reference 
value
Source:  Commission services. 
31. Revenue shortfalls explain much of the 
budgetary deterioration.  In 2008, the observed 
deterioration in budgetary positions in the euro area was largely the result of a lower revenue–to– GDP ratio. On the expenditure side, the slight increase in the expenditure-to-GDP ratio was mainly due to higher social benefits and transfers, i.e. automatic stabilisers. On the revenue side, a strong negative contribution came from taxes on   income and wealth, the latter not least due to 
rapidly declining corporate income taxes. Compared to the plans presented in the 2007 updates of the Stability and Convergence Programmes, significant nominal expenditure overruns came together with large revenue shortfalls. 
32. Government revenue decreased 
markedly in 2008. Revenues in the euro area fell 
from 45.5% of GDP in 2007 to 44.8% in 2008. Many countries recorded shortfalls due to lower-
than-expected growth (Por tugal, Greece, Italy and 
France). The decrease in taxes was especially marked in Ireland due to the slump in housing boom-related taxes. In addition to the impact of automatic stabilisers, a number of countries took discretionary fiscal measures in 2008 to reduce income taxes (Spain) or social contributions (Austria). By contrast, Slovakia took revenue-raising discretionary measures in the form of a broadening of the corporate and personal income tax bases and an increase in the maximum ceiling of social contributions. Some other countries recorded better-than-expected tax revenues (Finland, Austria and Germany). The Netherlands benefited from stronger non-tax gas revenues. 
33. Government expenditure edged up in 
2008. Expenditure increased from 46.1% of GDP 
in 2007 to 46.6% in 2008. Localised overruns took place in some countries (Belgium, Slovenia). Greece recorded both larg e expenditure overruns 
and higher debt servicing. Higher-than-expected expenditure in Malta mostly stemmed from measures related to shipyards. In Italy, a sizeable increase in compensatio n of employees and 
intermediate consumption pushed current spending upwards. 
34. Public finances are expected to be hit 
hard by the recession in 2009 and 2010.  
According to the Commission services' Spring 
2009 Economic Forecast, the budget deficit is set to more than double in the euro area, to the equivalent of 5¼% of GDP by 2009 and 6½% in 2010. The rise in deficits, at unchanged policies, is again in part due to the impact of the economic slowdown, mirroring the importance of automatic stabilisers (Graph 1.17). However, it is now also  
1. Macroeconomic Developments 
 
21 Graph 1.17:  Cumulated change in public balance, euro-
area countries (2007-2010) 
-18 -16 -14 -12 -10 -8 -6 -4 -2 0 2IEESFISINLLUCYEABEDEATFRPTSKITELMT
in percentage points of GDP2008/2007
2009/2008
2010/2009
Source:  Commission services. 
linked to the significant discretionary measures 
that were introduced in the context of the European Economic Recovery Plan. In particular, the expenditure ratio is set to increase by more than three percentage points of GDP in 2009 (and by a further percentage point ne xt year) partly because 
of a rise in social benefits and transfers, but also due to the decline in nominal GDP. The revenue ratio is expected to decrease, reflecting inter alia the continuing reversal of past revenue windfalls and the erosion of some tax bases. 
Graph 1.18:  Cumulated change in public debt, euro-area 
countries (2007-2010) 
- 2 0 - 1 0 0 1 02 03 04 05 06 0IEESFRPTEANLBEATDEELITSIFILUSKMTCY
in percentage points of GDP2008/2007
2009/2008
2010/2009
Source:  Commission services. 
In addition to the weakened budgetary situation, 
government debt will also be affected by sizeable 
"below-the-line" measures as part of the financial rescue plans, such as bank recapitalisations. Overall, gross debt is expected to increase from 69% of GDP in 2008 to close to 84% in 2010 (Graph 1.18). 1.4. LABOUR MARKET DEVELOPMENTS  
35. Employment has reacted strongly to the 
current downturn, reflecting the severity of the 
crisis. Employment still rose by 0.8% in 2008, 
compared to +1.8% in 20 07 (Graph 1.19), leading 
to the highest employment ratio in the euro area since its inception (66.1%). 
Graph 1.19:  Euro-area employment growth and 
unemployment rate 
00.40.81.21.62
2004Q1 2005Q1 2006Q1 2007Q1 2008Q1678910Employment growth (lhs)
Unemployment rate (rhs)y-o-y change, in %in % of the labor force
Source:  Commission services.  
Typically, employment reacts with a lag to 
economic fluctuations as companies attempt to hoard labour in uncertain times. In the first half of 2008, there was still some positive momentum, with employment growing by 0.5%. However, employment began edging down during the third quarter (-0.2%) and fell by 0.4% in the fourth quarter. The construction sector was particularly hit and lost 5.4% of its workforce from the fourth quarter of 2007 to the fourth quarter of 2008. In the manufacturing sector, adjustment took place mostly in the fourth quarter. Although the recession hit manufacturing hard, internal flexibility in many industries (flexible working-time arrangements, temporary closures etc.) has prevented more significant labour shedding so far. Employment contracted further in the first quarter of 2009 (-0.8% quarter-on-quarter). The deterioration in employment was especially severe in Spain (-6.4% year-on-year) and in Ireland (-3.9% year-on-year), owning mainly to the weight of labour-intensive sectors in these countries. 
36. A sharp reduction in hours worked has 
prevented the unemployment rate from 
increasing faster  (Graph 1.20). Euro-area 
unemployment stood at 7.5% in 2008, unchanged 
European Commission 
Annual Report on the euro area - 2009 
 
22 from 2007. The quarterly profile however shows 
unemployment rising sharply to 8.0% in the fourth quarter of 2008 and 8.8% in the first quarter of 2009. Spain (+10.3 percentage points) and Ireland (+6.3 percentage points) recorded the largest increase in unemploymen t. Temporary agency 
work was also particularly hit by the downturn. Yet unemployment would have worsened in the absence of the significant reduction in hours worked per person employed that many firms (sometimes supported by state subsidies) have been implementing to avoid lay-offs (Graph 1.20). 
Graph 1.20:  Contribution of labour productivity and labour 
supply components to GDP growth, euro area 
-10-8-6-4-2024
2008Q3 2008Q4 2009Q1y-o-y change, in %GDP per hour worked
Population 15-64
Activity rate
Employment rate
Hours worked per person employed
GDP
Note: The euro-area GDP annual growth rate is 
decomposed into the growth rates of GDP per hour worked, 
hours per worker, the employment rate, the activity rate and the population aged 15-64. 
Source:  Commission services. 
37. Wage developments were impacted with 
a lag during 2008.  Labour costs continued to grow 
at a fast pace throughout the first three quarters of 2008 (
3) (Graph 1.21). This was largely due to 
tight labour markets as well as to nominal wage indexation schemes linking wages to past inflation outcomes in some Member States (Belgium, Luxembourg, Cyprus, Malta and Spain).The annual growth of hourly labour costs even accelerated to 4% during th e fourth quarter of 2008 
on account of the large reduction in working hours 
                                                          
 
(3) The Labour Cost Index corrects employment for effects of 
the number of hours worked, such as changes in overtime hours and part-time employment. Although it is meant to 
give a better estimate of la bour costs than compensation 
per employee, caution is needed when interpreting it during the crisis, where a temporary reduction of hours worked 
has led to higher hourly labour costs, even though total 
labour costs as such have remained broadly constant. 
Derived from national account s data, compensation per 
employee includes wages and sala ries and social security 
contributions. implemented by many firms. However, the annual 
growth of compensation per employee fell sharply from 3.5% in the third quarter to 2.7% in the fourth quarter of 2008. 
Graph 1.21:  Nominal wage indicators, euro area 
012345
2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1Labour Cost Index
Compensation per employee
Negotiated wagesy-o-y chan ge, in %
Source:  Eurostat for Labour Cost  Index and compensation 
per employee, ECB for Negotiated wages. 
Taken together with the deterioration in 
employment and the relatively stronger growth in negotiated wages (
4), this suggests that firms were 
actively reducing the variable pay component of compensation, such as  overtime or bonus 
payments. 
Graph 1.22:  Compensation per employee, labour 
productivity and unit labour costs, euro area 
-2-1012345
2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3Labour productivity (inverted scale)
Compensation per employee
Nominal unit labour costsy-o-y chan ge, in %
Note: Compensation per employee, labour productivity 
and unit labour costs are based on employement in 
headcounts. 
Source:  Commission services. 
38. Unit labour costs picked up strongly 
following a contraction in labour productivity.  
Productivity growth gradua lly weakened over the 
                                                           
(4) Negotiated wages measure the outcome of collective 
bargaining in terms of basic pay or salary (i.e. excluding 
bonuses). 
1. Macroeconomic Developments 
 
23 first three quarters of the year, mainly on account 
of the relatively labour-rich growth composition (Graph 1.22). Unit labour costs increased strongly in the fourth quarter (4.5 % year-on-year), owing to 
the cyclical slump in pr oductivity (1.7% year-on-
year). A breakdown by sect ors indicates that cost 
pressures were most acute in the industrial sector, where measures to keep workers in employment helped alleviate the impact of the crisis, but resulted inevitably in a fall in labour productivity in the very short term (Graph 1.23). By contrast, labour shedding in the construction sector has resulted in higher productivity growth and relatively contained labour costs pressures in response to the crisis. Only in Spain did productivity experience a sizeable increase in line with the sharp drop in employment in construction as well as the fall in temporary employment affecting all economic sectors. 
Graph 1.23:  Compensation per employee, labour 
productivity and unit labour costs by sectors in 
2008, euro area 
-4-20246810
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4Labour productivity (inverted scale)
Compensation per employee
Nominal unit labour costsConstruction IndustryMarket 
services 
NACE G-IMarket 
services 
NACE J-Ky-o-y chan ge, in %
Note: Compensation per employee, labour productivity 
and unit labour costs are based on employment in 
headcounts. NACE G-I refers to transport, trade, hotels and restaurants. 
NACE J-K refers to financial in termediation and real estate. 
Source:  Commission services. 
39. Labour market outlook is poor. 
According to the Commission services' spring forecast, the contraction in employment, which began in late 2008, is set to accelerate this year to around 2.5%. The unemployment rate would increase to 9.9% in 2009. Further job losses (-1.5%) are forecast for 2 010. While the slack in 
the labour market should lead to a significant 
deceleration in nominal wa ges (to slightly below 
+2% in 2009 and +1.5% in 2010), very subdued consumer price growth might imply that real compensation growth may be the highest in a 
decade in 2009. 
1.5. COMPETITIVENESS DEVELOPMENTS 
40. The external position of the euro area as 
a whole has been balanced  over the past decade.  
The euro area as a whole moved from a nearly 
balanced current account pos ition (0.1% of GDP in 
2007) to a small deficit in 2008 (-0.7% of GDP). This indicates that the euro area provided a net 
demand stimulus to the rest of the world. The euro area's generally balanced external position over the last ten years contrasts sharply with other major economies (Graph 1.24). 
Graph 1.24:  Current account positions, euro area, United 
States and China (1999-2008) 
-7-5-3-11357911
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008in % of GDPEuro area 
United States
China
Source:  IMF. 
41. However, within the euro area, the issue 
of persistent differences in competitiveness has 
gained relevance.  Some of it can be traced back to 
labour cost developments across euro-area Member States. Over the past decade, annual average nominal unit labour cost growth has ranged from around zero in Germany to 2.5% or more in some Member States (Ireland, Greece, Spain, Italy, Cyprus, Portugal, Slovenia) (Graph 1.25). Labour cost developments are important for the functioning of the competitiveness channel of EMU. In the face of a po sitive asymmetric demand 
shock (
5), unit labour costs in  the country affected 
by the shock should increase faster than in the rest of the euro area. The incr ease in unit labour costs 
                                                          
 
(5) Theoretically, above-average  demand in a given country 
should push costs and prices upw ards.  The deterioration in 
the relative cost situation should then worsen cost and price 
competitiveness for the respective country and slow the 
pace of economic activity towa rds the euro-area average. 
European Commission 
Annual Report on the euro area - 2009 
 
24 implies competitiveness adjustment. However, 
such cost and price incr eases, if not offset by 
increases in productivity, lead to prolonged competitiveness losses and build-up of domestic imbalances. Evidence shows that in some Member States wage growth has been outpacing productivity growth for some time (Spain, Portugal, but also Belgium,  Ireland, Italy) (Graph 
1.25). 
Graph 1.25:  Compensation per employee, labour 
productivity and nominal unit labour costs 
(1999-2008) 
-5-3-113579
BE DE IE EL ES FR IT CY LU MT NL AT PT SI SK FIaverage annual changes, in %Labour productivity (inverted scale)
Compensation per employee
Nominal unit labour costs
Source:  Commission services. 
42. Distinguishing between 'benign' and 
'harmful' developments in competitiveness is 
essential for policy intervention.  Benign factors 
reflect the normal and healthy functioning of the euro-area economy, while harmful developments are related to the build-up of a range of domestic macroeconomic imbalances in some Member States. The harmful factors require policy intervention while adjustment to the others should be left to the market. In the euro area, benign factors such as Balassa-Samuelson effects (
6), 
price convergence or cycl ical differences have 
played a relatively minor role in driving the divergences in external performance. Differences in growth and inflation have tended to be significant and persistent, leading to large changes in Member States' relative competitive positions,   
                                                          
 
(6) The Balassa-Samuelson hypothe sis predicts that price 
levels will increase when rela tive productivity rises in the 
tradable sector. If prices in th e tradable sector are fixed and 
if wages equalise across sectors, wages will increase both in the tradable sector and in the non-tradable sector. As a 
consequence, the cost of pr oducing non-tradables will rise 
and the general price level will thereby increase. notably in terms of price competitiveness but also 
in terms of current account imbalances and net foreign asset positions. Although part of the current account dispersion within the euro area can 
be seen as a sign of increased financial market integration, with the euro acting as catalyst, less 'benign' factors seem to have played a more important driving role (
7). 
43. Differences in price competitiveness 
have been partly driven by an inappropriate 
response of wages to country-specific shocks in 
some Member States. Differences in current 
accounts reflect not only differences in price and cost competitiveness but also the build-up of domestic imbalances, mostly linked to excessive domestic demand pressures. Such pressures include high private-sector and external debt, a surge in house prices and increased vulnerability to abrupt changes in financial market conditions. Although catching-up economies in the euro area have benefited from large capital inflows, foreign capital has not always been channelled to the most productive uses, fuelling primarily consumption or housing investment. In some Member States, the deterioration of the current account positions can in part be explained by substantial losses in non-price competitiveness. In other Member States, fiscal policy has not always been sufficiently tight in the boom period. Graph 1.26 shows the divergence in price and cost competitiveness as measured by the real effective exchange rate (REER). The indicator shows significant divergences with Germany gaining 13% competitiveness and Spain losing almost 20% since 1998. 
44. Divergence in price competitiveness has 
been associated with a steady widening of current 
account differences within the euro area . Some 
Member States have registered large current account surpluses (Germany, Luxembourg, Austria,  Netherlands,  Finland), while others have seen large or very large deficits (primarily Greece, 
Spain, Portugal and Cyprus but also Ireland, Malta, Slovenia, Slovakia). 
                                                          
 
(7) For more details see Quarterly Report on the Euro Area 
Vol. 8 N°1 (2009), "Special report: Competitiveness 
developments within  the euro area". 
1. Macroeconomic Developments 
 
25 Graph 1.26:  Changes in intra euro-area Real Effective 
Exchange Rate (REER) 
-15-10-505101520
DE FI AT FR BE SI IT IE NL MT PT EL CY ES SKin %
1998-2008
1998-2010
Note; REER (GDP deflator) against other EA countries. (2) 
Belgium, including Luxembourg. (3) Slovakia is shown off 
scale. True rise in REER is 68% (1998-2008) and 76% (1998-2010) (intra). 
Source:  Commission services, 2010 data are based on the 
Commission services' spring forecast. 
These positions have mostly built up since the 
launch of the euro (Graph 1.27), although some countries have entered Stage 3 of EMU with an already sizeable deficit (Greece and Portugal). A few countries have experienced significant drops in their current account in recent years although 
their balance remains in surplus or in a comparatively moderate deficit (France, Italy and Belgium). 
Graph 1.27:  Current account positions, euro-area Member 
States (1999 to 2008) 
-20-15-10-50510
CY EL PT ES MT SI SK IE FR IT BE AT FI LU NL DEin % of GDP
1999
2008
Note: Net lending (+) and borrowing (-) from national 
accounts for all Member States except LU (balance of 
current transactions). 
Source:  Commission services. 
45. The build-up of large external liabilities 
has increased exposure to financial shocks.  The 
counterpart of la rge current account deficits in 
some Member States has be en the build-up of large  negative net foreign asset positions (NFA). In 
2007, Spain, Portugal  and Greece posted net 
external liabilities ranging between 80% and 100% of GDP (Graph 1.28). Slovenia and Slovakia have also registered a rapid deterioration in their negative NFA position in recent years. A few euro-area countries enjoy comfortable positive NFA positions (Belgium, Germany and Netherlands), but the orders of magnitude involved (15% to 30% of GDP) are, in relative terms, lower than in the case of countries with large net external liabilities. Moreover, the deterioration of the net external liabilities position is persistent for some euro-area Member States (Greece, Spain, Portugal and Slovenia). In the current downturn, financial markets have become more responsive to the net external financial asset position for the euro-area countries. Even if to a large extent the net external position is related to the private sector, the public sector can be affected by private-sector debt in the 
form of potential bail-outs and other fiscal implications. 
Graph 1.28:  Net foreign asset positions, euro-area Member 
States (1995-2007) 
-105-85-65-45-25-51535
EL PT ES SK AT IT FR DE BE NLin % of GDP
1995
2007
Source:  Commission services. 
 
46. However, the ongoing financial crisis is 
speeding up adjustment to external imbalances.  
According to the Commission services' spring 
forecast, current account divergence should diminish between 2008 and 2010 as the financial turmoil forces correction of some domestic imbalances in the credit and housing markets. However, the convergen ce in current account 
positions is moderate and asymmetric across the euro-area Member States (Graph 1.29). 
European Commission 
Annual Report on the euro area - 2009 
 
26 Graph 1.29:  Evolution of current account positions, euro-
area Member States (2008 to 2010) 
-18-13-8-32
CY EL PT ES MT SI SK IE FR IT BE AT FI LU NL DEin % of GDP
2008
2010
Note: Net lending (+) and borrowing (-) from national 
accounts for all Member States except LU (balance of 
current transactions 
Source:  Commission services 
The highest corrections are expected to take place 
in Spain (the current account deficit is to be reduced from -9% in 2008 to -5% in 2010) and Germany (the surplus is to diminish from 6.7% in 2008 to 3.4% in 2010). The Commission services' spring forecast sugges ts that the ongoing 
adjustments in current acc ount positions are not 
primarily driven by price changes. The rebalancing of relative prices has been limited (Graph 1.26), and therefore the adjustment might come at high cost in terms of unemployment and underutilisation of capital. The adjustment will probably require a substantial rebalancing of relative prices within the euro area, although it will also imply changes in the domestic part of the  economy concerned. There will be a need for 
reallocation of demand and productive resources between the non-tradable sector and the export sector, as well as changes in relative prices between the two sectors. The speed and the cost of the adjustment will very much depend both on the degree of price and wage flexibility and on the ease with which resources can be reallocated across sectors in the countries in question. Evidence shows that competitiveness adjustment in the euro area is working but could be slow. (
8) 
Countries with greater adjustment needs are 
generally facing product and labour market rigidities above the euro-area average, rendering the process of regaining price competitiveness more difficult in terms of length and economic cost. 
47. This divergence in competitiveness has 
implications both for the functioning of EMU 
and for economic governance.  Persistent 
divergence in competitiveness is a matter of common concern as intra euro-area adjustments to external imbalances work slowly, are costly and can have negative spill-over effects across Member States. Effective functioning of EMU calls for early detection of these external imbalances in order to prompt an adequate and timely policy response. The macroeconomic framework and the economic governance aspect related to the competitiveness dimension are discussed in Chapter 4, Section 2. 
                                                          
 
(8) European Commission (2006), 'Market adjustment, the 
competitive channel', chapter 4 in 'Dynamic Adjustment in 
the Euro area: Experiences and challenges', EU Economy 
Review 2006. 
2. MACROECONOMIC POLICIES 
 
27 48. These are testing times for economic 
policies.  The exceptional charact er of the current 
economic downturn provides a litmus test as policy-makers strive to attenuate its impact and to prepare a sustainable exit strategy. This chapter provides an overview and assessment of macroeconomic policies. Section 2.1 underlines the unique nature and scope of the crisis, justifying the need for an active and co-ordinated policy 
response. Section 2.2 covers monetary policy developments while financial market policies are presented in Section 2.3. Section 2.4 describes the European Economic Recovery Plan (EERP), with a focus on its budgetary and structural pillars. Section 2.5 delivers a first assessment of the national measures taken under the EERP. 
2.1. INTRODUCTION 
49. By any standards the current crisis has 
unique features . No region in the world escaped 
the fallouts. The turmoil in financial markets affected at a breathtakin g pace the real economy 
during the fourth quarter of 2008. Business surveys, closely followed by hard indicators, such as industrial production and external trade, tumbled to historic lows. Two months after the demise of Lehman Brothers it was all too clear that the world was entering its first global recession since the Great Depression. 
50. The financial sector has been in the eye 
of the storm.  The banking sector fulfils key 
functions for an efficient allocation of financial resources between lender s and borrowers in time 
and space. Banking crises, a major source of economic fluctuations in the nineteenth century, 
had long been considered to be a thing of the past in advanced economies. Macroeconomic models assumed that the banking sector played a relatively neutral role in the transmission of monetary policy impulses. Models ignored the endogenous dynamics of financial innovation, following the deregulation waves of the 1980s and 1990s. Although the boom-bust dynamic led by excessive monetary creation was well-identified in the case of smaller economies (
9), the possibility that 
                                                           
(9) The larger the size and duration of a credit boom episode, 
the greater the likelihood of a crisis. Borio C., Lowe P. 
'Asset prices, financial and monetary stability: exploring 
the nexus ' BIS Working Papers No. 114, July 2002. 'sudden stop' patterns could materialise on a global 
scale was never envisaged. At the climax of the financial crisis, liquidity on financial markets evaporated overnight and the risk of bank runs 
became a looming threat. 
51. Unsustainable debt build-up is at the 
root of the crisis.  Ample global liquidity 
conditions, combined with irresponsible lending policies and poor supervisory oversight laid the groundwork for the emergence of a housing bubble in the US and other advanced economies (Graph 2.1).  
Graph 2.1:  Debt-to-GDP ratios of various economic 
sectors among select advanced economies 
050100150200250300350
Mar-87 Mar-90 Mar-93 Mar-96 M ar-99 Mar-02 Mar-05 Mar-08(in %, GDP-weighted, 1987 = 100)Government
Households
Financial institutions
Nonfinancial corporations
Source:  IMF Global Financial Stability Report, April 2009. 
Its duration was prolonged by apparently endless 
flows of capital from emerging countries with large external surpluses,  notably China. Risk 
became mispriced and leverage increased for all economic agents, be they households, companies or financial institutions throughout the world, thanks to the enhanced financial interconnectedness. In the US, personal savings fell from 7% to below zero in 2005-2006. Private debt rose from 188% of GDP in 1997 to 295% in 2008. Domestic and global imbalances fed each other until breaking point. 
52. Reducing over-indebtedness takes time 
and generates negative feedback loops . Three 
negative spirals can be at  work in the current 
context. A first negative feedback loop involves bank losses. Capital losses on foreign financial products may force banks to curtail domestic lending to the real economy. The ensuing reduction in working cap ital for non-financial 
companies leads to higher default rates in the 
European Commission 
Annual Report on the euro area - 2009 
 
28 economy and eventually more capital losses for 
banks. A second vicious circle arises from confidence effects. Households and companies save more and downscale their investment plans. What seems reasonable at the individual level is harmful collectively, amplifying the economic downturn at the macroeconomic level. A third vicious circle is caused by the debt-deflation mechanism (
10). A disorderly deleveraging of 
banks and companies puts downward pressure on a large range of asset prices to the extent that the real value of residual debt increases as a result. All feedback loops imply strong negative spillover effects deriving from individual uncoordinated decisions of economic agents. Consequently, 
successive recessionary waves can hit the economy and turn recession into a depression. Indeed, historical experience shows that recessions 
triggered by banking crises are deeper and last longer than normal rece ssions (see Box 2.1). The 
economy is in need of a mutually supporting mix of financial and economic policies. 
53. Regulatory repair of financial 
supervision is a prerequisite for policy-makers . 
Initial policy action took the form of fast 
interventions by central banks to compensate for the liquidity shortfall on money markets. This necessary immediate action had to be complemented by a comprehensive set of regulatory reforms to remove sources of pro-cyclicality in the financia l sector (see Section 2.3). 
In addition, the credit channel had to be repaired through extensive support schemes for banks, ranging from recapitalisatio ns and guarantees to 
asset relief programmes. It is expected that credit distribution will bounce back after banks have successfully cleaned out their balance sheets. 
54. Sanitised balance sheets will maximise 
the expansionary turn of monetary policies.  In all 
advanced economies, monetary policy has become strongly expansionary. It is expected that lower policy rates will translate over time into lower interest rates applied to households and businesses, providing major support for recovery. However, the effectiveness of monetary policies depends on the soundness of the banking system. Even if this prerequisite is fulfilled, conventional monetary 
                                                          
 
(10) The phenomenon was first identified in 1933. Fischer, I. 
(1933), ' The Debt-Deflation Theory of Great Depressions ', 
Econometrica, October, Volume 1, Issue 4, pp. 337-57. policy is bounded by the fact that nominal interest 
rates cannot go below zero. However, central banks may rely on unconventional measures to enhance the effectiveness of monetary policy (see Section 2.2). 
55. Fiscal expansion plays a decisive role . 
Public spending should help bridge the gap between currently credit-constrained economic agents and aggregate demand, so that irreversible losses in capital and professional skills are limited as much as possible. A strong stimulus will sustain demand, limit the fall in output and restore confidence and private spending. It would also defuse risks arising from negative feedback loops, boosting credit and confidence among economic agents. Finally, such policy would also limit the negative impact on potential growth, as private investment is set to be depressed in the current year and the next. 
56. There is a particular need for 
coordination of fiscal policies within the EU and 
euro area.  Given the large trade and financial 
spillovers between Member States the European Economic Recovery Plan sets out action at the European level. It aims to restore consumer and business confidence, restart lending and stimulate investment in the EU's economies, create jobs and 
help bring the unemployed back to work (see Section 2.4 for details). 
57. Well-conceived exit strategies are crucial 
for long-term fiscal sustainability.  The eventual 
removal of discretionary policies through adequate exit strategies would maximise the impact of the stimulus in the short run. Economic policy support must be designed in a sustainable way to be effective. If the stimulus is perceived to lead to snowballing public debt and rising inflation, the private sector might save more to prepare for the inevitable increase in taxes.  In the euro area, the 
Stability and Growth Pact provides an effective framework that combines the short-term flexibility required to counter the crisis with a credible commitment to fiscal sustainability (see Section 2.4). This guarantees time-consistent fiscal policymaking. 
58. The expansion should be coordinated on 
a global scale.  Global crises call for global 
solutions. At the G-20 Summit in London, leaders of the world’s largest economies agreed to a 
2. Macroeconomic Policies 
 
29 combined USD 1.1 trillion package of national 
measures to restore growth and jobs and rebuild confidence and trust in the financial system (see Chapter 3). With fiscal stimulus measures that countries had already an nounced, the combined 
stimulus would amount to some five trillion dollars 
by the end of 2010. This joint endeavour effectively averts the risk  of beggar-thy-neighbour 
policies of a kind that amplified the downturn during the Great Depression of the 1930s. 
2.2. MONETARY POLICY  
59. The ECB policy response evolved in 
reaction to the changing challenges . In response 
to persistent money market tensions since mid-2007, the ECB developed a two-pronged approach. Liquidity injections catered for bank funding needs, while key interest rates were assigned to the preservation of price stability in a context of initially rising inflationary pressures. As the financial crisis unfolded, causing severe liquidity shortages in many financial market segments, and spread quickly to the real economy (Graph 2.2), the ECB mustered all available monetary policy instruments. 
60. Until mid-September 2008, the fight 
against inflationary pressures took centre-stage . 
The ECB increased its key interest rate by 25 basis 
points to 4.25% in July 2008 amid heightened upside risks to price stability. Inflationary risks were driven mainly by increases in commodity and food prices (see Box 1.3). HICP (
11) inflation 
reached 4% year-on-year in June and July 2008, well above the two-percent reference value for price stability. The surge in euro-area inflation raised concerns over second-round effects in price- and wage-setting, which wa s reflected in rising 
inflation expectations. Incoming data over the first half of 2008 suggested that euro-area real GDP growth would be moderate but remain fairly close to its potential both in 2008 and in 2009, predominantly driven by domestic demand. The ECB also took note that lending to the private sector, and in particular to non-financial companies, was still growing at a healthy rate. This suggested that tensions on financial markets were   
                                                          
 
(11) Harmonised Index of Consumer Prices. not affecting the supply of credit within the euro-
area economy. 
Graph 2.2:  ECB interest rates and Eonia 
01234567
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09ECB minimum bid rate
ECB marginal lending facility
ECB deposit facility
Overnight interbank rate (Eonia)in %
Source:  EcoWin. 
61. The Lehman bankruptcy opened a new 
period of unprecedented market stress and falling 
demand . Central banks responded to the rapidly 
changing environment (Gra ph 2.3). The ECB, in a 
coordinated move with the Federal Reserve, the Bank of England, the Bank of Canada, the Sveriges Riksbank and the Swiss National Bank, lowered its borrowing costs by 50 basis points to 3.75 percent on 8 October 2008. Before the end of the year, the Governing Council lowered borrowing costs by another 50 basis points in November and 75 basis points in December amid growing evidence of receding inflationary risks and severe fallout from the financial crisis on the real economy. Two additional 50 basis point cuts followed in January and March 2009, before two 25 basis point reductions in April and May. Overall, in the period under review, the ECB reduced its benchmark policy rate by 325 basis points to 1%. 
62. The ECB reacted to strong turbulences 
in money market activity since 2007 . Turmoil on 
money markets started in June 2007. The ECB was the first major central ba nk to address market 
tensions via enhanced liquidity provision to the banking system. From the fall of the US investment bank Bear Stearns in mid-March to the end of summer 2008, the ECB accommodated higher liquidity demand by allocating larger volumes in its main weekly refinancing operations. 
European Commission 
Annual Report on the euro area - 2009 
 
30  
Box 2.1: Banking crisis and growth: historical evidence
Historical evidence on recessions combined with banking crises may shed light on the likely impact of the 
current crisis on the economy. Using a sample of major financial crises in history, Reinhart and Rogoff 
(2009) find that, on average, output falls by 9 percent, real housing prices decline on average by 35 percent, 
equity prices decline by 55 percent and unemployment increases by 7 percentage points. While equity prices' 
declines are somewhat shorter-lived, the duration of housing price declines is long-lived, averaging roughly 
six years. Banking crises require a painful restructuring of the financial system which weighs heavily on 
public finances: public debt rises on average by 86 percent. 
For OECD countries, Haugh et al. (2008) find that recessions that are combined with financial crises have 
been, on average, twice as severe as 'normal' recessions (see Table). Moreover, the recovery is muted and 
investment and durables' consumption are disproportionately reduced. While business investment tends to 
rebound more strongly in the recovery phase, residential investment remains depressed during a protracted 
period of time. Exports play a strong role for the recovery. 
Evidence regarding possible effects on potential growth of a banking crisis is mixed. The banking crisis in 
Japan was followed by a deterioration in potential growth partly due to a worsening in productivity 
performance, which may be related to the protracted nature of the banking problems and the resulting 
misallocation of capital. Following the Nordic banking crises, which were resolved more quickly, there was 
no major deterioration in productivity performance. Notably, Finland used the crisis as an opportunity for a 
fundamental restructuring in particular in the industries marketing information and communication 
technologies. 
 
Table 1:  Banking crises and output losses 
R&B R Ratio R&B R Ratio R&B R Ratio
Spain (1980-1987) 28 12 2.3 -10.1 -6.0 1.7 2 4 0.5
USA (1990-1998) 32 13 2.6 -11.4 -6.2 1.8 5 3 2.0
Finland (1989-1998) 28 15 1.9 -40.6 -5.2 7.9 14 5 2.6
Japan (1997-2006) 32 16 2.0 -12.3 -7.3 1.7 3 4 0.8
Sweden (1989-1998) 28 11 2.5 -16.7 -4.3 3.9 7 3 2.3Norway (1986-1997) 35 9 3.9 -34.8 -6.5 5.4 1 1 1.0Recovery half-life (2)
(quarters)Duration of downturn (1)
(quarters)Cumulative output loss
(% pts of GDP)
 
Notes: A downturn is defined as a period of at least two years when the cumulative output gap is at least 2% of GDP 
and output falls at least 1% below potential output in at least one year.  
R&B: recession combined with banking crisis. R: normal recession. (1) Number of consecutive quarters for which 
output gap is negative. (2) The recovery half-life is the number of quarters following the though before the though 
output gap is halved. 
Source:  OECD. 
 
The severity of the present recession in the euro area becomes apparent when compared with previous euro-
area "normal" recessions. According to the standard approach – recessions are identified as GDP contracting for (at least) two consecutive quarters – the euro area has experienced a total of four recessions since 
1970 (
1). 1974Q1, 1980Q1, 1992Q1 and 2008Q1 mark the peaks of the previous expansion phases and the 
turning points in economic activity. As the comparison is made over a common time span of twelve quarters 
(three years), data up to the fourth quarter of 2008 is complemented with projections for 2009 and 2010 with 
the Commission services' spring forecast.  
 
                                                           
(1) Data before 1995 do not include Slovakia. 
 
(Continued on the next page) 
2. Macroeconomic Policies 
 
31 The ECB also raised the volume allotted in its 
three-month refinancing operations and introduced six-month refinancing operations, as from April 2008. 
These policies were largely successful in 
stabilising money markets, with the differential between the Eonia (effective overnight interest rate) and the ECB's key policy rate remaining 
close to zero. 
63. The ECB responded decisively to 
mounting tensions on the money market . The 
ECB decided on 8 October 2008 to carry out its main weekly operations as fixed-rate tenders with full allotment. This meant that the ECB satisfied all liquidity bids at a fixed interest rate. The ECB Box (continued) 
Graph C: Private consumption across 
recessions, euro area
9698100102104106108110
0123456789 1 0 1 174Q3 downturn
80Q1 downtun
92Q1 downturn
08Q1 downturn
Quarters from peak of economic cycleGraph A shows that the first crisis in 1974 was sharp but short-lived. GDP decreased by 2.5% at the bottom 
of the cycle. The recession due to the second oil shock of 1980 was the shallowest (a 0.5% GDP loss at the 
trough). However, the upswing was rather sluggish. The 1992 downward trend in growth –linked to the 
aftermath of German unification– was comparatively protracted. At its trough, GDP dropped by 1.9% four 
quarters after the start of the recession. 
Graph A: GDP across recessions, euro area   Graph B: Investment across recessions, euro area  
92949698100102104106108
0123456789 1 0 1 174Q3 downturn
80Q1 downtun
92Q1 downturn
08Q1 downturn
Quarters from peak of economic cycle 8084889296100104
0123456789 1 0 1 174Q3 downturn
80Q1 downtun
92Q1 downturn
08Q1 downturn
Quarters from peak of economic cycle 
Source:  Commission services.  Source:  Commission services.  
The role of investment as a main driver of the GDP fall is pinpointed in Graph B. If forecasts are confirmed, 
the current steep decline in investment will have had no eq uivalent in its scale. By contrast, the recessions of 
the mid-1970s and early-1990s were characterized by a resumption of positive investment growth at a 
relative early stage of the business cycle and, as a result, the level of investment three years after the start of 
the recession was broadly back to the level of its previous peak. 
Overall, the weakness of investment in the current 
recession is far greater than in previous recessions. This 
might eventually weigh on potential growth. By 
contrast, private consumption has always been resilient 
in times of recessions. Graph C exhibits different 
patterns. Consumption rebounded strongly in 1974 and 
recovered its pre-crisis dynamic trend after two quarters. 
The patterns of 1980 and 1992 were markedly different. 
Consumption was initially relatively resilient, but the 
upturn materialised only after four quarters. 
Haugh, D., Ollivaud P. and Turner D. (2008), 'The 
macroeconomic consequences of banking crisis in 
OECD countries', OECD Economics Department 
Working Paper, No. 683. Source:  Commission services.  
Reinhart, C. and Ro goff K. (2009 ), 'The Aftermath of Financial Crises', NBER Workin g Papers, No. 14656.  
 
European Commission 
Annual Report on the euro area - 2009 
 
32 reduced the width of the corridor around its main 
refinancing rate from 200 basis points to 100 basis points (
12). In addition, on 15 October 2008, the 
ECB expanded the list of collateral eligible for refinancing and reduced the minimum rating for debt securities, except as set-backed securities, 
from A- to BBB-. Debt securities denominated in the US dollar, pound sterling and Japanese yen were also accepted. The provision of liquidity in foreign currencies, initiated at the end of 2007, was substantially amplified after mid-September 2008. On 24 June 2009, the ECB allocated EUR 442 billion in its first long-term refinancing operation with a maturity of 12 months, carried out as a fixed-rate tender with full allotment. 
Graph 2.3:  Central banks' policy interest rates 
01234567
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09ECB minimum bid rate Bank of England benchmark rate
US federal funds target rate Bank of Japan target rate
Source:  EcoWin. 
Overall, ample liquidity provision and changes 
made to the ECB's collateral framework supported the continuity and functioning of the euro-area money market. At the same time, these interventions contributed to the growth in the size of the Eurosystem’s balance sheet which increased by around EUR 700 billion (
13) since the end of 
June 2007 to reach EUR 1.9 trillion by the end of 
June 2009. This figure is equivalent to 22% of the nominal GDP of the euro area (
14). 
64. The ECB recently added unconventional 
measures to its policy arsenal . Following its 
Governing Council meeting on 7 May 2009, the 
                                                           
(12) The decision was subsequently reversed in order to 
encourage banks to resume trading in the interbank market 
(13) The Eurosystem's balan ce sheet consists of the 
consolidated balance sheet of the ECB and the National 
Central Banks which are part of the euro area. 
(14) At the same time, the balance sheet of the Federal Reserve 
System was around USD 2 trillion or 15% of the US 
nominal GDP. ECB agreed to purchas e euro-denominated 
covered bonds for a total amount of EUR 60 billion – a programme of credit easing which is similar in kind, although smaller in size, to those already implemented by the Federal Reserve and the Bank of England (see Box 2.2). Direct financing on capital markets plays a smaller role in the euro area than in th e US and UK, which called 
for a more measured response (
15). On 4 June, the 
ECB announced that the purchases would be distributed across the euro area from July 2009 and carried out by means of direct purchases on both the primary and secondary ma rkets. As a rule, only 
covered bonds which were given a minimum rating of AA or equivalent by at least one of the major rating agencies (and in any case not lower than BBB) would be eligible for purchase. 
2.3. FINANCIAL MARKET POLICIES 
65. With the financial sector at the core of 
the crisis, policy repair was urgently needed . In 
reaction to the financial crisis, the Commission launched an ambitious agenda of proposals to restore a stable financial system. The agenda was outlined in the Communication 'Driving European recovery' adopted on 4 March 2009. The programme was consistent with the ongoing efforts at international level coordinated by the G-20. It included reform of the EU micro-prudential and macro-prudential supe rvisory framework for 
financial services, which was highlighted by the de Larosière report (see Section 4.3). Several initiatives were taken to improve and remove gaps in existing legislation (e.g. concerning hedge funds, private equity and capital requirements for banks) to protect consumers and SMEs (e.g. initiatives to foster responsible lending and borrowing), to improve incentives to reduce excessive short-term risk-taking (e.g. initiatives on remuneration in financial services) and to strengthen sanctions for infringements of the rules. Since measures in all policy strands required action at EU and Member State' level, coordination between policy makers was essential. This holds in particular, for euro-area Member States, which   
                                                          
 
(15) Outstanding debt securities amounted to 81% of GDP in 
the euro area in 2007 as agai nst 168% in the United States. 
By contrast, the stock of outstanding bank loans to the 
private sector amounted to around 145% of GDP in the 
euro area, but only 63% in the United States. 
2. Macroeconomic Policies 
 
33 share highly integrated market segments, for 
instance in wholesale activity. 
The financial crisis and the EU's immediate 
response 
66. The banking sector in the euro area was 
not spared the contagion coming from the US.  
Although euro-area banks had not originated risky 
('subprime') US loans, they were exposed to the consequences of US developments through several channels: (i) in a bid to enhance nominal returns, euro-area banks purchased complex securitised financial products on international financial markets (
16). Their exposure to the US housing 
market became a liability after it had sharply deteriorated; (ii) the default of Lehman Brothers put in doubt the viability of even systematically-
                                                          
 
(16) Banks purchased them either directly or through complex 
sponsored structured investment vehicles (SIV), mostly 
located in offshore centres. important financial institutions, with a significant 
rise in risk premia as a result, which made bank funding more difficult and costly; (iii) the aforementioned comprehensive reassessment of risk led markets to question the viability of highly-leveraged financial entities and overly ambitious business models. A number of vulnerable banks were put under stress as a result. Access to liquidity and short-term funding of a number of banks became difficult. 
At the climax of the financial crisis in October 
2008, banks preferred to park their available liquidity with the central bank instead of lending to other banks; (iv) fees and underwriting activity as a source of income suff ered from the growing 
defiance of investors. As a result, the perception of default increased in successive waves, as evidenced through the prices of credit default  
Box 2.2: Unconventional monetary policy measures
In normal times, central banks steer the level of key interest rates in order to manage liquidity conditions in 
money markets and pursue their objective of maintaining price stability. When interest rates fall close to 
zero, a central bank exhausts its capacity to provid e stimulus to the economy via its conventional policy 
tools. The effectiveness of monetary policy is also impaired if the interest rate transmission channel is compromised. In such circumstances, policy-makers have at their disposal additional tools, such as 
quantitative easing, to alleviate financing conditions for the economy.  
Such unconventional measures are generally associated with an increase in the size of central banks' balance 
sheets (see Graph). Through direct quantitative easing  measures, the central bank purchases securities 
(usually government bonds) from banks in order to increase their liquidity. 
It is expected that banks w ill, in turn, use this extra 
amount of liquidity to extend lending to the non-
financial sector, as they will hardly earn any 
additional income from deposits in a near-zero 
interest rate environment. The expected ensuing flattening of the yield curve at longer maturity 
would also encourage investment. 
A variant of quantitative easing, called direct credit 
easing, involves central banks' purchases of private 
papers to address liquidity shortages or excessive spreads in specific financial market segments. An 
alternative method, called indirect quantitative 
easing, involves lending to banks at longer 
maturities against collateral which includes assets 
whose markets are temporarily impaired. Graph: Central banks' balance sheet size 
(in % of GDP)
0510152025
Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09European Central Bank
Federal Reserve System
Bank of England
Source: Commission services.
 
 
European Commission 
Annual Report on the euro area - 2009 
 
34 swaps (17) and other financial instruments (Graph 
2.4). Reduced expectations on banks' profitability over the medium term became apparent from September 2008 on, as bank equities underperformed the all-equity stock price index (Graph 2.5). 
Graph 2.4:  Default risks of euro-area financial institutions 
0100200300400
Jan-08 May-08 Sep-08 Jan-09 May-09in basis pointssubordinate financials
senior
Note: As proxied by iTraxx yield spreads on selected 
financial instruments. 
Source:  EcoWin. 
67. Throughout 2008 the risk of a negative 
spiral on financial markets remained high.  
Several structural features of financial markets 
were prone to pro-cyclicality. In other words, they amplified rather than cushioned the impact of the financial turmoil: (i) rating agencies overlooked risks when financial market activity was buoyant; they downgraded complex products only after it had become apparent to all that these products were not risk-proof; (ii) accounting rules tended to magnify capital losses on securities held in banks' balance sheets; (iii) capital adequacy rules did not promote provisioning against expected loss for credit risk over the entire economic cycle.  
In retrospect, capital cu shions proved to be 
insufficient in comparison to the amount of risk borne. The pressure to keep capital adequacy ratios constant compelled banks to engage in successive waves of recapitalisation, a process that became increasingly difficult as the crisis unfolded. 
                                                          
 
(17) A credit default swap (CDS) is a derivate contract between 
two counterparties. The protection buyer makes periodic payments to the seller, and in return receives a payoff if an 
underlying financial instrument defaults. The price of a 
CDS evolves in tune with the probability of default. Graph 2.5:  Equity prices in the euro area (January 2008 = 
100) 
020406080100120
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09-20-10010203040
Financials (lhs)
EuroStoxx50 (lhs)
Relative value of financials (rhs)
Note: A negative value means that the financial sector is 
under-performing the overall stock index 
Source:  EcoWin, Commission services. 
Deleveraging their positions was another option 
chosen by financial institutions to relieve their capital position. It implied a reduction of financial institutions' asset portfolios, which could hamper the distribution of credit to the economy;  (iv) liquidity in many financial market segments proved to be pro-cyclical, as it dried out completely in acute stress conditions, making it impossible for market participants to reduce their overall risk exposure. Tensions reached a climax in September 2008 with the demise of Lehman Brothers. Faced with the risk of illiquidity of major European players on financial markets and the associated contagion effects national governments resolutely embarked on large-scale rescue measures. 
68. Immediate policy steps targeted the 
provision of liquidity and capital, coverage of 
deposit guarantees schemes and accounting 
relief.  On 12 October 2008, an extraordinary 
Eurogroup Summit at the le vel of Heads of State 
and Government spelled out six principles and objectives for a coordinate d approach to tackle the 
crisis: 
(i) Ensure appropriate liquidity conditions; (ii) Facilitate longer maturity funding; (iii) Allow the provision of additional capital; (iv) Commit to recapitalise distressed banks;  
2. Macroeconomic Policies 
 
35 (v) Apply accounting rules more flexibly; 
(vi) Enhance cooperation and information 
exchange. 
These principles were eventually endorsed by the 
European Council for the 27 Member States the 
following week. First concrete steps within this framework included the Commission's proposal to revise EU rules on deposit guarantee schemes. It entailed an increase in deposit guarantee coverage to a minimum of EUR 50 000 as of 30 June 2009 and to EUR 100 000 by end-2010 as well as a reduction of the payout period. Improved deposit guarantee coverage was aimed at maintaining confidence in banks at a cr itical juncture. Further 
measures covered changes to accounting standards, allowing reclassification of financial instruments from the trading book to the banking book in an effort to avert th e threat of a negative price spiral. 
For its part, the ECB counteracted the shortage of liquidity by adjusting its operational framework to changed market circumstances (for more on monetary policy measures, see Section 2.2). 
69. Rescue packages for national banking 
sectors were rapidly set up . They comprised a set 
of national measures aimed at safeguarding financial stability, restoring the normal functioning of wholesale credit markets and underpinning the supply of credit to the real economy. The main 
instruments that had been used were: 
(i) Capital injections to shore up banks' 
capital base, in order to avoid the dual threat of disorderly deleveraging and bankruptcy; 
(ii) State-backed guarantees on bank 
liabilities to allow banks to tap private debt markets in order to refinance their lending activity; 
(iii) Asset relief schemes in order to relieve 
banks' balance sheets of illiquid assets under specific conditionalities; 
(iv) Increased access to liquidity from Central 
Banks (in some cases covered by state guarantees) as a means to allow business continuity. 
70. National rescue plans, while guided by 
common principles, conformed to country-
specific conditions.  Their features varied along the 
following lines:   (i) Coverage of the schemes both in terms of 
financial instruments/markets and institutions considered; 
(ii) Eligibility criteria for both the financial 
instruments/markets and institutions to gain access to the schemes; 
(iii) Mechanism for implementing the scheme 
(e.g. creation of a special  vehicle, form of the 
capital injection, etc.); and 
(iv) Pricing aspects, conditionality and exit 
strategy. 
71. Rescue packages are subjected to State 
aid control.  Although the EC Treaty generally 
prohibits State aid, it leav es room for a number of 
policy objectives for which State aid can be considered compatible, fo r example 'to remedy a 
serious disturbance in the economy of a Member State' (Article 87 (3) (b)). On this basis, the Commission adopted three major guidance documents outlining how State aid rules would be applied in the context of the current global 
financial crisis: the Banking Communication of 13 October 2008, the Recapitalisation Communication of 5 December 2008 and the Communication on the treatment of impaired assets of 25 February 2009. They were complemented by recommendations on the pricing of recapitalisations and government guarantees for bank debt issued by the ECB. These documents aimed to ensure legal certainty and a level playing field. As of the end of May 2009, the Commission had approved 11 schemes in  the euro area and ad 
hoc interventions in two other euro-area Member States. On 23 July 2009  the Commission agreed a 
Communication explaining its approach to assessing restructuring aid given by Member States 
to banks. The approach is based on three fundamental principles: i) aided banks must be made viable in the long term without further State support, ii) aided banks and their owners must carry a fair burden of the restructuring costs, and iii) measures must be taken to limit distortions of competition in the Single Market. 
European Commission 
Annual Report on the euro area - 2009 
 
36 Graph 2.6:  Write-downs and capital injections of main 
euro-area financial institutions 
050100150200250
3Q2007 4Q2007 1Q2008 2Q2008 3Q2008 4Q2008 1Q2009in billion USDWrite downs
Capital injections
Source:  Bloomberg, Commission services. 
72. Member States allocated sizeable public 
means to banking rescue packages . State 
guarantees and liquidity support measures were the most widely-used measures in the early phase of these plans. Member Stat es proceeded rapidly to 
inject capital into weakened institutions (Graph 2.6). As the impact of the financial crisis continued to impair the provision of credit to the economy, Member States started devising asset relief schemes. 
Finland, Ireland, the Ne therlands and Portugal 
notified guarantee schemes only, while France and   Italy notified guarantee schemes in the first place 
and recapitalisation measures shortly after. Slovenia added a liquidity support measure as a complement to its guarantee. Another group of Member States, which included Austria, Germany and Greece, opted for schemes combining several measures from the start (guarantee, recapitalisation, other forms of equity interventions, etc). Spain notified a fund for the acquisition of financial assets. In addition to general schemes, several Member States have adopted ad hoc individual interventions in favour of certain financial institutions. Overall, the global sum committed and approved by the Commission for the re-capitalisation of banks is about EUR 240 billion (2.7% of the euro-area's GDP, see Table 2.1). As of mid-May 2009, effective injections amounted to about EUR 131 billion of this sum (1.4% of the euro-area' s GDP). A sum close to 
EUR 1,870 billion (20.7% of the euro-area's GDP) has been committed and approved by the Commission to guarantee bank borrowing, of which an amount of about EUR 788 billion has been allocated (8.7% of  the euro-area's GDP). 
These impressive figures compare to data on total US government support for financial assets and liabilities announced in 2008 and in the first  
Table 2.1:  Euro-area public interventions in the banking sector (in % of GDP) 
approved effective approved effective approved effective approved effective approved effective
Austria 5.0 1.7 25.7 5.1 0.4 0.4 1.6 1.5 32.8 8.7
Belgium 5.3 6.1 76.6 16.3 10.1 4.2 NA NR 92.0 26.7
Cyprus 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Finland 0.0 0.0 27.7 0.0 0.0 0.0 0.0 0.0 27.7 0.0
France 1.2 0.8 16.6 4.5 0.2 0.2 0.0 0.0 18.1 5.6
Germany 4.4 1.6 18.6 7.1 1.4 0.4 0.0 0.0 24.4 9.1
Greece 2.0 1.5 6.1 1.2 0.0 0.0 3.3 1.8 11.4 4.6Ireland 6.6 4.2 225.2 225.2 0.0 0.0 0.0 0.0 231.8 229.4
Italy 1.3 0.0 NA 0.0 0.0 0.0 0.0 0.0 1.3 0.0
Luxembourg 6.9 7.9 12.4 NR 0.0 0.0 0.9 0.9 20.2 8.8
Malta 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Netherlands 6.4 6.4 34.3 7.7 3.9 3.9 7.5 7.5 52.0 25.4
Portugal 2.4 0.0 10.0 3.3 0.0 0.0 0.0 0.0 12.5 3.3
Slovakia 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Slovenia 0.0 0.4 32.8 0.0 0.0 0.0 0.0 0.0 32.8 0.4
Spain 0.0 0.0 9.3 3.2 0.0 0.0 2.8 1.8 12.1 5.0
Euro Area 2.7 1.4 20.7 8.7 1.1 0.6 1.0 0.8 25.4 11.5
Memo item
EU-2712.6Total
2.6 1.5 24.8 8.1 0.8 0.4 2.9 2.6 31.2Capital injectionsGuarantees on bank 
liabilities Relief of impaired assetLi
quidit y and bank fundin g 
support
Note: NA - Not available indicates that the amount is not available in the state aid decision. NR - Not reported indicates that  
the amount was not reported by the Member State. Approved : Amounts approved in state aid decisions by the Commission 
under State aid rules. Effective: Amounts from schemes effectively implemented, for example capital effectively injected in banks or State guarantees effectively granted to banks on their issuance of liabilities. Data covers approved measures from 
June 2008 to 17 July 2009 and effective measures from June 2008 to mid-May 2009. 
Source:  Commission services. 
 
2. Macroeconomic Policies 
 
37 months of 2009, which amounted to USD 13,900 
billion (18). 
73. These emergency measures averted a 
meltdown of the EU financial sector . Determined 
and timely action prevented a run on fragile banks, ensured confidence of savers and paved the way for an orderly return to normal market conditions. Short-term interbank lending on money markets gradually improved, as illustrated by the declining spreads between overnight and three-month interest rates. These peaked in October 2008 and fell steadily thereafter (Graph 2.7). 
Graph 2.7:  Interest rate spreads (OIS over three-month 
Euribor, Libor in percentage points) 
050100150200250300350400
Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09in basis pointsEuro area
USA
UK
Source:  Sources: EcoWin, Commission services. 
In June 2009 spreads were broadly comparable to 
those prevailing before the summer of 2008. However, they remained higher than before the emergence of the first tensions on interbank markets in 2007. 
74. Still, global banks have incurred 
significant losses since the start of the financial 
turmoil.  According to estimates published in the 
June 2009 ECB Financial Stability Review, by 28 May 2009 the total reduction in net income attributable to write-downs by global banks since the turmoil erupted has amounted to USD 1,042 billion. US, Canadian and Australian banks reported the bulk of the income losses – about 56% of the overall figure. A further 20% was suffered 
by UK, Swiss and other non-euro-area European banks, and another 20% by euro-area banks. 
                                                          
 
(18) Data from 'Supervisory Insights' Vol. 6 Issue 1, Summer 
2009, Federal Deposit Insurance Corporation. 75. Uncertainties related to total losses over 
the full credit cycle remain . In its Financial 
Stability Review of June 2009, the ECB staff estimated the total amount of write-downs on securities and loans of euro-area banks at USD 649 billion over the four-year period 2007-2010. Losses on securities could amount to USD 218 billion and losses on loan books to USD 431 billion. For its part, the IMF estimated in its Global Financial Stability Report of April that the total amount of write-downs of euro-area banks over the period 2007-2010 could reach USD 904 billion. The differing estimates of  the write-downs reflect 
differences in assumptions made and in the methods used to calculate potential losses on loan exposures. 
76. As a result, doubts about the ability of 
the banking sector to finance the economy 
remained.  Most of the credit slowdown was driven 
by demand factors, i.e. related to the economic slowdown and housing-market corrections. Banks' deleveraging proceeded, with the bulk of the adjustment taken through trimming down external assets. Banks' issuance of debt securities recovered, yet with a high  market share of state-
guaranteed debt. Amid the difficulties in obtaining equity capital from private investors, public capital injections were instrumental in underpinning the level of bank capital. However, persistent uncertainty about the exposure of banks to toxic assets and the impact of the economic slowdown on their credit risk remained. 
The medium-term perspective: regulatory reforms 
77. In October 2007, the Ecofin Council laid 
down a roadmap to tackle the shortcomings of 
the existing regulatory framework . It focused on 
four main issues – transparency, valuation, prudential oversight and the functioning of markets. The EU could thus promote effectively its agenda in talks to reform the international financial system at the G-20 level and in the relevant international fora (see Chapter 3). 
78. The work of credit rating agencies 
should be better framed . The possibility to 
repackage loans and transfer the full credit risk to markets was considered as contributing to the rise in the volume of Collateral Debt Obligations (CDOs), which had been crucial for the build-up of financial imbalances in the US. Private investors  
European Commission 
Annual Report on the euro area - 2009 
 
38 and financial institutions trusted too readily the 
ratings attributed to these financial instruments by credit rating agencies. In November 2008, the Commission proposed a regulation on credit rating agencies, setting out a framework for their authorisation, operation and supervision in the EU. 
79. Smarter rules for bank capital and 
remuneration . At the beginning of 2008, the new 
regime for banks' regulatory capital entered fully into force (Basel II). While most banks were able to keep their capital positions above regulatory requirements, they came under stress due to inherent pro-cyclicality in both investors' strategies and regulatory rules. Firs t, investors became more 
risk-averse as the financial crisis unfolded and markets tightened their view on sustainable capital positions. Banks were then under pressure to improve the size and quality of their capital positions in difficult funding conditions. Second, banks were obliged to hold capital in a fixed minimum ratio to their risk-adjusted assets. In October 2008, the Commission submitted a proposal (adopted by the Council and the European Parliament in April 2009) to amend the Capital Requirements Directive (CRD) introducing important changes so that:  (i) National supervisory authorities will have 
a better overview of the activities of cross-border banking groups; 
(ii) There will be clear  EU-wide criteria for 
assessing the quality of bank capital;  
(iii) Rules on securitised debt will be 
tightened.  
The latter will require that firms that re-package 
loans into tradable securities retain some risk exposure to these securities. It also imposes strict rules on the due diligence that firms must exercise before investing in securitisation positions. The aim is to ensure that firms fully understand the risks involved, including the risk characteristics of the underlying exposures. On 13 July 2009, the Commission adopted a proposal to make further amendments to the CRD, which would: 
(i) impose higher capital requirements for re-
securitisations, and further enforce the required due diligence for highly complex re-securitisations; 
(ii) strengthen the capital requirements for market 
risks in the trading books;  
Box 2.3: Ongoing work on further bond market integration in the euro area
In light of the turmoil experienced in sovereign debt markets, national debt managers took steps to improve 
coordination of their bond issuance. In the context of the Economic and Financial Committee Sub-
Committee on EU Bills and Bonds Markets, government debt managers meet on a regular basis to exchange 
views and promote further the integration and a better functioning of EU government bond markets. Several 
Member States introduced enhanced flexibility and adap tability in their auction strategies to cope with 
difficulties in accessing the market, including the use of syndications (1). This raised the issue of competing 
auctions among euro-area sovereign issuers. Compe tition for intermediaries and investors implies that 
governments face market pressures on prices and spreads. In order to enhance the communication in respect 
of issuance intentions, including syndicated issuance, EU debt managers agreed to update on a more regular 
basis the issuance calendars as well as to publish them on the Sub-Committee's web-page. 
Most euro-area government debt managers (excluding Germany) agreed on a Harmonised Reporting Format 
for their Primary Dealers on their market activities, to be published by the Secretariat of the Economic and 
Financial Committee. Publication would be on a quarterly basis with a three month time lag. Work is further 
under way among government debt managers as regards the harmonisation of auction procedures. 
                                                           
(1) Syndications are used when governments try to achieve cost-effectiveness by appointing a group of institutions 
which, for a ne gotiated fee, will subscribe to its bond issues and then sell them to other retail or institutional investors.  
 
2. Macroeconomic Policies 
 
39 (iii) require firms to have remuneration policies 
that are consistent with and promote sound and effective risk management, and bring remuneration practices within the scope of supervisory review. Banking supervisors will be given the power to sanction banks whose remuneration policies do not comply with the new requirements. 
80. An adequate regulatory framework 
should cover all relevant areas of the financial 
system . Parallel efforts have been undertaken with 
reference to other relevant segments of the financial sector: 
(i)  On 3 July 2009, the Commission 
published a Communication that explores ways to improve the transparency and stability of derivatives markets. 
(ii) The Commission adopted on 29 April 
2009 a proposal for a Directive on Alternative 
Investment Fund Managers (AIFM). The proposed Directive will plug a significant gap in existing legislation related to hedge funds and private equity. It will make all fund managers in the EU subject to authorisation and ongoing supervision. The purpose is to ensure th at funds are transparent, 
with appropriate governance standards, and have robust systems in place for the management of risks, liquidity and conflicts of interest. The proposals differentiate between hedge funds and private equity, so there will not be a one-size-fits-all approach. 
(iii) Since pay and bonus systems inside many 
financial institutions tended to encourage excessive risk-taking and reward short-termism, the Commission adopted on 29 April 2009 a Recommendation on remuneration in financial services. The Recommendation aimed to link pay and incentives to long-term performance and prevent excessive risk-taking behaviour. In addition, the proposed amendments of the CRD which were unveiled in July 2009 would impose binding principles for sound remuneration practices in banks and investment firms. 
(iv) Finally, the Commission adopted on 29 
April 2009 a Communication concerning investor protection in the field of packaged retail investment products. 2.4. THE EUROPEAN ECONOMIC RECOVERY 
PLAN (EERP) 
81. The European Economic Recovery Plan 
constitutes Europe's integrated response to the 
crisis.  As the financial and economic crisis 
intensified, the Commission presented in its Communication of 26 November 2008 a European Economic Recovery Plan (EERP) to combat the economic downturn. It was later endorsed by the European Council of 11  and 12 December 2008. 
The EERP aims at cushio ning the blow of the 
recession in the short term by swiftly stimulating demand, boosting consumer confidence and lessening the human cost of the economic downturn. At the same time, the EERP promotes measures needed to reinforce Europe's 
competitiveness in the medium and long term through structural reforms and smart investment. Thus, the EERP is designed to ensure full coherence between immediate actions and the EU's medium- to longer-term objectives. As a result, fiscal policy developments in the euro area have been guided by this comprehensive EU response to the crisis. 
The fiscal arm of the EERP 
82. The budgetary pillar of the EERP is a 
major injection of purchasing power into the 
economy.  Extraordinary circumstances combining 
a financing crisis and a recession justify budgetary 
expansion in the EU and the euro area (see Section 2.1). Member States a nd the EU agreed on an 
immediate fiscal impulse amounting to EUR 200 billion (1.5% of GDP). It consisted of a budgetary expansion by Member States of EUR 170 billion and EU funding in support of immediate actions of the order of EUR 30 billion (see Box 2.6). 
83. The EERP sets out a framework for 
coordinating national budgetary measures . Since 
the EU budget is too small to be used for EU-wide economic stabilisation, national governments are enacting the bulk of fi scal measures. This 
multiplicity of decision-makers calls for proper coordination so that the positive impact of national decisions can be mutually supporting. Beggar-thy-neighbour policies or free-riding on the stimulus generated by others would be detrimental to both the EU and the euro area as a whole. To ensure effectiveness the Commission spelled out three conditions for fiscal action to be consistent with 
European Commission 
Annual Report on the euro area - 2009 
 
40 the EERP: it should be timely, targeted and 
temporary. 
84. Timely measures are much-needed to 
support demand in the short run . Fiscal policy is 
notoriously slow to deliver tangible results, owing to the need for government s to structure and adopt 
measures, and effectively disburse funds. These 
lags explain why the EERP had to be launched quickly with a view to steering national governments towards taking resolute and coordinated measures. Rapid action would boost demand, defuse the risk of vicious circles and complement other action taken. 
85. Targeted measures must pinpoint 
vulnerable populations and sectors and prepare 
for the future . Governments must not repeat the 
mistakes of the 1970s, when wasteful broad-based fiscal stimuli had a deleterious effect on fiscal positions without much impact on potential growth. With necessarily limited resources, measures on the expenditure side must target low-wage earners, small and medium-sized enterprises, and economic sectors which are especially hard-hit by the recession. Credit-constrained households are likely to spend most of the additional purchasing power, with a fast impact on growth as a result. Well-designed financial incentives can provide at the same time relief for economic agents, facilitate the transition to a low-carbon economy and improve trend productivity (for instance, by introducing tax breaks for energy efficiency investment). 
86. Temporary measures are warranted so 
that they can be reversed once the economy 
rebounds.  The effectiveness of expansionary fiscal 
measures depends crucially on whether market participants perceive such  measures as temporary. 
Calculations with the Commission services' QUEST III model show that the fiscal stimulus would be far less effective if households and companies were to believe that today's fiscal effort would be followed by extra taxes or eventually threaten debt sustainability (Table 2.2) (
19). To 
avert this threat, commi tments to reverse the 
impact of the fiscal stimulus must be taken and made credible enough to maximise effectiveness. 
                                                          
 
(19) Roeger W., in't Veld J. 'Fiscal policy with Credit 
Constrained Households, ' European Economy Economic 
Papers 357, January 2009. Measures must have built-in reversibility features 
so that Member States  can switch back to 
consolidation course wh en economic recovery 
picks up steam. 
 
Table 2.2:  First year GDP effects of fiscal stimulus 
amounting to 1% of GDP 
Fiscal measurePermanent 
stimulusTemporary 
stimulus (one 
year)Temporary with 
monetary 
accommodation (1)
Investment 
subsidy0.46 1.37 2.19
Government 
investment0.84 1.07 1.40
Government 
consumption0.36 0.99 1.40
Consumption tax 0.37 0.67 0.99
Government 
transfers0.22 0.55 0.78
Labour tax 0.48 0.53 0.68
Corporate profit 
tax0.32 0.03 0.05
Notes: The table depicts the GDP percentage difference 
from baseline for global shocks of 1% of (baseline) GDP, 
assuming long-run financing through labour tax increases. (1) Unchanged national interest rates for one year 
Source:  Commission services 
 
87. However, not all Member States are in a 
position to contribute to the overall effort . The 
fiscal effort should take  account of the starting 
fiscal positions of each Member State. Countries 
which took advantage of good economic times to achieve more sustainable public finance positions have more room for manoeuvre. Countries which were lagging behind have less leeway. Countries saddled with high public debt and macroeconomic external or domestic imbalances should also exhibit prudence, since capital markets may adversely react to a further deterioration of such imbalances. These elements are encapsulated in the concept of 'fiscal space',  that is 'the room in a 
government's budget that allows it to provide resources for a desired purpose without jeopardising the sustainability of its financial position or the stability of the economy' (
20). 
According to QUEST III simulations, if risk 
premia on both sovereign and private debt increase because the fiscal stimulus  is perceived to be non-
credible, the short-term fiscal multiplier is reduced to close to zero. Therefor e such countries are not 
 
                                                          
 
(20) For more information see European Economy X/2009 
'Public finances in EMU – 2009 '. 
2. Macroeconomic Policies 
 
41 encouraged to engage in net fiscal stimulus, but 
will benefit from the fiscal stimuli of neighbouring countries. 
88. Automatic stabilisers will also contribute 
to smoothing out the economic cycle . This effect 
derives from progressive tax systems and social and unemployment benefits. Tax revenues decrease more than proportionately when GDP 
falls. Similarly, expenditure for social and unemployment benefits increases markedly in economic bad times. Both effects worsen the fiscal position and produce a smoothing countercyclical effect. They are called 'automatic' because their action does not require discretionary interventions by fiscal authorities. Because of the larger  
Box 2.4: Government accounts and bank rescue schemes
Governments have mobilised substantial public funds in  support of the banking sector. This box summarises 
how such government measures in support of the financial sector impact government accounts (in particular 
the government deficit and gross debt) compiled according to the European System of Accounts, which are 
relevant for the Stability and Growth Pact. 
As a general ESA rule, transactions are recorded according to their economic substance, rather than on the 
basis of formal considerations. In 2008, governments in the euro area used four tools to support their 
domestic banking sectors: 
(i) Recapitalisation includes the purchase of new (or existing) shares in quoted and unquoted banks. Most 
cases of purchase of equity are recorded without any direct impact on the government deficit, unless the 
government has paid for the shares more than their mark et price or fair value, or if the expected rate of 
return is deemed to be insufficient. In all cases, the purchase of equity adds to the government gross debt. 
(ii) Granting a loan has no direct and immediate impact on the government deficit. However, there will be a 
need to record a deficit-increasing transaction in the future, in case of insolvency of the debtor. The debt 
increases in all cases. 
(iii) Asset relief schemes, i.e. the purchase of impair ed financial assets previously in the banks’ balance 
sheet, are also neutral for the government deficit provided that the price paid by the government is estimated 
to be a fair value. However, a deficit-increasing capital transfer is booked in case the price paid was in 
excess of the fair value. Government disposal of these a ssets at maturity or earlier, will lead to holding gains 
or losses. These are usually recorded in the revaluation account and have no direct impact on the 
government deficit. As in the other cases, the debt also increases. 
(iv) Guarantees to banks’ liabilities (bonds or loans) have also been granted by governments. A guarantee is 
a contingent liability that has no direct impact on the pub lic deficit and debt. In case the debtor honours his 
liability, the guarantee is never booked in the government finance statistics. However, in the cases the 
guarantee is called and the liability has to be taken over by the government because the debtor defaults, there 
will be an increase in both government deficit and debt at the time of the debt takeover. Governments 
usually collect some fees when they grant guarantees. These fees are recorded as sales of services and 
reduce the government deficit. 
Most support to the financial sector has been directly provided by the government. However, there are a 
number of cases in relation to which one needs to consider the classification in government or in other 
sectors of the entities providing support. To make economic substance prevail over legal arrangements, a 
transaction in support of the financial sector carried out by a public corporation (e.g. a government-owned bank that is classified in the corporate sector) for public policy purposes under government instructions 
rather than for commercial reasons will be recorded in the government accounts. By the same token, support 
provided by privately-owned entities (like bad banks or ganized as special purpose vehicles established by 
the private sector) does not, in principle, enter government accounts. However, these bad banks often benefit 
from government guarantees; in that case, rules applicable to the treatment of guarantees apply. 
 
 
European Commission 
Annual Report on the euro area - 2009 
 
42 government sector in the EU (in 2008 the 
expenditure-to-GDP ratio in the EU was almost 47% compared to 39% in the US), automatic stabilisers play a more important role than in the US. They explain why fiscal balances are also deteriorating in countries with no fiscal space to 
enact discretionary measures. 
89. Supporting households' purchasing 
power relies both on automatic stabilisers and on 
discretionary measures . Against the background 
of a decline in private consumption for 2009, measures that support household disposable income and purchasing power help to sustain consumption and aggregate demand. They also provide income support for groups hit hardest by the downturn. 
90. Bank rescue packages are also a 
component of the overall fiscal stimulus  (see 
Section 2.2). Bank guarantees, asset relief schemes  and capital injections have important macroeconomic stabilisation functions. They will weigh substantially on public debt (see Box 2.4 on the accounting treatment of  bank rescue package 
measures) and reinforce th e need for appropriate 
exit strategies. 
91. The revised Stability and Growth Pact 
allows Member States to combine short-term 
fiscal stimulus with medium-term sustainability 
considerations.  The 2005 revision of the Pact 
allows better account to be taken of cyclical conditions while strengthening medium- and long-term fiscal discipline. The resulting framework is 
more demanding in good times but affords more flexibility in bad times. It functioned broadly well in 2006-2007, as the general government deficit was reduced to 0.7% of GDP in the euro area, although its narrow scope meant that not enough emphasis was laid on growing macroeconomic imbalances within a number of EU and euro-area countries. Most Member States are now running 
deficits above 3% of GDP. But that does not mean that the functioning of the Stability and Growth Pact is impaired. Excessive deficit procedures have been opened against a number of countries (see Section 1.3). Member States putting in place counter-cyclical measures submitted an updated Stability Programme in December 2008, which spelled out the measures taken to eventually reverse the fiscal deterioration and ensure long-term sustainability. The Commission has assessed them against the following objectives, well in line 
with the SGP principles: 
(i) ensuring the reversibility of measures that 
increase deficits in the short run; 
(ii) improving budgetary policy-making in 
the medium term, through strengthening of the national budgetary rules and frameworks; 
(iii) ensuring the long-term sustainability of 
public finances, in particular through reforms curbing the rise in age-related expenditure. 
92. All in all, fiscal policy should provide 
support to the economy in the region of 5% of 
GDP over 2009 and 2010.  According to 
simulations conducted  with the Commission 
services' QUEST III model based on announced national measures, the stimulus measures will have a positive impact on GDP growth of slightly more than 0.75 GDP points in 2009 and 0.3 GDP points in 2010 for the EU as a wh ole. This shows that the 
EU and the euro area are doing their fair share of 
the work to support the global economy, in line 
with the outcome of the G-20 Summits in Washington and London (see Chapter 3). 
Graph 2.8:  Fiscal policy stance in the euro area 
-4-3-2-101234
2004 2005 2006 2007 2008 2009 2010Change in CAPB
GDP growth
 
Note: Commission services' spring forecast for 2009 and 
2010. CAPB: Cyclically-adjusted primary balance. 
Source:  Commission services. 
The structural arm of the EERP 
93. The European Economic Recovery Plan 
calls for 'increased e fforts to implement 
structural reforms envisaged in the Lisbon 
strategy' . While the main aim of  structural reforms  
 
2. Macroeconomic Policies 
 
43 is to tackle longer-term challenges, structural 
policies can immediately contribute to recovery efforts. A particularly relevant issue to consider is the interplay between short-term effectiveness and the challenge to provid e proper incentives for 
employment and growth in the medium and longer term. Structural reforms improve the resilience of economies and contribute to the recovery by facilitating the adjustment process, which is all the more important in a monetary union such as the euro area. In addition, engaging in structural reforms can have macroeconomic and distributional effects in the short term that mitigate the economic and social im pact of the downturn. 
Moreover, adherence to ambitious structural reform agendas can enhance the credibility of short-term policy responses to the economic slowdown. In this respect , the country-specific and 
euro-area Member Stat e recommendations under 
the Lisbon strategy (see Box 2.5) offer guidance for structural reforms with a view to raising the growth and jobs potential over the medium term. 
94. Labour market measures should 
combine immediate policies reacting to the rapid deterioration of employme nt levels with medium- 
and long-term reforms.  Employment decreases 
more in countries that are more exposed to the boom-bust cycle in construction and finance. The slump in employment is expected to be more persistent where job-specific skills reduce workers' mobility across sectors. A first priority is to avoid job losses in sectors and firms that were fundamentally sound prior to the crisis. Policies that promote mobility from contracting to expanding sectors, adequate unemployment insurance and active labour-market programmes will facilitate the matching process. The Commission signalled in its communication to the Spring European Council that indiscriminate, tax-funded support for jobs in declining industries or regions should be avoided, as this could delay necessary restructuring. 
95. Investment measures have the potential 
to influence trend growth . Private investment has 
been hit hard in the cu rrent economic climate. 
Investment growth is forecast to remain negative in 2010. Against this background, investment    
Box 2.5: 2008/2009 council recommendations to the euro area in the context of the Lisbon 
strategy
• Ensure timely and consistent implementation of all pending and new EU financial services legislation and 
take measures to deepen cooperation among national authorities within the EU in the fields of crisis 
prevention, management and resolution. 
• Taking into account the fiscal stimulus injected during the current economic crisis, euro area Member 
States should take appropriate measures to secure the sustainability of their public finances in line with the 
Stability and Growth Pact. Where appropriate address macroeconomic imbalances, contain persistent 
inflation divergences or trends of unbalanced growth. 
• Improve the quality of public finances by reviewing public expenditures and taxation and by modernising 
public administration, with the intention to enhance productivity and innovation and to pursue a dynamic 
and competitive single market, thereby contributing to economic growth, employment and fiscal 
sustainability. 
• Vigorously implement the EU Common Principles of Flexicurity in accordance with the specific 
circumstances of each Member State and fully compatible with sound and sustainable public finances; and 
enact measures to promote labour mobility across border s, regions, sectors and occupations; better align 
wage growth with productivity, employment growth and competitiveness at the aggregate, sector, regional 
and occupational level. 
 • Step up reforms that increase the flexibility and competition in goods and services markets and contribute 
to deepen the internal market. 
 
 
European Commission 
Annual Report on the euro area - 2009 
 
44  
Box 2.6: The community pillar of the EERP
EU funds announced in the EERP have supported action in the most critical areas affected by the crisis. 
Funding of the order of EUR 30 billion in support of immediate actions help stem  the loss of jobs, protect 
workers, and promote investments to modernize Europe's infrastructures. Progress with the implementation 
of Community measures to support growth and jobs is promising. Importantly, close cooperation between 
the Commission, the Council and the European Parliame nt was established which helped speed up decision-
making and enabled the EU to take swift action. 
Additional EUR 6.3 billion have already been made available for EU Member States in 2009 through the 
frontloading of Structural Funds to help underpin growth and employment and prepare our economies for 
recovery. This frontloading implies more than a doubling of the structural funds advances to Member States 
in 2009 and will support smart investment in growth-enhancing areas for employment and businesses. 
To further lessen the human cost of the economic downturn, the Commission has proposed a renewal of the 
European Globalisation Fund (EGF). The European Parliament recently adopted this proposal. The renewed 
EGF will allow more workers made redundant in the crisis to be helped. In particular, funds will be made 
more easily available through: (i) an increased funding rate from 50% to 65% until the end of 2011; (ii) by lowering the eligibility threshold for EGF applications  from 1,000 to 500 redundant workers in a sector, 
region or undertaking; and by (iii) extending the duration of EGF support to 24 months (from the current 12 
months) to leave sufficient time for the measures to be  effective in re-integrating particularly the most 
vulnerable workers into new jobs. 
The European Investment Bank (EIB) is playing an important role in enhancing access to finance and in 
particular the financing of the development of new business opportunities. The EIB plans its lending to 
increase to EUR 70 billion in 2009, EUR 25 billion more than originally foreseen. Lending to small and 
medium enterprises (SMEs) and lending from the Europ ean clean transport facility loans is being strongly 
increased. The EIB expects to be able to provide almost EUR 7 billion in loans by July for automotive sector 
projects, while initially EUR 4 billion was foreseen. 
Under the Trans-European Network programme (TEN-T) the Commission launched on 31 March a EUR 
500 million call for individual projects. These funds have been brought forward to support works which can 
start in 2009 or 2010 and be largely implemented over this two-year period (or which have already started but can be accelerated over 2009 and 2010). 
The Commission's proposal to mobilize EUR 5 billion for trans-european energy interconnections and 
broadband infrastructure projects has been approved by the European Parliament and the Council. This 
allows Europe to get moving immediately on projects that will provide a welcome boost to the European 
economy and make a real contribution to giving Europe more energy security and better availability of high-
speed internet in the future.  
A total of EUR 3.2 billion will be allocated from 2010 to 2013 for research proj ects through three public-
private-partnership (PPP) initiatives with half of the funds coming from industry and half from the 
Community budget. The "Factories of the Future" PPP initiative (EUR 1.2 billion) aims at helping EU 
manufacturing enterprises, in particular SMEs, to adap t to global competitive pressures by increasing their 
knowledge and use of the technologies of the future. The objective of the "Energy-efficient Buildings" PPP 
initiative (EUR 1 billion) is to deliver, implement and optimise building concepts that have the potential to 
drastically reduce energy consumption and decrease CO² emissions, both in relation to new buildings and to 
the renovation of existing buildings. The "Green Ca rs" PPP initiative (EUR 1 billion) focuses on the 
development of renewable and non-polluting energy sources, safety and traffic fluidity in the automotive 
field. 
 
 
2. Macroeconomic Policies 
 
45 measures lay the groundwork for a stronger 
recovery for two reasons. Firstly, economic growth would be positively influenced in the short run, given the relatively large multiplier effects associated with increased investment. Secondly, over the longer run, higher investment can remove various impediments to growth and enable faster recovery when conditions improve. From a competitiveness perspective, well-designed investment policies help to raise trend productivity and strengthen competitiveness. Conversely, a sustained fall in investment may have significant implications for future productivity growth rates. Such a contraction in physical investments would also be at odds with the need to adapt the 
infrastructure to climate and energy challenges. 
96. In the short run business support 
measures can help counter unnecessary labour 
shedding and the exit of otherwise viable and 
sound companies.  These take the form of three 
main types of action: i) measures to ease financing constraints on businesses; ii) sector-specific support, and iii) non-financial support measures. These measures can contain the negative effects of the crisis on potential output by preventing a permanent loss of knowledge and skills and a reduction of productive capacity. However, a trade-off exists between the desirable short-term aim and potentially adverse distorting effects over the medium term. In order to limit risks to competition and preserve a level playing field within the Single Market, the EERP underlines the critical importance of the temporary character – for 
the duration of the crisis – of business support measures. 
2.5. FIRST ASSESSMENT OF NATIONAL 
MEASURES TAKEN UNDER THE EERP 
97. Most Member States have drawn up 
national recovery plans in response to the EERP 
and they are now being implemented . On the 
basis of a preliminary assessment, the Commission reported to the 2009 Spring European Council that the agreed level for a co-o rdinated fiscal stimulus 
(1.5% of EU GDP) had been met. In response to worsening economic conditions, several Member States have announced additional discretionary fiscal measures on top of their national recovery programmes announced before the 2009 Spring European Council. As a resu lt, in the euro area, the size of the announced discretionary financial 
stimulus over 2009 and 2010 has reached 1.8% of the euro-area GDP to date. This brings the total euro-area budgetary support to underpin growth and employment, which in cludes the support from 
automatic stabilisers, to 4.6% of the euro-area GDP (5% of GDP for the EU as a whole). 
98. The scale of the measures varies greatly 
from one Member State to another . In 2009 the 
largest fiscal stimulus in the euro area is being run in Spain (2.3% of GDP). Other sizeable stimuli are 
being undertaken by Austria (1.8%), Finland (1.7%), Malta (1.6%), Germany (1.4%) and 
Luxembourg (1.2%). Given their limited room for fiscal manoeuvre, some Member States make little or no contribution to the EERP. This category comprises Cyprus, Greece, Ireland, Italy and Slovakia. Overall, in structural terms, i.e. net of cyclical factors and one-off and other temporary measures, the projected de terioration in the euro 
area in 2009 (1% of  GDP) is smaller than that of 
the headline deficit, but still significant given that many Member States supp ort their economies with 
discretionary measures under the EERP (Table 2.3 and Graph 2.8). The fiscal stimulus is expected to be around 0.8% in 2010. 
 
Table 2.3:  Total fiscal stimulus over 2009 and 2010 by 
Member State (in % of GDP) 
Total Expenditure Revenues
AT 3.6 0.8 2.8
BE 0.8 0.5 0.3
CY 0.1 0.0 0.0
DE 3.3 1.2 2.1EL 0.0 0.0 0.0
ES 2.9 1.6 1.3
FI 3.8 1.0 2.8
FR 1.0 0.7 0.3
IE 1.0 0.6 0.4
IT
(1)0.0 0.0 0.0
LU 2.6 0.1 2.5
MT 3.2 2.7 0.5
NL 1.9 0.8 1.1
PT 1.0 1.0 0.0
SI 1.1 0.9 0.2SK 0.1 0.0 0.1
Euro Area 1.8 0.8 1.02009-2010
Note:  Italy has adopted fiscal measures in response to the 
downturn, but their net impact is either neutral or deficit-
reducing. 
Source:  Commission services 
 
99. The funds allocated to the economy 
could be broken down in four categories . Out of 
the 590 national measures reported by euro-area 
European Commission 
Annual Report on the euro area - 2009 
 
46 Member States to the Commission: (i) 22% are 
supporting households' purchasing power; (ii) 25% are buttressing investment activity; (iii) 32% are in support of industrial sectors, businesses and companies; (iv) 21% should improve the functioning of labour markets. In volume terms, support to household purchasing power absorbs most of the additional budgetary resources over 2009–2010 (0.9 percentage points of GDP). These are followed by investment-related measures (0.5% of GDP) and measures aimed at companies (0.3% of GDP). Labour market measures make up a rather small part (0.1 percentage points of GDP) of total measures adopted so far. It should be noted, however, that some measures are of a cross-cutting nature as they can affect both household income and labour markets (for example measures in the field of tax and social contributions). The following paragraphs look at these four categories 
of measures. 
Support to households' purchasing power 
100. Support to households' purchasing 
power accounts for the lion's share of national 
measures . Most measures relate to changes in 
income tax rates, tax bands or thresholds and to some extent also social contributions. Some measures are directed at  alleviating mortgage 
payments for those hardest hit by the crisis. Some Member States have temporarily lowered VAT on selected consumer goods. 
101. General changes in income tax schemes 
have been implemented in several Member States.  
Non-negligible reductions in effective income tax 
rates have been implemented in Germany and Finland, while other countries have made more limited changes to tax bands or other parametric changes (Luxembourg, Spain and Malta). On the one hand, general income tax reductions have the advantage of being transparent, easily implemented and unbias ed towards specific 
sectors. They also tend to  increase incentives to 
work. On the other hand, depending on the design of the tax cuts, high-income earners often benefit more (in absolute tax reductions), which may reduce the impact on aggregate consumption, given their relatively low propensity to consume. These measures are also often costly and liable to become permanent, which may explain their limited scope in many Member States. Several countries have also adju sted social security contributions paid by employees (for example 
Germany and the Netherlands). 
 
Table 2.4:  Overview of structural reform measures 
relevant to national recovery programmes 
Supporting 
household 
purchasing 
powerSupporting 
investment 
activitySupporting 
industrial sectors, 
businesses and 
companiesSupporting the good 
functioning of 
labour markets
AT 17 14 18 8
BE 11 9 16 17
CY 6 7 5 5
DE 12 14 13 8
EL 5 6 5 9
ES 17 11 36 14
FI 6 6 4 12
FR 18 12 21 12
IE 3 6 2 3
IT 9 10 8 7
LU 8 7 8 2
MT 1 3 5 2
NL 3 17 14 7
PT 8 7 16 6
SI 0 10 9 5
SK 4 6 12 8
EA 128 145 192 125
In % 22% 25% 32% 21%Breakdown of measures by category
(number of measures)
Note: In some cases, a measure can be relevantly classified 
under two policy type headings or contribute to multiple 
policy objectives. In other cases, measures needing clarification are not included in the statistics of the table 
Source:  Commission services. 
 
102. Specific support is provided to the most 
vulnerable group of citizens . The focus of these 
measures is mostly on low-income households but also pensioners and families with children. Such measures are applied for example in Belgium, Spain, Germany and the Netherlands, although targeted measures are often of a limited overall size in terms of budget impact. Support is ensured through targeted tax cuts  and benefits' increase. 
Finally, there are also me asures that subsidise 
household consumption of certain goods and services. By focusing on groups with relatively high propensity to consume, such measures may be more cost-efficient than more general ones. While in some cases arguments could be raised as regards negative incentives to work, this may overall be less of a concern in a context of high, crisis-induced, unemployment. 
Labour market measures 
103. The financial crisis and the ensuing 
global downturn are beginning to impact 
significantly on labour markets.  Recent data 
confirm that unemployment is now rising steeply, and projections indicate that employment will decline in absolute terms over the next two years 
2. Macroeconomic Policies 
 
47 leading to a further steep rise in unemployment, 
which, on unchanged policies and labour market   
Graph 2.9:  EERP - Measures aimed at supporting 
household purchasing power in the euro area 
(fiscal stimulus as % of country GDP, 2009-2010) 
2.2
0.10.02.1
0.00.52.6
0.21.0
0.02.4
0.5 0.5
0.10.0 0.00.9
0123
AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK EA16
Source:  Commission services. 
behaviour, is set to exceed 11% in 2010. Overall, 
labour market measures represent a small proportion of the total discretionary fiscal impulse (Graph 2.10) but can be quite cost-effective in the present circumstances. 
104. Flexible working time arrangements are 
being adopted in several Member States.  
Temporary working time reductions, temporary 
closures of factories and other forms of short-time work implemented by firms to prevent mass layoffs are underpinned by public support schemes. Many euro-area countries have either introduced new forms of public support for flexible working time or temporary unemployment (Portugal, Slovenia and Slovakia), or extended the duration or the level of existing public support schemes (Austria, Germany, France, the Netherlands, Belgium and Italy). Some Member States provide incentives for using the reduced hours for training activities (Austria, Belgium and Germany) in order to maximise the employability of workers on short-time arrangements. The experience so far with such measures is positive.  
105. Training and active labour market 
policies should ensure that structural 
unemployment does not increase . Almost all 
Member States are endeavouring to support and ease the re-integration into the labour market of recently laid-off workers.  Training opportunities and incentives have been expanded in Austria, 
Greece, Finland, France, Portugal and Slovenia. Overall, it is too early to judge whether the measures taken are adequate and will thus reduce the risk of a detrimenta l increase in long-term 
unemployment. 
Graph 2.10:  EERP - Labour market measures in the euro 
area (fiscal stimulus as % of country GDP, 
2009-2010) 
0.40.5
0.00.2
0.0 0.00.00.1
0.0 0.0 0.00.10.3
0.2
0.1
0.00.1
0.00.10.20.30.40.5
AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK EA16
Note: EA excluding Luxembourg.  
Source:  Commission services 
106. Other measures attempt to boost labour 
demand through reductions in social security 
contributions.  Measures such as reductions in 
social security contributions, cutting income taxes or changes in wage setting can influence –directly or indirectly– labour costs, depending on whether the measures are temporary or not. Rebates on social security contributions to boost labour demand have been applied in a number of euro-area Member States and have typically been made conditional on job creation (in Belgium, Spain, France, Portugal and Slovakia). Lowering labour costs for both employers and employees is already a feature of some medium-term national reform programmes and has gained additional relevance in the framework of the cris is (Belgium, France and 
Germany). Increased competitiveness has been sought in the Netherlands, where wage moderation over the medium term is traded against cuts in social security contribu tions for both employers 
and employees. In the same vein, Belgium has extended the inter-sectoral structural wage adjustment system, which is a scheme consisting of a reduction of wage costs and taking the form of a partial exemption from the withholding tax on wages. However, in countries with a deteriorated competitiveness position, such policy actions are less prominent. 
European Commission 
Annual Report on the euro area - 2009 
 
48 107. Improving the incentives to work 
embedded in the tax and benefit system is in line 
with long-term economic goals . Apart from some 
countries where the tax pressure on labour was reduced, especially for low-wage earners (Finland and Malta), most measures appear to be temporary and contingent on the economic crisis. Income supplements and targeted in-work tax credits have been reinforced (Belgium, the Netherlands and Slovakia). Commuters' tax allowances have been increased (Austria and Slovakia) and the design of unemployment insurance has been modified so as 
to increase work attractiveness (Spain and Italy). Newly implemented social assistance schemes are conditional upon availability to work (France). A few measures were also taken to support female labour market participation (in Malta and the Netherlands). 
Investment policies 
108. Nearly all euro-area Member States 
have announced measures aimed at supporting 
investment in physical infrastructure . The 
prominence attached to public investment in recovery efforts varies considerably across Member States, with the largest increases in spending as a percentage point of GDP observed in Germany, Cyprus, Spain, Malta, the Netherlands and Slovenia (Graph 2.11). By type of physical infrastructure, a majority of the measures aim at 
supporting investment in transport infrastructure. 
The bulk of these investments is related to the road and railway sectors. The information available suggests that investment in transport infrastructure is focused on traditional infrastructure with few measures geared to innovative solutions (such as modernisation of air traffic control infrastructure as in Slovenia). 
109. The second biggest group of investment 
expenditure relates to the construction sector . 
Many are focused on education facilities or other social infrastructure. Im plementation is mostly 
planned for 2009 or 2010 but in practice projects often lag behind schedule. In this perspective, investment in maintenance tends to be timelier (especially for measures to renovate existing buildings in Austria, Spai n, France and Portugal). 
A significant number of measures provide support 
to the building sector without being linked to energy efficiency improve ments. In cases where 
the housing market has experienced a bubble such measures may implicitly contribute to postponing 
the necessary restructuring of the oversized construction sector and thus lead to lower long-term productivity. 
Graph 2.11:  EERP -Measures aimed at stepping up 
investment expenditure in the euro area 
(fiscal stimulus as % of country GDP, 2009-2010) 
0.4
0.2
0.01.0
0.00.9
0.40.4
0.0 0.0 0.02.5
0.9
0.40.4
0.00.5
0.00.51.01.52.02.5
AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK EA16Source:  Commission services. 
110. Supporting energy-efficiency investment 
will mitigate the impact of the downturn while 
contributing to achieving long-term objectives.  
Speeding up the shift towards a low-carbon 
economy allows the EU to implement its climate change policy and reduce dependence on imported energy. Examples of specific measures include grants to small-scale energy-efficiency renovations (Ireland, Luxembourg, the Netherlands), public procurement for low-carbon or highly energy-efficient public buildings (France, Austria), tax and other financial incentives, etc. Such investments have the potential to stimulate job- and innovation-rich sustainable construc tion and renewable energy 
markets and are in line with long-term objectives. They will help minimise insolvencies of companies in the eco-innov ation sector, which is 
expected to be dynamic and highly competitive when the economy starts recovering. Measures to support energy-efficiency  investment focus on 
reducing the energy consumption of buildings, which account for over 40% of the EU's final energy consumption. Countries like Austria, Germany and Finland have reinforced guarantees and agreements with national public financial institutions to provide loans and other financial risk-covering instrume nts. The European 
Investment Bank has also announced a substantial increase in its lending in 2009 and 2010 for low-carbon and energy-saving infrastructure projects. 
2. Macroeconomic Policies 
 
49 111. Research and Development (R&D) 
measures can increase productivity growth and 
competitiveness.  R&D measures generally account 
for a small share of investment measures. Recovery measures mostly aim at helping R&D funding at a time when financial institutions tend to be more risk-averse. A significant proportion of R&D measures are targeted at SMEs. Firms' support takes the form of loans (Germany, Austria), R&D tax credits (Germany, Spain, Ireland, the Netherlands), depreciation rule (France and Germany) and direct subsidies (Austria, Germany, Finland). The pr eliminary assessment of 
recovery measures suggests that some countries are more successful in aligning their short-term actions with their medium- and long-term needs: for instance, Germany with detailed measures aimed at SMEs; Slovenia with measures aimed at fostering private R&D; Belgium and Spain, with fiscal incentives aimed at attracting researchers, as well as the Netherlands, reinforcing support instruments to stimulat e private R&D. The EERP 
encourages Member States  to conduct research on 
green technologies. Among the countries in the euro area, plans to invest  in green technologies can 
be found in Spain, France, Italy and Germany. There might be a risk, however, that the crisis may widen the R&D gap between 'innovation leaders' and 'moderate innovators' and 'catching-up countries' (
21). 
Business support measures 
112. The overall response to the crisis in 
terms of business support measures is strong . 
Business support measures comprise: (i) the easing of financing constraints; (ii) sector support; and (iii) non-financial business support. The strong recourse to such measures can be explained by the fact that the crisis has se verely affected European 
businesses and industries, firstly through tightening financial conditions, and secondly through a generalised contraction of global demand associated with a widespread loss of confidence among both consumers and businesses across the world. For an overview of business support measures at the i ndividual country level, 
see Graph 2.12. 
                                                          
 
(21) This terminology is taken from the European Innovation 
Scoreboard. Graph 2.12:  EERP- Business support measures in the euro 
area (fiscal stimulus as % of country GDP, 
2009-2010) 
0.6
0.0 0.0 0.0 0.01.5
0.8
0.3
0.0 0.00.20.10.20.30.6
0.00.3
0.00.61.21.8
AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK EA16
Source:  Commission services. 
Easing financing constraints  
113. Almost all euro-area countries have 
moved to counteract the drying-up of credit for 
businesses . Examples of relevant policies are the 
extension of credit guaran tees, including export 
credit, particularly for SMEs; the increase in the capital of public development banks to bring this about; easing conditions for access to and repayment of loans; temporary tax reductions and exemptions; and changes in depreciation rules favouring SMEs. These measures are for the most part horizontal in nature and are considered to be effective in the short term without major risks, as long as their temporariness is ensured. 
114. Corporate taxation has been adjusted to 
improve the fiscal environment for businesses.  In 
the euro area corporate taxes have been lowered on a permanent basis in some euro-area countries (France, Luxembourg and Slovenia) and on a more temporary basis in others (the Netherlands, Portugal, Greece and Spain). Already in 2008, Germany implemented a corporate tax reform that reduced the corporate tax rate from 25% to 15%, which is providing substantial relief for corporations over the period 2008-2012. 
115. Other financial measures were also 
undertaken.  Germany, the Netherlands, Austria, 
France and Finland indicated changes in the rules governing capital depreciation; the Netherlands, Spain and France adopted measures such as VAT acceleration payments, and Portugal, the Netherlands and Belgium sped up government bills. Some Member States have also moved to 
European Commission 
Annual Report on the euro area - 2009 
 
50 ensure that financial sector problems do not 
undermine financing and insurance of foreign trade. 
Sector support  
116. Sectors receiving support account for a 
large and variable share in the economies . All 
measures supporting specific sectors have an inherent potential to distort competition or hinder the process of economic restructuring within the EU. Most Member States have put in place horizontal frameworks that allow policy support to be given to sectors that are most affected by the crisis (e.g. cars, tourism, construction). Most measures seem temporary,  targeted and timely. 
However, while the most affected sectors are broadly the same in all Member States, there is a considerable variation across Member States in terms of support actually provided – both in terms of sectoral composition and regarding the mix between supply- and demand-side measures. Therefore, even if schemes are consistent with internal market and stat e aid rules, they could 
nevertheless have an effect on the internal market through their differential impact on corporations depending on the Member State in which they are located. 
117. Sector-specific measures focused on the 
automotive industry . Ten euro-area countries 
(Germany, Spain, France, Italy, Cyprus, the Netherlands, Luxembourg, Austria, Portugal and Slovakia) have implemented car-scrapping schemes to support demand. These measures are temporary and make support conditional on the purchase of new or nearly new vehicles that should be less polluting. Most of the scrapping schemes were helping to generate additional car sales at the beginning of 2009, thus stimulating short-term demand. New passenger car registration increased in Germany, France and Sl ovakia by a significant 
amount (+40% on a year in Germany in June 2009). 
118. Measures in the automotive industry 
have also been taken on the supply side . The 
automotive sector is being supported in France ('Pacte Automobile' proposed in February 2009), Italy and Spain (Competitiveness automobile plan proposed in March 2009), Austria and Portugal. In addition, companies receive support through other schemes: greening of products (Germany, Spain and France) or subsidised loans (France). The 
environmental challenge to which the car sector is exposed makes it the main beneficiary of the greening schemes. 
Non-financial business support 
119. Non-financial business support includes 
reduction of administrative burdens and 
implementation of regulatory reforms.  This set of 
measures is warranted where fiscal constraints may limit recourse to other options to enhance the business environment. Also, where such measures are already at an advanced stage, they can contribute to accelerating the adjustment process 
of the eventual recovery through an improved business environment, es pecially in countries 
where doing business was less easy before. Significant improvements in the business environment can be expected from a rapid and thorough implementation of the Services Directive and reforms in services going beyond the Directive.  
120. Most of the measures undertaken in this 
area relate to the reduction in administrative 
burdens for businesses . Such measures are being 
taken in Italy, the Netherlands and Malta. Others aim at stimulating entrepreneurship and SME activities, improving the conditions for starting up new businesses (Belgium and Spain). In 2008, prior to the crisis, structural reforms were implemented in the French services sector, especially in retail, where various constraints on opening new shops were lifted. Spain committed to accelerate the implementation of the Service Directive. The reform of  professional services 
should also create positive effects. Finally, improvement of the administrative implementation of Structural Funds has been put on the agenda in Slovakia. 
Overall assessment of national economic 
recovery measures 
121. The preliminary findings are 
encouraging.  Member States’ recovery 
programmes constitute a robust response to the crisis and are broadly in line with the principles 
enunciated in the EERP,  encompassing financial 
rescue packages, fiscal st imuli, temporary support 
to hard hit sectors and targeted support to vulnerable groups. Most measures seem 
2. Macroeconomic Policies 
 
51 temporary, targeted and tim ely, although there are 
some questions relating to the reversibility of a number of policies. The stimulus package - alongside significant monetary easing and important bank rescue plans - has arguably put a “floor” to the collapse of economic activity in the EU and the euro area. Importantly, there are no obvious cases of rolling back past reform measures. 
122. As regards progress with recovery 
measures in specific areas, the following insights 
can be drawn : 
Labour market policies  in many Member States, 
notably through innovative short-term working measures and common guidance developed at EU level, have to date been rather effective in stopping unemployment from shooting up. Overall, however, labour market measures only represent a small proportion of the total discretionary fiscal impulse. Given the sharp projected rise in unemployment, and the la rge economic and social 
costs of long-term unemployment or withdrawal from the labour force, more emphasis is now needed on policies to support the unemployed. There is considerable variation across Member States in the composition of their labour market 
response by types of measures, and consequently there seems to be scope for policy learning between Member States. 
123. As regards investment,  a welcome finding 
is that new or accelerated spending on public investments forms a signi ficant share of fiscal 
stimuli in line with the EERP. As the focus is mostly on projects already in the pipeline, most actions will support economic activity in 2009 and  2010. Moreover, there is a degree of focus on 
energy efficiency, althou gh at the aggregate level 
there are few indications of a substantial shift towards green investment. Going forward, a key policy issue is whether the observed fall in private investment will have significant adverse repercussions on R&D spending, and in turn be detrimental to potential growth. 
124. As regards business support  measures, 
most Member States have put in place horizontal frameworks that allow temporary policy support to be given to sectors that are most affected by the crisis (e.g. automobile, tourism, construction). However, there is considerable variation across Member States in terms of support actually provided and the effectiveness of national schemes for industries that operat e across the whole of the 
internal market could be somewhat limited. Risks remain that recovery measures adopted shortly after the outbreak of the crisis deepen rather than reduce intra-euro area m acroeconomic divergences 
(see Section 1.5). 
125. Overall, the preliminary analysis 
indicates that Member States have adopted a 
wide-ranging policy response to the economic crisis in line with the approach indicated in the 
EERP.  The effectiveness and adequacy of 
measures will need to be continuously monitored in terms of the evolving economic situation. An exchange of best practices can help to improve mutual learning and enhance the effectiveness of measures in order to use the potential of the single market to the full. Devising detailed exit strategies would complement existing national frameworks and ensure the sustainable nature of the recovery. 
3. THE EXTERNAL DIMENSION 
 
52 126. The international financial crisis has 
pushed the world economy in its first global 
recession in post-war history . This chapter looks 
at how the external envir onment of the euro area 
evolved over the last year. Section 3.1 starts by investigating how the shocks spread over the world economy and what meas ures policymakers of 
major economies took to alleviate the impact of the crisis. Section 3.2 goes on to describe the recent developments in the exchange rate of the euro. Section 3.3 looks at the impact of the crisis on global imbalances. Section 3.4 presents recent efforts by world leaders to reform the international financial system. Section 3.5 explores the impact of the crisis on the international position of the euro. 
3.1. THE GLOBAL NATURE OF THE CRISIS 
127. The financial crisis started in the 
advanced economies … After the bursting of the 
US sub-prime bubble the crisis spread rapidly through financial channels to other advanced economies. Tightening financing conditions caused economic activity to slow down and 
advanced economies fell into recession in the fourth quarter of 2008. 
128. … and spread to emerging markets 
afterwards.  Emerging markets seemed to be 
initially sheltered from the financial turbulence thanks to their limited exposure to US subprime loans. However, the situation changed with the intensification of the financial crisis in autumn 2008. Sudden re-pricing of risk and flight to quality triggered massive withdrawal of funds from emerging markets. Funding provided to emerging markets by foreign banks dried up on the back of financing problems in their home countries. Internal imbalances in some emerging markets, veiled previously by favourable financing conditions, became exposed, adding to investors' risk aversion. 
129. World trade suffered heavily . At the end 
of 2008, trade collapsed as a result of the synchronised fall in demand in all parts of the world economy. World trade fell at an annualised rate of 24% in the last quarter of 2008. The scale of this drop was unpreced ented and illustrated the 
depth of international trade linkages due to the rapid extension of global production chains during 
the last two decades (
22). These developments had 
severe consequences for the export-oriented Asian economies, where exports contracted at double-
digit rates. In addition to the slump in demand, increasing difficulties in obtaining trade credit and insurance also played a role. 
Graph 3.1:  Capital flows to emerging and developing 
economies, annual flows 
-600-400-2000200400600800
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009in billion USDDirect investment, net
Private portfolio flows, net
Other private capital flows, net
Source:  IMF World Economic Outlook database. 
130. No economic area seemed to be spared . 
With the exception of China and India, where the slowdown was nevertheless marked, growth is expected to be negative in most of the world's economies in 2009. Going by the past experience of financial and banking crises, world growth will be sub-par also in 2010. According to the Commission services' spring forecast, world growth is set to decrease by 1.4% in 2009 and to increase by 1.9% in 2010. World trade is expected 
to contract by 11% in 2009, and edge up (+¾%) in 2010. This outlook for global activity and trade is the bleakest since World War II. Emerging markets are likely to recove r somewhat faster from 
economic doldrums as they might benefit more from the expected gradual recovery in trade. 
131. The US economy entered a severe 
recession in the second half of 2008 . The bursting 
of the real estate bubble and the ensuing breakdown of the sub-prime mortgage market had acute consequences for the real economy. Tightened financial conditions and large capital losses depressed consumer confidence and consumption. Savings, which had been on a 
                                                          
 
(22) The largest quarterly decrease recorded thus far was 
-11.1% in the first quarter of 1975. 
3. The External Dimension 
 
53 declining path for two decades, rose sharply. In the 
face of the slump in demand, businesses cut production, employment and investment. Exports fell rapidly on the back of the collapse in external demand. Growth tumbled at an annual rate of 5.4% during the fourth quarter of 2008 and 6.4% during the first quarter of 2009.  Growth decreased at a 
slower annual pace –1.0 percent– in the second quarter of 2009. A return to positive growth numbers is only projected for the second half of 2009. The magnitude of the contraction in 2008/09 is likely to exceed the decline in output during all previous recessions since the Second World War. Macroeconomic policy measures, a possible stabilisation of the housing market in the second half of 2009 and the downward adjustment in business inventories should translate into annual GDP growth of -2.9% in 2009 and +0.9% in 2010. 
Graph 3.2:  World trade and GDP growth (annual average 
growth rate) 
-12-9-6-3036912
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010in %
Trade volume of goods and services
GDP, constant prices
Source:  Commission services, IMF. 
132. The Japanese economy was hit hard by 
the collapse in external demand . Initially 
Japanese banks and financial institutions seemed relatively shielded from the fallout of the US subprime crisis because they had adopted cautious investment strategies following the banking sector crisis of the 1990s. Yet the Japanese economy was severely affected by the crisis. Due to its dependence on exports, the economy went into 
recession in mid-2008 as  demand from the EU and 
US collapsed. The recession intensified and broadened to all sectors of the economy. Corporate profits were eroded, financial conditions deteriorated, and a negative feed-back loop between the real and the financial sectors materialised. The downturn affected the labour market, and unemployment surged to levels not seen since the Asian financial crisis. In 2009, the 
Japanese economy is expected to contract by -5.3% (after -0.7% in 20 08) and to stagnate in 
2010. 
Graph 3.3:  Profiles of GDP growth in major economies 
(2007-2010) 
-4-3-2-1012
2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3quarter-on-quarter changeEuro area
USA
Japan
Source:  Commission services' spring forecast. 
133. The Chinese economy slowed down 
rapidly, but growth remained robust . China fared 
better than many other economies thanks to its limited reliance on external financing. However, after the crisis spread worldwide, China's exports fell sharply, affecting private investment and consumption. After growing at an annual rate of 
13% in 2007, GDP deceler ated to 6.8% year-on-
year in 2008Q4 and 6.1% in 2009Q1. Growth then accelerated again to 7.9% year-on-year during the 
second quarter, as a large fiscal stimulus programme unfolded. 
 
Table 3.1:  GDP growth in major economies 
2008 2009 2010
World 3.1 -1.4 1.9
USA 1.1 -2.9 0.9
Japan -0.7 -5.3 0.1
China 9.0 6.1 7.8
Russia 5.6 -3.8 1.5
Note: Data for 2009 and 2010 from the Commission services' 
spring forecast. 
Source:  Commission services. 
 
134. After a decade of robust growth, Russia 
is expected to fall in to recession in 2009 . Similar 
to the situation in other emerging economies, the crisis became visible only in the second half of 
2008. Hit by a dual shock of drying sources of external finance and dropping commodity prices, the economy stalled towards the end of 2008. In 2009, real GDP is forecast to contract by -3.8%, 
European Commission 
Annual Report on the euro area - 2009 
 
54 and to recover only slowly in 2010. The large 
fiscal surplus that had been built up thanks to high commodity prices and robust growth is expected to turn into a deficit on the back of an expansionary fiscal policy. 
Policy measures to sustain growth  
135. The crisis triggered energetic policy 
responses to support growth . International 
coordination of policy stimuli was crucial in order to ensure effective polic y action. In an open 
economy parts of the national demand stimulus spills over across the borders thus limiting the growth impulse for the domestic economy. G-20 Summits were instrumental in fostering a worldwide coordinated approach to policy stimulus (see Section 3.4). As a consequence, in most large economies (advanced and emerging alike), policy actions were taken to support demand. 
136. The US authorities made massive use of 
fiscal measures to combat the crisis . Two large 
stimulus packages were adopted. The Economic Stimulus Act of February 2008 consisted mainly of rebates in personal income taxes and had a total budgetary cost of USD 168 billion (1.2% of 2008 GDP). Households seemed to have spent up to about half of the tax rebates received. It supported GDP growth temporarily in the middle of 2008. A second and much larger stimulus package (the American Recovery and Reinvestment Act) was adopted in February 2009. Its total budgetary cost was estimated at USD 787 billion (5.5% of 2008 GDP). Almost three quarters of this sum is foreseen to increase public spending: infrastructure projects, assistance to state and local governments, extension of unemployment insurance benefits and additional funding for other existing social programmes. The rest of the stimulus has financed cuts in personal income ta x. Measures estimated to 
cost 2.1% of GDP were apportioned to 2009 and most of the remainder to 2010. This second stimulus package is expected to provide significant support to economic activity in the second and third quarters of 2009, but with a fading effect thereafter.  
137. US monetary policy was loosened 
aggressively . Continuing the cycle of interest rate 
cuts from the preceding year, the Federal Reserve gradually reduced the federal funds target rate from 4.25% at the beginning of 2008 to a range 
between 0 and 0.25% in December. This exceptionally low level was to be maintained for an 'extended period'. However, due to credit market disruptions, the effectiveness of interest-rate policy was reduced. Consequently, since the autumn of 2008, the Federal Reserve has been taking unconventional measures to ease inappropriately tight financial conditions. In particular, it resorted to 'quantitative easing' (see Section 2.2 for a definition), which involved a large increase in its balance sheet through the introduction or expansion of lending facilities, the purchase of vast amounts of agency (Government-Sponsored Enterprises) debt and mortgage-backed securities. In March 2009, the Federal Reserve started to purchase longer -term Treasury securities, 
thereby partially monetising the government deficit. Also in March 2009, the Federal Reserve launched the Term Asset-Backed Securities Lending Facility (TALF) – a USD 1 trillion programme aimed at restarting the securitisation process by providing low-cost funding to investors who purchase asset-backed securities. 
138. The US authorities provided direct 
support to the financial sector . Most prominently, 
the Troubled Asset Relief Program (TARP) was launched in October 2008. TARP received a total budget of USD 700 billion. The initial amount proved insufficient in the face of the losses in the financial sector. In February/March 2009, it was modified to more effectively relieve the financial system of impaired assets  and to unfreeze credit 
markets. A Public-Private Investment Program was introduced and could eventually expand to USD 1 trillion in the process of removing impaired assets from the balance sheets of private banks. To assess 
the vulnerability of the banking system, US regulators carried out 'stress tests' to gauge the health of the 19 biggest US banks. This revealed that banks might require more reserves in the event of a further deterioration in the economic outlook. Ten out of the 19 banks were found to be in need of a combined USD 74.6 billion of extra funds to boost their reserves. 
139. Japan adopted the highest-ever fiscal 
stimulus in spite of limited room for manoeuvre . 
One of the lessons from the Japanese entrenched crisis in the 1990s was that policy reaction, in order to be effective, must be swift and decisive. In view of the severity of the situation, the Japanese 
3. The External Dimension 
 
55 government announced a first policy package 
responding to the crisis in August 20 08. Because 
of the worsening economic situation, another stimulus package, equivalent to 3% of GDP, was adopted in April 2009. These packages represent the biggest stimulus ever adopted in Japan. The measures focus on direct cash payments to households, tax cuts, investment support and subsidies. The government also decided to inject public funds into firms (including banks) that had become undercapitalised and were unable to secure financing because of the financial crisis. Other measures were designed to provide credit guarantees, in particular to SMEs and exporters. However, the highest debt-to-GDP ratio among OECD countries (almost 170% in 2007) limits the room for manoeuvre. The authorities' medium-term fiscal consolidation programme involves reaching primary surplus by financial year 2011 and a progressive reduction in the debt-to-GDP ratio afterwards. However, due to the sharp deterioration of the economic situation, the primary deficit is now projected to exceed 2% of GDP in Fiscal Year 2011, and debt is forecast to progressively approach 200% of GDP. 
140. The Bank of Japan (BoJ) cut interest 
rates to virtually zero . As interest rates had already 
been very low before the crisis, the BoJ adopted a 
wide range of unconventional monetary measures to support growth and counteract tightening financing conditions. The BoJ increased liquidity provision and broadened the range of eligible collateral. To support corporate financing and financial institutions, the BoJ has been buying commercial paper and corporate bonds, while providing long-term loans to banks at 0.1% interest. 
141. The arsenal of policy instruments 
available to Chinese authorities is wider and 
deeper . China can rely on many assets: (i) foreign 
reserves reached USD 1.95 trillion at the end of 2008; (ii) its debt level is  low (18% of GDP); (iii) 
its fiscal position is relatively sound; and (iv) China's monetary policy still has room for manoeuvre. For these reasons China is in a better position to counter the negative consequences of the turmoil in the international economy than most other emerging economies. In the run-up to the G-20 summit in November 2008, the Chinese authorities announced a very large fiscal stimulus package amounting to RMB 4 trillion (around 13% of GDP). As a result, growth in the second quarter 
of 2009 benefited from the stimulus package. While investment in fixed assets is likely to remain buoyant, a stronger pe rformance of private 
consumption is unlikely due to uncertainties for employment prospects. 
142. The bulk of the fiscal stimulus was 
allocated to infrastruc ture and construction 
projects.  The net additional spending was much 
lower than the headline figure of RMB 4 trillion, as the programme incorporated expenditure which had already been earmarked (e.g. reconstruction efforts following the 2008 earthquake in Sichuan province). Given that the central government is 
directly in charge of only RMB 1.2 trillion, the 
final impact of the package depends, to a large extent, on lower levels of government, which usually promote investment in fixed assets. A relatively small part of the stimulus was dedicated to social security schemes, in particular to the health sector, where reforms could help spur domestic consumption. As a result, China's trade and current account surpluse s are likely to remain 
high in 2009 and in the following years. 
Graph 3.4:  Changes in EUR cross-rates since 02 Jan 2008 
-3.8
-17.3
14.9
-7.6
14.7
-9.9
30.1
12.2
9.4
- 3 0 - 2 0 - 1 0 0 1 02 03 04 0THB/EURPHP/EURKRW/EURCNY/EURSEK/EURCHF/EURGBP/EURJPY/EURUSD/EUR
30/06/09in %
Note: "-" indicates euro depreciation 
USD = US Dollar; JPY = Japanese Yen; GBP = Pound Sterling; 
CHF = Swiss Franc; SEK= Swedish Crown; CNY = Chinese Renminbi; KRW = Korean Won; PHP = Philippine Peso; THB = Thai Baht. 
Source:  Commission services. 
143. After a long period of tightening, 
monetary policy was loosen ed in the second half 
of 2008.  Faced with a real estate bubble, stock 
market exuberance, and inflationary pressures, monetary policy was further tightened in the first half of 2008. The financial crisis put a temporary end to these threats, an d the strong decline in 
global commodity prices drove consumer prices 
European Commission 
Annual Report on the euro area - 2009 
 
56 down. Therefore monetary policy was assigned to 
growth stimulation. The People's Bank of China (PBoC) reduced the benchmark lending rate from 7.47% in summer 2008 to 5.31% in April 2009. The reserve requirement ratio (RRR) was lowered from 17.5% to 15% for most banks over the same period of time. Equally important for easing monetary conditions was the lifting of limits on credit growth and the en d of moral suasion on 
banks not to lend, which had been employed earlier to avoid overheating. This policy delivered results in the first months of 2009. Increased bank lending amounted to RMB 7.5 trillion in the first seven months of 2009. 
144. In Russia, policymakers enacted an 
extensive set of policy measures on the fiscal 
side...  The combined value of all the measures 
taken as a response to the crisis was estimated at 14% of Russian GDP, spread throughout 2008-2010. Measures in the fis cal package ranged from 
cuts in oil export duties,  reduced corporate income 
tax to increased unemployment benefits. Responding to fears of banks' insolvency, bank 
deposit insurance was extended. The State started buying unsold real estate on the market to prevent a collapse in prices. Short-selling of stocks was prohibited, and caps were set for currency swaps and foreign assets of banks. The authorities re-capitalised several banks and encouraged further consolidation of the banking system. 
145. … as well as on the monetary side . To 
provide liquidity and support of stock markets, the Central Bank of Russia (CBR) and the Ministry of Finance resorted to frequent direct short-term injections of liquidity. The CBR provided loans to banks without any collateral. Banks could also be compensated for losses in curred on the interbank 
lending market and benefited from a long-term credit facility of RUR 950 billion (USD 36 billion) in the form of subordinated loans with a ten-year maturity. Banks with lower credit ratings were able to borrow on a repurchase agreement basis from the CBR. Companies and banks could obtain re-financing for maturing external debt. Moreover, exchange-rate policy has been used actively to 
encourage depreciation of the currency. 3.2. RECENT DEVELOPMENTS IN THE EURO 
EXCHANGE RATE 
146. The financial crisis increased exchange 
rate volatility and triggered sudden trend 
reversals.  In the wake of the financial crisis, 
foreign exchange markets were largely driven by portfolio shifts and changes in risk perception. In particular, in the second half of 2008, the increasing tensions in the global financial markets as well as the rapid global economic downturn led to diminished demand for risky assets. As a result, large and liquid currencies served as 'safe havens', while smaller currency areas saw waning demand and capital flight. The coordinated central bank actions, together with fiscal stimulus packages, eventually mitigated risk aversion and led to some exchange-rate stabilisation worldwide. 
147. Since January 2008, the euro has 
depreciated by around 4% against the US dollar 
amid significant volatility . In the first half of 2008, 
the euro strengthened agai nst the dollar reaching a 
record high in nominal terms, slightly above USD 1.60 in mid-July 2008. The appreciation was driven by hopes that the euro area could decouple 
from the downturn in the US. The significant widening of the euro area-US interest rate differential also played a role. The ensuing reassessment of the outlook for growth and interest rates as well as precautionary flows into dollar assets led to a depreciation of the euro to USD 1.25 by the end of October 2008. The euro strengthened temporarily at the end of 2008 as the Federal Reserve embarked on a zero-interest-rate policy. However, rate cuts by the ECB and concerns over public finances in some euro-area Member States as well as worries about prospects for euro-area banks with Eastern European subsidiaries, pushed the euro lower again in early 2009. The euro started gaining ground again in mid-March on the back of the Federal Reserve's decision to enhance its quantitative easing policy and to directly buy government securities. On 30 June 2009 the euro stood at USD 1.41, some 4% below its January 2008 level (Graph 3.4). 
148. The euro weakened substantially against 
the yen. Owing to the large interest rate 
differential, the euro ap preciated strongly against 
the yen in the first half of 2008, reaching JPY 170 
in July 2008, the highest level in the euro's history. In the subsequent months, the intensifying tensions 
3. The External Dimension 
 
57 in financial markets led to a significant increase in 
risk aversion among investor s. In addition, interest 
rate differentials between Japan and the euro area 
began to narrow. These factors led to portfolio shifts by Japanese enterprises and households and to the unwinding of carry trades (
23). As a result, 
the euro depreciated sharply against the yen to JPY 116 in mid-January 2009. Since then, the euro has 
been recovering as the do wnturn in the Japanese 
economy intensified and the trade surplus fell. At the end of June 2009 the euro-yen exchange rate 
stood at JPY 135, which corresponds to a fall of 17.3% compared to the beginning of 2008.  
Graph 3.5:  Euro exchange rates (daily data) 
1.11.21.31.41.51.61.7
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09110120130140150160170
USD/EUR (lhs)
JPY/EUR (rhs)
Note: Last observation is 30 June 2009. 
Source:  Commission services, ECB. 
149. The British pound has been hit hard by 
the global deleveraging . The pound sterling has 
been one of the currencies most negatively affected since the onset of the financial market crisis. After a sharp depreciation of the pound in December 2008, the euro reac hed a record high of 
0.98 against the pound at  the end of 2008. It 
amounted to a 34% appreciation over one year, half of which took place in December alone. The 
fall in the pound was the result of a change in market sentiment attributable to concerns about the UK's twin deficit (a large trade deficit coupled with a growing budget deficit and large contingent liabilities) and sharp interest rate cuts by the Bank of England at the end of 2008. There were also widespread fears that the recession in the UK would be deeper than in other advanced economies due to its dependence on financial services and to the bursting of the house price bubble. In 2009, 
                                                          
 
(23) Carry trades consist of borrowing in currency at low 
interest rates (e.g. Japanese ye n) in order to invest in a 
currency offering high interest rates (e.g. the euro). this perception of divergence faded somewhat as 
growth forecasts in the euro area were also revised downwards. As a result, the pound regained some of the ground lost against the euro and stood at 0.85 at the end of June. 
150. Other European currencies have also 
recorded significant depreciation against the 
euro . These include the Swedish Crown and the 
currencies of the new EU  Member States with 
flexible exchange rate regimes (the Czech koruna, the Polish zloty, the Romanian leu and the Hungarian forint), as well as non-EU currencies such as the Russian rouble . Increased risk aversion 
and the 'flight to quality' constituted the common factor behind these exchange rate moves. In times of elevated uncertainty investors seek the safety and liquidity of large international currencies. In some cases, however, a correction of the strong past appreciation experienced before the financial turmoil was part of the explanation.  
Graph 3.6:  Euro real effective exchange rate (41 
countries, CPI deflated) 
708090100110120
1994 1996 1998 2000 2002 2004 2006 2008average 1994-2008=100
Source:  Commission services. 
151. Overall, the euro appreciated in effective 
terms.  Weighting the bilateral exchange-rate 
movements by trade flows with its 41 most important partners, the euro stood about 3% higher in June 2009 than at the beginning of 2008. In real effective terms, i.e. taking into account the differences in consumer pr ice inflation between the 
euro area and its trading partners, the euro appreciated by 2.6% over  the same time span. 
However, volatility within this period was high. Two rounds of considerable appreciation (in early 2008 and since November 2008) contrast with a significant depreciation in the period from April to November 2008.  
European Commission 
Annual Report on the euro area - 2009 
 
58 3.3. GLOBAL IMBALANCES – AN UPDATE 
152. Global imbalances – a cause for global 
concern.  The term 'global imbalances' refers here 
to the pattern of curr ent account deficits and 
surpluses that have been building up in the world economy since the late 1990s (
24). The United 
States and some other countries developed large current account deficits, while other systematically important economies developed large surpluses (notably China, Japan, and oil exporting countries). There are two reasons to be worried about these asymmetries in external positions. First, correcting the imbalances to sustainable levels may require large exchange rate adjustments with possible disruptive effects on global financial markets and economic act ivity. Second, as the 
experience of the financial crisis shows, large global imbalances can cont ribute to the creation of 
excess global liquidity, the reinvestment of which can exacerbate asset price booms and sow the seeds of future global instability. 
153. The crisis has so far led to some 
correction of the imbalances . It is mainly due to 
the marked declines in domestic demand in the key deficit countries – the US and the UK, which together account for 60% of the total world current account deficit – and the fa ll in oil prices since 
August 2008. Table 3.2 shows that in 2008 current account imbalances narrow ed in the US, the UK, 
Japan and China. The surpluses widened in 2008 in most of the oil-exporting countries on the back of the steep increase in oil prices in the first half of the year. Nevertheless, th e annual data mask a 
marked reduction in the surpluses in the second 
half of the year. In China,  the surplus increased in 
dollar terms despite falling as a percentage of GDP. 
154. The US has led the reduction in current 
account deficits . Reflecting the sharp deceleration 
in domestic demand and the effect of the dollar depreciation between 2002 and mid-2008, the US current account deficit narr owed from the peak of 
                                                          
 
(24) The current account of the balance of payments keeps a 
record of all current trans actions (such as exports and 
imports, tourist expenditure, di vidend and interest income) 
between a country and the rest of the world. The difference 
between exports and imports of goods and services (i.e. 
trade balance) usually constitutes the largest part of the current account. An economy posting current account 
deficits (surpluses) can be characterised as having a level 
of consumption higher (low er) than its production. 6.0% of GDP in 2006 to 4.7% of GDP in 2008. 
The correction was briefly interrupted in the first half of 2008 due to the sh arp increase in oil prices, 
but resumed in the second half of 2008 due to the weakness of US domestic demand and the marked fall in oil prices. The US income balance (
25) 
improved and the surplus increased from 0.4% of GDP in 2006 to 0.9% of GDP in 2008. The decline in interest rates, which has been more pronounced in the US, resulted in a sharper decrease in income payments on foreign-owned assets in the US than in income receipts on US-o wned assets abroad. As 
this phenomenon is temporary, this source of improvement in the US income balance is unlikely to last. 
155. The UK also reduced its current account 
deficit. The current account deficit narrowed from 
2.9% of GDP in 2007 to 1.7% of GDP in 2008. This follows a period of gradual increase in the deficit between 1997 and 2006, which resulted in a peak of 3.4% of GDP in 2006. The main factor explaining the recent improvement in the UK's current account deficit is the sharp increase in the 
UK's surplus on the income account, which primarily records investment income flows, including losses from asset write-downs. In 2008, the income surplu s reached its highest value (2.3% 
of GDP) since records began in 1955. Much of this improvement is linked to the impact of the financial crisis on write-downs on UK assets held abroad and foreign assets held domestically. It seems that the losses of foreign investors holding UK assets have been higher than the losses of UK investors holding foreign assets. In the second half of 2008, the trade defic it showed an improving 
trend, reflecting the re latively deep and early 
downturn in the UK and the strong depreciation of the pound (see Section 3.2). Recently, however, 
the trend in the UK’s trade balance has been broadly flat. 
156. Surpluses narrowed in Japan and China 
as a percentage of GDP . Japan's current account 
surplus fell from 4.8% of GDP in 2007 to 3.2% of GDP in 2008, mainly driven by the decline in the trade surplus. Japan's trade balance turned into a slight deficit (0.1%) in 2008Q4 for the first time since records began in 198 5. The marked decline 
                                                          
 
(25) The income balance is a subcomponent of the current 
account balance. It traces net income deriving from direct 
investments, portfolio invest ments and other investments. 
3. The External Dimension 
 
59 in global demand for Japanese exports and the 
lagged effects of the appreciation of the yen that had occurred between 2007 and 2008 seemed to be the main factors explaining the deterioration in Japan's trade balance. In addition, the income account – which had previously been stable – recorded a significant fall in its surplus on the back of falling overseas investment receipts (they declined from 3.1% of GDP in Q3 to 2.1% of GDP in Q4). In China, the current account surplus increased from USD 372 billion in 2007 to USD 426 billion in 2008 but fell as a percentage of GDP from 11% to 10.5%. Exports declined sharply in the second half of 2008 as a result of the contraction in global demand. Imports, however, fell even more sharply in value terms due to lower oil and other commodity prices. As a result, the trade surplus increased. 
 
Table 3.2:  Current account balances of major 
economies (as % of GDP) 
2005 2006 2007 2008
USA -5.9 -6.0 -5.3 -4.7
Japan 3.6 3.9 4.8 3.2
Euro area 0.4 0.3 0.1 -0.7
UK -2.6 -3.4 -2.9 -1.7
China 7.2 9.5 11.0 10.5
GCC 
countries27.4 28.7 25.1 27.2
Russia 11.0 9.5 5.9 6.1
Note: GCC stands for Gulf Cooperation Council. 
Source:  IMF Spring 2009 World Economic Outlook and 
China's State Administration of foreign exchange. 
 
157. Surpluses of most oil-exporting 
countries widened in 2008 . The increase in 
surpluses was mainly due to the steep rise in oil prices in the first half of the year. Current account 
data for Russia and trade data for the Gulf Cooperation Council countri es (GCC) showed that 
the increase in surpluses in the first half of the year was partially reversed in the second half due to the sharp fall in oil and other commodity prices. 
158. Despite some rebalancing, global 
imbalances have remained large and should stay 
on the policy agenda . There is the risk that some 
of the recent improvements may unwind when the global recovery takes hold and international commodity prices increase again. In the medium 
term, the continuing reduction of global imbalances and a move towards a more balanced global growth path will be essential to limit the risks of another crisis in the future. IMF multilateral consultations in 2007 concluded that major economies should take bold policy measures 
over the medium term. In the US, measures should aim at increasing domestic savings (both public and private). In China, the share of private consumption in China’ s GDP should increase 
(facilitated by an orderly appreciation of the renminbi), while higher potential growth should be sought in the euro area and Japan. 
3.4. REFORMING THE INTERNATIONAL 
FINANCIAL ARCHITECTURE 
159. The global financial crisis exposed 
shortcomings in the international financial 
architecture . Fragmented supervision of global 
financial market players and lack of macro-prudential oversight preven ted early detection of 
the mounting financial problems and delayed remedies (see Section 2.3). Favourable macroeconomic conditions provided a fertile breeding ground for asset price bubbles and current account imbalances . In particular, overly 
accomodative monetary policy in some developed economies and insufficien tly flexible exchange 
rate policies in some key emerging market economies contributed to the build-up of global macroeconomic imbalances and asset price inflation. 
160. The global nature of the crisis 
underlined the need for truly global action . After 
the intensification of the financial crisis in September 2008, there was a growing consensus among world leaders on the urgent need for joint action on a global scale. Against this background, the leaders of the Group of Twenty (
26) (G-20) met 
for the first time in Washington on 15 November 2008. European heads of state and government played a key role in launching the G-20 summit. The EU Presidency, the Pr esident of the European 
Commission and the ECB represented the EU in the G-20 process. The Washington summit set out broad principles for reform, as well as some specific short- and medium-term actions in response to the crisis. 
                                                          
 
(26) The Group of Twenty Finance Ministers and Central Bank 
Governors was established in 1999 and brings together the 
19 biggest world economies plus the European Union, 
represented by the EU Pres idency and the ECB. The 
countries are represented by the respective Finance 
Ministers and Central Bank governors. The Washington 
meeting was the first one on the level of state leaders. 
European Commission 
Annual Report on the euro area - 2009 
 
60 161. As the economic situation was 
worsening, G-20 leaders further coordinated 
their responses.  As the economic situation 
deteriorated further, the leaders of the G-20 met 
for the second time on 2 April 2009 in London. They hammered out further details of the collective action necessary  to stabilise the world 
economy, to reform global financial regulation and supervision, and to strengthen the international financial institutions. World leaders showed their determination to work together to overcome the crisis and restore confidence. The EU contributed actively and substantively to the G-20 process, insisting on the importance of financial regulatory and supervisory reform, facilitating the coordination of positio ns among EU Member 
States and contributing financial resources to Summit agreements. Measures taken were aimed at: (i) restoring growth; (ii) improving financial regulation and supervision; and (iii) strengthening international financial institutions. 
Restoring economic growth 
162. Faced with an unprecedented downturn, 
the G-20 agreed on an unparalleled joint policy 
action.  Overall, the leaders pledged an additional 
USD 1.1 trillion of resources aimed at fighting various facets of the crisis. These funds will finance a comprehensive programme by international institutions with the aim of supporting credit, growth and jobs in the world economy (
27). 
163. Decisive measures at national level 
contribute to mitigating the severity of the global 
downturn . Leaders agreed to deliver the sustained 
fiscal effort necessary to  restore world economic 
growth, within the constraints of ensuring medium-term fiscal sustainability. Central banks, fighting the crisis in the front line since its beginnings, pledged to maintain expansionary monetary policy and to use the full range of available instruments, while maintaining price stability. However, these actions could not be fully effective until domestic lending and international capital flows were restored. Therefore, repairing the credit channel and dealing with financial institutions' impaired assets were given high priority. Once the crisis was over and policy 
                                                          
 
(27) See the Communiqué from the London Summit on 
www.g20.org measures had served their purpose, the stimulus 
provided would have to be gradually withdrawn by both fiscal and monetary authorities. 
164. Open markets, trade and free 
competition are part of the solution . Leaders 
reaffirmed their commitment  to open markets, free 
trade and investment and called for an urgent conclusion of the WTO's Doha Round. Rapidly falling world trade raised concerns in many countries as trade had long been a source of 
growth, in particular in developing countries. As a lack of trade finance was one of the causes of the steep fall in trade activity, the G-20 agreed to make available USD 250 billion for trade finance over the next two years. 
Financial regulation and supervision 
165. The London Summit agreed on an 
ambitious plan to reshape global financial 
regulation.  In the future, all markets, instruments 
and institutions are expected to be subject to appropriate regulation and oversight. The EU has long called for such a step. This implies the elimination of existing supervisory 'blind spots'. Global colleges of supervisors for all large cross-border banks will be established. In addition, the Financial Stability Forum, renamed 'Financial Stability Board' (FSB), has been enlarged to include all G-20 members, plus Spain and the European Commission. Its mandate has been broadened to promote financial stability. Jointly with the IMF, the FSB will devise an early warning system designed to identify global macroeconomic and financial vulnerabilities. 
166. The problem of tax havens and offshore 
financial centres has been addressed . Action 
against non-cooperative jurisdictions in regard to anti-money laundering, tax information exchange and prudential matters was agreed. The political pressure exerted on non-cooperative jurisdictions since the outbreak of the cr isis had already induced 
several of them to subscribe to international standards on the exchange of tax information before the London summit. The G-20 announced that it would monitor the situation and stand ready to deploy sanctions, if needed. Along with the FSB's new principles on executive pay and bonuses in financial institutions, which G-20 leaders endorsed, these measures represent 
3. The External Dimension 
 
61 progress towards global regulatory convergence 
and stronger supervision. 
International financial institutions 
167.  The resources of the IMF will see a 
threefold increase . G-20 leaders agreed to triple 
IMF lendable resources to USD 750 billion, initially through bilateral loans from member countries and later through expanded and more flexible New Arrangements to Borrow (NAB). This expansion of resources will ensure that the IMF has the funds at its disposal to help countries with financing problems. EU Member States have done their fair share in offering financial support. They pledged to provide EUR 75 billion to the IMF (approximately USD 100 billion) via bilateral agreements. Leaders also supported a new allocation of Special Drawing Rights of USD 250 billion, which would provid e low-income countries 
with an extra USD 19 billion. In addition, the IMF's ability to help emerging markets and low-income countries will be supported by using part of agreed sales of IMF gold for concessional lending and the possibility to borrow funds directly on the market, if necessary. In parallel, the IMF has created a new lending instrument that will help to prevent the withdrawal of external capital rather 
than to remedy its consequences. With its new Flexible Credit Line, the IMF makes available financial resources to its member countries with a 
good policy track record ('ex ante conditionality'). The resources can be used unconditionally when needed. 
168.  Multilateral Development Banks will 
increase lending and other forms of finance . The 
G-20 stressed the need to ensure that the Multilateral Development Banks (MDBs) were adequately financed to co ntribute to the resolution 
of the crisis. MDB lending is set to increase by 50% to USD 300 billion over the next three years. For this purpose, MDBs ha ve been encouraged to 
extend their balance sheets and to use other financial tools to leverage private capital more effectively. Moreover, the capital of the Asian 
Development Bank will be increased threefold and the corresponding needs of other MDBs will be reviewed. 
169. Further coordination is warranted. The 
decisions taken by G-20 leaders have to be implemented. To ensure continued coordination and monitor progress, the leaders agreed to meet 
again on 24-25 September 2009 in Pittsburgh. The EU will drive the reform process forward both domestically, by implementing the G-20 agreements on all fronts, and internationally, by playing an active leadership role in the G-20. 
3.5. THE FINANCIAL CRISIS AND THE GLOBAL 
ROLE OF THE EURO 
170. The euro’s role as the second most 
important international currency remains firmly 
established.  Since its introduction in 1999 the euro 
has quickly become an important international currency, surpassing the combined international 
status of its legacy curr encies. The share of the 
euro in foreign exchange reserves stood at 25.9% 
at the end of the first quarter of 2009, 4.6 percentage points higher than at the end of the first quarter of 1999, albeit below the peak of 28.4% that it reached in 2003 (
28). In the first quarter of 
2009, the dollar remained we ll ahead, with 65% of 
total reserves. As for international debt securities, evolutions differ depending on the measurement chosen (
29). The broad measure, based on BIS data, 
consists of all bonds targeted at the international market, i.e. those placed by  a syndicate of financial 
institutions in which at least one institution does not share the borrower's residency. According to this measure at constant exchange rates, the euro's share was 46.7% at the end of the first quarter of 2009 (-0.6 percentage point on a year), compared with 37.5% for the US dollar. By contrast, the narrow measure strips out from the broad measure all those debt securities that are issued in the currency of the issuer, thus counting only debt securities issued in a currency that is different from the issuer's home currency. Under this definition, the euro remains second after the US dollar, with 32.2% and 44.7% respectivel y at the end of 2008.  
                                                          
 
(28) Data on the currency composition of foreign exchange 
reserves at the global level come from the IMF. The IMF 
database covers around two thirds  of total official reserves 
but does not include assets managed by sovereign wealth funds. 
(
29) Conceptually, an internati onal debt security can be 
understood as a bond denominated in a currency that is 
either not the issuer's or not the buyer's home currency, or 
both. In practice, the identity (and hence residency) of the 
buyer is often unknown, wh ich explains why several 
practical definitions might be used to approximate the concept. The broad measure might overstate the euro's 
share in the international bo nd market. The narrow measure 
might understate it. 
European Commission 
Annual Report on the euro area - 2009 
 
62 The share of the euro according to this narrow 
definition rose by about one percentage point between end-2007 and end-2008 at constant exchange rates (
30). In global foreign exchange 
markets, the euro-dollar currency pair is the most actively traded one, accounting for more than a quarter of global turnover, but third currencies are traded substantially more against the dollar than against the euro (approximately 90% of foreign exchange transactions involve the US dollar; around 41% involve the euro). The euro is widely used as a reference currency for managed exchange-rate regimes, sometimes as part of a larger basket of currencies (see Table 3.3). It is used in this way mainly by countries in geographical proximity or with some historical or institutional ties to euro-area countries. 
171. The financial crisis has so far had only 
limited impact on the relative positions of 
currencies in the world economy . Over the course 
of 2008 the euro's share increased in many dimensions – including official reserves, debt securities, cross-border lo ans and deposits, foreign 
exchange trading and cross-border invoicing of those countries for which data are available. However, most variables posted only a modest rise over 2008. While in many market segments overall market size and transaction volumes have declined 
                                                          
 
(30) See the ECB's Annual Review of the International Role of 
the Euro (July 2009), available on the ECB website. in the wake of the crisis, the currency composition 
has remained broadly unchanged. 
172. This relative stability challenged certain 
views on prospects for international currencies . 
Before the current financial crisis and in its early stages, there was widespread debate on whether the large global imbala nces in current account 
positions would trigger a decline in the international use of the US dollar. However, the trend appreciation of the US  dollar at the height of 
the financial crisis was reminiscent of the flight-to-quality phenomenon, as capital was repatriated from markets perceived as risky (in particular emerging markets). This safe-haven status may also have helped the US dollar to maintain its position as the most important international currency through the crisis. 
173. The euro meets many of the criteria of 
an international currency . The credible stability-
oriented framework of EMU has helped to build confidence that the euro is  a reliable store of value 
for households, businesses and investors. The euro area also comprises countries with stable political systems. In economic terms, the euro area is large enough for its curren cy to be attractive for the rest 
of the world. Measured at current exchange rates, the euro area accounts for about 22% of world 
GDP and more than 18% of world trade. The future entry of other EU Member States into the euro area will increase its weight in the global economy further. At the same time, financial  
Table 3.3:  Countries and territories with exchange rate re gimes linked to the euro (as of 30 June 2009) 
Candidate and potential candidate countriesEuropean Union (non-euro area)
OthersEuroisation authorised by a monetary arrangement
Peg arrangements and managed floats based on the SDR and 
other currency baskets involving the euroUnilateral euroisationEuro-based currency board
Algeria, Azerbaijan, Belarus, Botswana, Fiji, 
Libya, Morocco, Myanmar, Russian Federation, 
Samoa, Seychelles, Syria, Tonga, Tunisia, 
VanuatuManaged floating with euro as reference currency (de facto 
pegs)Croatia, Former Yugoslav Republic of 
Macedonia
Managed floating with euro as reference currency Serbia
Monaco, San Marino, Vatican City, French 
territorial communities (2)
Euroisation without monetary arrangement Andorra
Peg arrangements based on the euroCFA franc zone (3), French overseas territories 
(4), Cape Verde, ComorosKosovo (1), Montenegro
Euro-based currency boards Bosnia and HerzegovinaInflation targeting, but officially with a managed floating 
system with the euro as reference currencyCzech Republic, RomaniaBulgariaRegion Exchange rate regimes Countries/territories
ERM II Denmark, Estonia, Latvia, Lithuania
Notes: (1) The euro replaced the Deutsche Mark, which was introduced by UNMIK in 1999. (2) Mayotte, Saint-Pierre-et-
Miquelon. (3) WAEMU (Benin, Burkina Faso, Côte d'Ivoire, Guinea-Bissau, Mali, Niger, Senegal and Togo) and CAEMC 
(Cameroon, Central African Republic, Chad, Republic of Congo, Equatorial Guinea, Gabon). (4) French Polynesia, New Caledonia, Wallis and Futuna. 
Source:  ECB, Commission services. 
 
3. The External Dimension 
 
63 market integration as part of the EU's single 
market has achieved a lot in terms of making euro-area capital markets larger, more liquid and more efficient. However, the euro still lags the US dollar in this respect; according to the 2008 RBS Reserve 
Management Trends Survey, whereas all Central Bank reserve managers rank US government bonds as 'highly liquid', only 74% have a similar opinion of euro-denominated ones. Still, the assessment of euro-denominated securities is markedly better than that of the Pound Sterling (50%) or the Japanese Yen (48%). 
Graph 3.7:  Foreign Exchange Reserves of which currency 
is known (at constant end-2008 exchange 
rates) 
0%10%20%30%40%50%60%70%80%
1999 2002 2005 2008currency shareUSD (constant FX rates)
EUR (constant FX rates)
Other currencies (constant FX rates)
Source:  IMF COFER database. 
174. Even with the euro being an attractive 
currency in many respects, the development of its 
international role will be a long-term process. 
Inertia generally supports the incumbent currency. 
More specifically, network externalities, including simple convenience, favour the permanent use of just one currency for certain purposes, such as commodity price quotations. Furthermore, historical precedents unde rline the gradual nature 
of currency internationalisation (
31). For instance, 
the erosion of the poun d sterling as leading 
international currency throughout the 20th century 
was caused by a series of momentous events, including the two World Wars, but took place at a much lower speed than the effective weight of the 
UK in the world economy would have implied.  
                                                          
 
(31) See B. Eichengreen: 'Sterling's past, Dollar's future: 
Historical Perspectives on Reserve Currency Competition', 
NBER Working Paper No. 11336, May 2005. The process stretched over decades and included a 
period of coexistence of the pound sterling and the US dollar as international currencies.  
175. It is too early to assess with certainty 
how the global financial crisis will impact on the 
international monetary syst em and the role of the 
euro within it . The significance of small short-
term shifts in currency  shares should not be 
overstated, in particular as the available data only cover a limited period since the intensification of the crisis in the autumn of 2008. However, the crisis has prompted some initiatives and proposals for reforms of the international monetary system.  
Graph 3.8:  Total international bonds outstanding, broad 
measure (at constant end-2008 exchange 
rates) 
0%10%20%30%40%50%60%
1999 2002 2005 2008Currency shareEuro US dollar
Yen Pound sterling
Note: The broad measure consists of all bonds targeted at 
the international market, i.e. those placed by a syndicate of 
financial institutions in which at least one institution does not share the borrower's residency 
Source:  BIS. 
On 23 March 2009, the governor of China's 
Central Bank called for a greater role for the IMF's Special Drawing Rights (S DR) in global reserve 
holdings (
32). Since then, the IMF has started to 
prepare an allocation of USD 250 billion (as supported by the G-20 summit in London, see Section 3.4) and the issuance of SDR-denominated notes, which Brazil, Russia and China have announced they would purchase. 
                                                          
 
(32) The SDR is an international reserve asset, created by the 
IMF in 1969 to supplement the ex isting official reserves of 
IMF member countries. SDRs are allocated to IMF 
member countries in proportion to their IMF quotas. The SDR also serves as the unit of account of the IMF and 
some other international organi sations. Its value is based on 
a basket of key internationa l currencies (euro, Japanese 
Yen, pound sterling and US dollar). The SDR is neither a 
currency, nor a claim on the IMF. Rather, it is a potential 
claim on the freely usable currencies of IMF members. 
4. ECONOMIC GOVERNANCE IN TIMES OF CRISIS 
 
64 176. Recent economic events have put the 
conclusions of the EMU@10 Report to the test . 
To mark the tenth anniversary of the euro, the European Commission presented in May 2008 a Communication and an accompanying Report to review the experience of the first decade and to look to the future (
33). Since the report had been 
released, the global economic situation has deteriorated dramatically. The global crisis is putting the Economic and Monetary Union to the test and underscores the need to improve its governance along the lines indicated in the EMU@10 Report. This chapter recalls its main conclusions and recommendations and highlights follow-up work in the light of the current 
economic and financial turmoil. Section 4.1 stresses how recent events have enhanced the relevance of the Commission's EMU@10 Report. Section 4.2 reviews the wo rk carried out in 2008 
regarding the broadening and deepening of macroeconomic surveillance. Section 4.3 looks at the recent substantial developments in financial governance. Finally, Section 4.4 highlights the continuing enlargement of  the euro area since 
2007. 
4.1. THE EMU@10 REPORT IN THE LIGHT OF THE 
CRISIS 
177. To address the challenges facing the 
euro area, the Commission proposed a three-
pillar agenda in the EMU@10 Report . First, the 
domestic agenda sought to deepen fiscal policy co-ordination and surveillance, to broaden macroeconomic surveillance in EMU beyond fiscal policy and to better integrate structural reform in overall policy co-ordination within EMU. Second, the external agenda aimed to enhance the euro area's role in global economic governance. Third, both agendas required a more effective system of economic governance. 
178.  The recommendations set out in the 
EMU@10  Report more than a year ago are more 
relevant than ever . The manifold successes of the 
euro in the first decade were a blessing in disguise. The euro delivered macroeconomic stability through a consistent single monetary policy and 
                                                          
 
(33) COM (2008) 238 final, 7 mai 2008, 'EMU@10: successes 
and challenges after 10 years of Economic and Monetary 
Union'. improved fiscal behaviour in Member States. It 
fostered a decade of low inflation and interest rates, bringing substantial savings for consumers and business. It underpinned the Single Market, serving as a major catalyst for trade and investment and deepened financial integration. Economically and politically, the single currency has become the symbol of the European integration process. At the same time, the achievements have blunted the willingness of policy-makers to address the remaining challenges facing the euro area. Now,  though, the crisis has 
brought those challenges fully into focus. 
179. Deepening macroeconomic surveillance 
will prove essential to foster an orderly return to 
more sustainable fiscal positions . The EMU@10 
Report stressed the importance of securing the sustainability of public finances for the benefit of future generations. In response to the crisis, most euro-area Member States have engaged resolutely in fiscal stimuli to stabilise the economy. Bank rescue packages have inflated substantially public debt outstanding and increased contingent liabilities. Against this background, sustainability considerations have become more relevant than ever. Coordinated surveillance benefits considerably from the sound functioning of the Stability and Growth Pact, which provides a frame, an anchor and directions for deeper surveillance. 
180. Broadening macroeconomic surveillance 
should address imbalances at an early stage . The 
surveillance of fiscal policies has delivered immense benefits to the euro-area economy. 
However, economic imbalances can originate from other quarters. Over-indebtedness in the private sector could trigger unsustainable economic trends that should be detected and dealt with at an early stage. Macroeconomic surveillance should be broadened in this perspective. The EMU@10 Report stressed that 'while market integration, 
particularly in financial services, is beneficial overall for EMU, it can also, if not accompanied by appropriate policies, amplify divergences among the participating countries' . The crisis 
demonstrated eloquently how fast the successive financial shocks hit the rest of the economy and how strong the feedback loops were. It also revealed that the resolution of financial crises might prove very costly in fiscal terms. Early detection of asset price booms and busts is 
4. Economic Governance In Times Of Crisis 
 
65 essential to avert costly corrections of fiscal and 
external imbalances at a later stage. Therefore surveillance should incorporate in earnest financial market developments and their interplay with the real economy. From a more operational perspective, the crisis showed that a gap existed between financial market watch on the one hand, and macroeconomic watch based on traditional national accounts data on the other hand. This gap should be bridged without delay by an all-encompassing macro-financial analysis (see Section 4.3). 
181. Global crisis resolution accentuated the 
external policy agenda laid down in the 
EMU@10 Report . Global macroeconomic 
imbalances lay at the root of the crisis. Although the euro area enjoye d balanced economic 
fundamentals, it was struck with considerable force by the global crisis fallout. The euro area cannot afford to be a byst ander. It has to express 
itself more forcefully on the international scene to help solve global issues. The G-20 process, which the EU has successfully promoted, offers an opportunity to consolidate the representation of the euro area. In this resp ect, the EMU@10 Report 
stressed that 'the euro area must build an international strategy commensurate with the international status of its currency'. This issue was to some extent considered to be of a medium-term nature. The crisis acted as a wake-up call and urgent steps are needed in the short run instead. To be more influential in the ongoing overhaul of global governance, the euro area should rapidly consolidate its external representation and speak 
with one voice in international fora. 
182. EMU's system of economic governance 
has been tested in times of crisis . The EMU@10 
Report stressed that the Eurogroup and the Commission should play a more active role in coordinating euro-area economic policies within the scope defined by the Treaty. The design and implementation of consistent response to the crisis has been challenging (see Section 4.3). More than ever, euro-area Member Stat es should take the lead 
in driving policy action to combat the current crisis and contribute to the overall recovery of the EU economy. 
183. As a follow-up to the EMU@10 Report, 
the Commission succeeded in triggering a deeper 
dialogue concerning EMU among the EU institutions and with the public at large.  The 
dialogue increased awareness of the significant benefits of the euro, such as its role as a protective shield during the current financial turmoil. The discussions highlighted the need for closer 
economic policy coordination as well as broader and deeper surveillance and governance. 
184. The European Parliament's resolution 
on the first ten years of the euro constitutes an 
important contribution to the discussion of this 
subject.  Adopted in November 2008, the bipartisan 
Report from MEPs Pervenche Bères and Werner Langen affirms the consensus achieved on fundamental questions pertaining to the EMU (
34).  
It highlights the success of the euro and supports the Commission's intention to strengthen the influence of the euro area in international financial institutions. Furthermore, the resolution sketches out an ambitious agenda for strengthening economic governance in the euro area. In 
particular, the Parliament supports the strengthening of the preventive arm of the SGP and a closer involvement of national Parliaments in the revision of the Lisbon Integrated Guidelines. It has put forward proposals for revising the existing banking and financial supervisory architecture and called on the Commission to examine the creation of  European bonds and 
develop a long-term strategy on this issue. 
185. The European Central Bank highlighted 
the achievements and responsibilities of the euro 
area.  The ECB published a special edition of its 
monthly bulletin in May 2008 that looked back at the ECB’s work over the pa st ten years. It also 
reviewed the challenges that the ECB and the euro area faced as they entered their second decade. In a speech at the January ceremony of the European Parliament marking the tenth anniversary of the euro, the ECB President me ntioned some of these 
challenges (
35). First, the euro area should 
overcome successfully the financial crisis by playing an active part in the global efforts to address the weaknesses in the global financial system and to redesign the regulatory and institutional framework. Second, the euro area 
                                                          
 
(34) Report from the European Parliament A6-0420/2008 of 
28.10.2008. 
(35) 'The euro@10: achievements and responsibilities' Remarks 
by Jean-Claude Trichet, Pres ident of the ECB, at the 
ceremony of the European Pa rliament to mark the 10th 
anniversary of the euro, Strasbourg, 13 January 2009. 
European Commission 
Annual Report on the euro area - 2009 
 
66 should implement the Stability and Growth Pact in 
a firm and credible way and make efforts to render the economies of the Union more productive, innovative and dynamic, and avoid major competitive divergences within the euro area. Third, the handling of enlargement would be an inspiring and demanding challenge for all Institutions. 
186. At its meeting of 24 March 2009, the 
European Economic and Social Committee 
(EESC) adopted an opinion on the EMU@10 Report, which highlighted the successes of the 
euro in terms of price stability. The opinion (
36) 
stressed the need for better representation of EU institutions on the international scene. The EESC also noted the remaining challenges regarding the integration of goods and services markets and financial supervision, for which clear rules should be put in place. In particular, and in relation to the current crisis, the EESC called on all economic and monetary authorities to learn from the US subprime crisis and to thoroughly overhaul the policies underpinning the operation of the financial markets. 
4.2. THE BROADENING AND DEEPENING OF 
MACROECONOMIC SURVEILLANCE 
Overall, the dialogue with major stakeholders 
underlines the need for European policymakers to 
step up surveillance of th e economies of euro-area 
Member States. This ought to include taking a closer look at competitiveness developments and paying more attention to the quality of public finances. 
Broadening surveillance to cover competitiveness 
developments 
187. Competitiveness developments warrant 
broader surveillance . Since the launch of the euro, 
differences in growth and inflation have tended to be significant and persistent, leading to large changes in Member States' relative competitive positions, notably in terms of price competitiveness but also in terms of current account imbalances and net foreign asset positions. As a result, some Member States have recorded diverging current account positions since 1999. 
                                                          
 
(36) Opinion CESE 633/2009 of 24 March 2009. 188. Intra euro-area divergences matter for 
the functioning of EMU . It is a matter of common 
concern as intra euro-area adjustments to external 
imbalances work slowly and may have negative spill-over effects across Me mber States. Effective 
functioning of EMU calls for an early detection of these external imbalances in order to prompt an adequate and timely policy response. While some of the divergence is a sign of increased financial market integration, with the euro acting as catalyst, and normal convergence processes, less 'benign' factors have played a more important driving role. For instance, housing bubbles and credit-financed consumption have fuelled the divergence in some Member States (see Section 1.5 for details) (
37). 
189. Euro-area Member States have agreed to 
set up a framework for early detection of external 
imbalances.  The Eurogroup agreed to conduct a 
surveillance exercise -in the spirit of the Mid-Term Budgetary Review regularly  carried out for public 
finances- on macroeconomic imbalances and competitiveness divergences. It would be held within the Eurogroup at th e end of the year 2009. 
Moreover, as agreed by the Ecofin Council in October 2008, the analysis of competitiveness developments should also be extended to non euro-area Member States. The findings would feed into both the Lisbon process and the assessment of Stability and Convergence Programmes. 
Paying more attention to the Quality of Public 
Finances (QPF) 
190. While QPF featured explicitly in the 
revised Stability and Growth Pact and the re-
launched Lisbon strategy from 2005, its practical implementation under the EU's  surveillance 
framework evolved recently . First, in response to 
uneven reporting by Member States on QPF issues in the past, the Ecofin Council conclusions of May 2009 underlined the need for consistent data. This includes providing information on measures to improve expenditure control, tax reforms and value-for-money initiatives as well as detailed information on changes in Member States' fiscal governance, such as national fiscal rules, independent fiscal institutions and medium-term budgetary frameworks . Second, in the 
                                                          
 
(37) For more details see Quarterly Report on the Euro Area 
Vol. 8 N°1 (2009), 'Special report: competitiveness 
developments within  the euro area'. 
4. Economic Governance In Times Of Crisis 
 
67 Commission's assessment of the 2009 Stability and 
Convergence Programmes, QPF issues were more systematically addressed. In particular, the Council 
Opinions included a section focusing on key aspects of QPF and issued policy invitations to Member States. While the focus was largely on fiscal governance, other aspects such as the efficiency of public sp ending and revenue systems 
were to some extent covered. Third, progress was achieved in getting Member States to provide datasets on government expenditure by classification of functions of government (COFOG II). Such data are important for analysing trends in the composition of public expenditure and possibly identifying efficiency gaps. In its May 2009 
conclusions, the Ecofin Council recommended that some selected COFOG II data should become mandatory to ensure further progress. 
4.3. RECENT DEVELOPMENTS IN FINANCIAL 
MARKETS GOVERNANCE 
191. The crisis tested the capability of 
European economic and financial governance to 
deliver swiftly.  Financial contagion between 
markets and institutions, the threat of bank runs and the interplay between financial and economic variables called for a swift and coordinated response at the European level. 
192. Initial crisis responses of national 
governments lacked clear EU and euro-area 
perspective . In the early stages of the financial 
crisis, in the absence of a coherent pan-European crisis management framework, assistance to distressed financial institutions was conducted on an ad hoc basis in each c ountry, sometimes leading 
to a reversal of past pan-European consolidation in the banking sector. These hesitant and rather disjointed early actions contrasted with the efficient and consistent handling of the situation on interbank markets by the ECB. On 4 October 2008, the EU G8 Members (Fra nce, Germany, Italy, 
United Kingdom) met, together with the President of the Commission, the President of the Eurogroup and the President of the ECB. At its regular meeting in Luxembourg on 7 October, the Ecofin Council agreed on 'conclusions on a coordinated EU response to the economic slowdown'. 
However, operational details on how to tackle the banking crisis remained evasive.  
193. Euro-area governments eventually put 
up a united front.  On 12 October 2008, the French 
Presidency organised the first Summit of the Eurogroup at the Heads of State and Government level. The British Prime Minister attended the meeting. They issued a common framework for the 
implementation of national banking rescue plans, which was affirmed by th e European Council for 
the EU as a whole on 15-16 October. The European Council al so announced the 
establishment of a 'crisis cell', aimed at improving crisis management among EU Member States through measures includ ing informal warnings, 
information exchange and an evaluation mechanism. 
194. The Commission reacted speedily to the 
evolving situation . On 29 October 2008, the 
Commission issued a communication paving the way for a coordinated Eu ropean recovery action 
plan. The Commission initiative called for a new EU architecture for financ ial markets, efforts to 
create jobs and drive growth, and a global response to the financial market crisis (
38). As the economic 
situation was deteriorating, the Commission issued its European Economic Recovery Plan (EERP) on 26 November. It aimed at cushioning the impact of 
the financial crisis on the real economy (see Section 2.3). In January 2009, Commission services brought forward by a month their interim forecast to assess the ma gnitude of the slowdown 
and provide timely information to policymakers. In its contribution to the Spring European Council of 19-20 March 2009, the Commission drew a first tentative assessment of the effectiveness of financial plans and stressed the need for greater co-ordination in the implementation of measures decided under the EERP umbrella (
39). The 
Eurogroup also monitored the economic situation throughout this period and regularly shared its assessment with the Ecofin Council. 
 
                                                          
 
(38) Commission communication COM (2008)706 'From 
financial crisis to recovery' of 29 October 2008. 
(39) Commission communication COM (2009)114 'Driving 
European recovery' of 4 March 2009. 
European Commission 
Annual Report on the euro area - 2009 
 
68 195. The financial crisis has highlighted the 
weaknesses in the EU's supervisory framework.  
Supervision remains fragmented along national lines despite substantial progress achieved in 
financial market integration and the ever-growing importance of cross-border entities. Around 70%  
Box 4.1: Activities of the Eurogroup in 2008 and 2009
The Eurogroup is a corner-stone of euro area economic governance. It regularly gathers Ministers of Finance 
of the euro area on an informal basis. Over the last decade, the Eurogroup's responsibilities for the economic 
governance of EMU have grown markedly. 
 
Table 1:  Activities of the Eurogroup during the year 2008 and the first months of 2009 
JanuaryThe EG assessed the introduction of the Euro in Cyprus and Malta. In addition, Ministers discussed
guidelines within the Lisbon Treaty framework, with special emphasis given to the euro-area chapter.
FebruaryThe EG invited euro-area Member States to benefit from good economic times to consolidate public
finances so as to reach a balanced financial stance  by 2010.
AprilThe EG expressed concern on the high level of inflation within the euro area. The EG called for
moderation in the adjustment of administered prices and prudence when rearticulating indirect
taxation.
May The EG discussed compensation schemes in the corporate sector.September The EG elected for a new mandate Jean-Claude Juncker at the head of the Eurogroup. 
OctoberSummit of the Eurogroup Heads of State and Governments in Paris. A declaration on a coordinated
action plan to fight the banking crisis is adopted.
NovemberBased on the autumn forecast of the European Commission, the EG discussed the resulting financial
and budgetary consequences of the deterioration in economic activity. With respect to public
investment in different Member States of the euro-area, Ministers exchanged views on the necessarycoordination for efficient use of investment at the current juncture. 
DecemberThe EG discussed the Commission's European Economic Recovery Plan. It also decided to allow
automatic stabilisers to work fully in 2008 and 2009. 
JanuaryThe EG examined the economic stimulus packages of different Member States. It concluded that these
stimulus packages correspond to the level of action required by the European Council in December
2008. 
FebruaryThe EG expressed concerns about credit distribution to the real economy and affirmed its willingness
to monitor closely the situation.
MarchThe EG approved Terms of Reference regarding the European Monetary System II, as a preliminary
condition to an eventual adoption of the euro by non euro-area member states. It also prepared the
discussion on specific recommendations to the euro area with respect to the "de Larosière report" on
financial stability.
AprilThe EG reviewed the financial and budgetary situation of different euro-area member states. It called
on Greece to take resolute measures, a position that Greek authorities shared. 
MayThe EG stressed the need to assess first the effectiveness of current stimulus packages before
contemplating further action.  
Given the severity of the crisis in Ireland and the measures already taken by the Irish government, the
EG agreed to grant Ireland an additional delay to comply with the Stability and Growth Pact. Thepublic deficit should come below the 3% reference value by 2013 instead of 2012.2008
2009
 
Source:  Commission services 
 
This reflects the growing political importance of the Eurogroup but also the increased number of items on its 
agenda, with the economic situation, inflation and euro-area responsibilities under the Stability and Growth 
Pact and Lisbon Strategy being among the topics that are regularly discussed within the Eurogroup. The 
appointment of its President for a two-year term from January 2005 added to the visibility of the Eurogroup. 
On 12 September 2008, Jean Claude Juncker was re-appointed for a third term.  
Since the Eurogroup is an informal body, its deliberations are confidential and it does not release public 
statements. The table 1 in this box is based on regular press releases of the Ministry of Finance from 
Luxembourg and does not necessarily cover all the items that were discussed.  
 
4. Economic Governance In Times Of Crisis 
 
69 of EU banking assets are held by 43 cross-border 
banking groups. In particular, increasingly sophisticated financial products are increasingly dealt with on a pan-European basis. The Lamfalussy approach, st arted in 2001, largely 
succeeded on the regulatory side, by speeding up the adoption of EU financial service law, but progress was slow and uneven on the supervisory side. For instance, no common reporting formats for banks were agreed, while persistent divergences resulted in slow progress on standards for clearing and settlement.  
196. Macro-prudential risks, both at the 
national and EU level, were not emphasised 
enough.  One of the most serious challenges 
highlighted by the crisis is the fact that the present EU arrangements –like arrangements at national and global level– placed too much emphasis on the supervision of individual firms, and too little on risks to the stability of the financial system as a whole. Analyses were fragmented and performed by different authorities at different levels. In so far as risks were identified there was no EU mechanism to ensure that this assessment of risks 
translated into action. Information did not flow well between national supervisors, something that was compounded by the lack of consistent powers among Member States' supervisors. In particular, the so-called Level-3 Committees of the Lamfalussy process (Committee of European Securities Regulators, Committee of European Banking Supervisors, Committee of European Insurance and Occupational Pensions Supervisors) were designed as advisory committees for the Commission. They had neither the legal basis nor adequate resources to properly engage in crisis prevention and resolution. These shortcomings were laid bare in the current financial turmoil. Most notably, it resulted in the emergency 'de-consolidation' of several large financial institutions and their restructuring along national lines. Based on this widely-shared diagnostic, the Commission saw the need for new impetus in this area. 
197. The de Larosière Group set out a 
comprehensive action plan.  In October 2008, 
President Barroso took the initiative to give a mandate to a High-Level Group to make proposals to strengthen European supervisory arrangements. The Group, chaired by former IMF Managing Director Jacques de Larosière, released its report on 25 February 2009. In its conclusions, the European Council of 19/20 March 2009 agreed to 
the de Larosière report as 'the basis for action'. 
198. Macro-prudentia l concerns should be 
effectively catered for . The de Larosière Group 
suggested establishing a new body – the European Systemic Risk Council (ESRC) – that would pool and analyse all information pertaining to macroeconomic conditions that is relevant for financial stability. The ESRC would be composed of the members of the General Council of the ECB, the Chairpersons of the three Level-3 
Committees as well as one Member of the Commission. The ESRC would issue risk warnings to relevant bodies, including national supervisors, the EFC and the IMF depending on the nature of the threat. The ESRC may appeal to the Economic and Financial Committee if it feels that a supervisor has not responded in an adequate manner. 
199. Micro-prudential aspects would be 
handled by a European System of Financial 
Supervisors (ESFS) . The ESFS would be a 
decentralised network, still relying on national supervisors for day-to-day supervision. However, three new European Authorities would be set up, replacing the Level-3 Lamfalussy Committees. They would coordinate the application of supervisory standards and guarantee strong cooperation between national supervisors, including recourse to binding and proportionate mediation in case of conflicts. 
200. A two-stage approach to implementation 
would combine harmonisation of rules and 
powers and supervisory reforms . The de Larosière 
Group sketched out a roadmap for the 
implementation of its recommendations. The competences and powers of supervisors should be aligned with the most comprehensive systems in the EU, while regulation should be streamlined in order to get a consistent set of core rules. Colleges of supervisors should be se t up for all systemically 
important financial institutions, both in the EU and internationally. These steps would pave the way for the establishment of the European System of Financial Supervision and the three Authorities. They should be independent and accountable to the Council, the European Parliament and the Commission. In addition, a review clause after three years would examine the possibility of merging banking and insurance authorities. 
European Commission 
Annual Report on the euro area - 2009 
 
70 201. The Commission endorsed the de 
Larosière approach and laid the ground for a 
two-pillar framework for European Financial 
Supervision.  The Commission capitalised on the 
findings of the report in its May Communication with a view to first deci sions at the June 2009 
European Council (
40). The Communication set out 
a detailed proposal for the functioning and composition of the ESRC and the ESFS. It affirmed the leading role of central banks in macro-prudential supervision through the participation of the heads of the ECB and of all EU 
National Central Banks in the European Systemic Risk Council (
41). The ECB would provide 
administrative support as well as technical expertise to the ESRC. Decisions of the ESRC should be taken by a simple majority. 
Proposed financial governance arrangements 
according to the recommendations of the De Larosière Group:  
European Systemic Ris k
Council (ESRC)
European 
Banking 
AuthorityEuropean 
Insurance and 
Occupational 
Pensions 
AuthorityEuropean System of Financial Supervision (ESFS)Early risk warningInformation on micro-
prudential development s
European 
Securities and 
Markets 
Authority
National 
Banking 
SupervisorsNational 
Insurance 
SupervisorsNational 
Securities 
Supervisors
 
Source : Commission services. 
                                                           
(40) Commission communication COM (2009)252 'European 
financial supervision' of 27 May 2009. 
(41) The three Chairpersons of  the European Supervisory 
Authorities and a Member of the European Commission 
will be members with voting rights as well. The Members 
without voting rights would be one high-level representative per Member State of the competent national 
supervisory authorities and th e President of the Economic 
and Financial Committee. The three existing committees of supervisors 
would be replaced by th ree new Authorities, each 
of which would have legal personality in order to contribute to the development of a single set of harmonised rules, improve the supervision of cross-border institutions by developing common supervisory approaches and help settle possible disputes between national supervisors. Each new independent Authority would have a Board of supervisors comprised of the highest-level representatives from the appropriate national supervisory authorities. The chairperson would be nominated after an open competition and confirmed by the European Parliament. In order to foster accountability, th e ESRC and the three 
Authorities would report to the Council and the European Parliament on a frequent basis. 
202. The European Council, in its 
conclusions of 19 June 2009, supported the 
creation of a European Systemic Risk Board (ESRB) (
42) and a European System of Financial 
Supervisors (ESFS).  However, given the potential 
or contingent liabilities that may be involved for Member States, the European Council stressed that decisions taken by the newly-created European 
Supervisory Authorities (ESAs), which are the 
mainstay of the ESFS, should not impinge in any way on the fiscal responsibilities of Member States. It agreed that the European System of 
Financial Supervisors should have binding and proportionate decision-making powers in respect of whether supervisors are meeting their requirements under a single rule book and relevant Community law and in the case of disagreement between the home and host state supervisors, including within colleges of supervisors. ESAs should also have supervisory powers for credit rating agencies. The European Council finally stressed that the new framework, comprising both macro-prudential an d micro-prudential 
components, should be fully in place in the course of 2010. 
203. The Commission adopted operational 
arrangements for the esta blishment of the ESRB 
and the ESFS.  On 23 September 2009, the 
Commission adopted a pack age of legal texts 
underpinning the new framework. The package comprises: 
                                                          
 
(42) The name was eventually chosen in lieu of ESRC. 
4. Economic Governance In Times Of Crisis 
 
71 (i) A proposal for a regulation on 
Community macro-prudential oversight of the financial system and establishing a European Systemic Risk Board (
43). The regulation defines 
the mission and tasks of the ESRB, lays out its organisation and governance, and sets procedures for the ESRB to issue warnings and recommendations. 
(ii) A proposal for a Council Decision 
entrusting the ECB with specific tasks concerning the functioning of the ESRB (
44). It lays out the 
modalities of the ECB's analytical, statistical, administrative and logisti cal support to the ESRB. 
(iii) Proposals for three regulations 
establishing, respectively, a European Banking Authority (EBA) (
45), a European Insurance and 
Occupational Pensions Authority (EIOPS) (46) and 
a European Securities and Markets Authority (ESMA) (
47). The new Authorities will take over 
all of the functions of the Lamfalussy Level-3 committees. In addition, it will have certain extra competences, includi ng the following: 
(a) developing proposals for technical standards, respecting better regulation principles; (b) resolving cases of disagreement between national supervisors, where legislation requires them to co-operate or to agree; (c) contributing to 
ensuring consistent application of technical Community rules (including through peer reviews); (d) the European Securities and Markets Authority will exercise direct supervisory powers for Credit Rating Agencies; (e) a co-ordination role in emergency situations. 
4.4. THE CONTINUING ENLARGEMENT OF THE 
EURO AREA 
204. From 2008 to 2009, the euro area has 
welcomed three new members . The euro area grew 
from thirteen to sixteen Member States as Cyprus and Malta (in 2008) and Slovakia (in 2009) joined the group. The entry of these countries was the result of a successful convergence process, fostered by stability-oriented policies and structural reforms (see Box 4.2). With the 
                                                          
 
(43) COM(2009)499. 
(44) COM(2009)500. 
(45) COM(2009)501. 
(46) COM(2009)502. 
(47) COM(2009)503. successful entry of Slovakia  into the euro area on 1 
January 2009, 328.6 million people out of the EU's 499.7 million now share the single currency. 
205. The recent introduction of the euro in 
Slovakia was managed successfully . It did not 
lead to significant pri ce increases. Thanks to 
detailed preparatory work, the technical aspects of 
the transition went well and almost all Slovak shops were giving change in euro as of the first days of January 2009. According to a European Commission Flash Eurobarometer survey conducted in January 2009, 90% of Slovaks felt well-informed about the euro. As a result, perceptions of changeover-related inflationary pressures were limited. 
206. The next regular assessment of fulfilling 
the conditions for euro adoption will take place in 
the first half of 2010.  Major differences remain 
between non euro-area Member States with respect to their progress with nominal convergence. Pursuing nominal convergence faces additional challenges in the current financial crisis environment. While inflation is decelerating rapidly in most new Member States, their fiscal balances, exchange rates and long-term interest rates as well as their ability to borrow on financial markets have been negatively affected by the financial crisis. 
European Commission 
Annual Report on the euro area - 2009 
 
72   
Box 4.2: The three new euro area Member States: Cyprus, Malta and Slovakia
The entry of Cyprus and Malta in January 2008 and Slovakia in January 2009 into the euro-area has been 
the result of a successful process of nominal convergence towards the euro-area. In recent years, inflatio n 
in Cyprus and Malta has been close to the euro-area average, standing at 2.9% in Cyprus and 2.7% in Malt a 
on average in 2006-2008. Slovakia experienced more volatile and at times high inflation, reflecting the
impact of external factors and adjustment of administrative prices. Developments of underlying inflation wereon the whole favourable and HICP inflation averaged 3.4% in 2006-2008.  
Before joining the euro area, interest rate convergence was largely achieved in the three countries, wit
h 
spreads vis-à-vis the euro area for short-term and long-term interest rates having almost disappeared several months before euro adoption. The general government deficit has declined to below 3% since 2007 i
n
Slovakia and since 2006 in Cyprus and Malta, but in the latter the deficit widened above the 3% threshold i n
2008. In the three countries, the public debt as a share of GDP declined significantly in recent years. Itamounted in 2008 to 49.1% in Cyprus, 64.1% in Malta and 27.6% in Slovakia.  
Cyprus, Malta and Slovakia have also rapidly converged to the euro area in real terms.  In 2008, their GDP 
per capita in Purchasing Power Standards (PPS) reached respectively 82.9%, 73.4% and 65.4% of the euro-
area level. Their real GDP growth has been strong in the last decade, averaging 4.1% in Cyprus, 2.8% i
n 
Malta and 8.4% in Slovakia in 2006-2008. While the labour market situation in Cyprus compares well vis-à-vis the euro-area, with an unemployment rate of 3.8% in 2008 and a high employment rate (70.3%), the 
picture is less rosy in Malta and Slovakia with a relatively low employment rate (55.8% in Malta; 57.5% i n
Slovakia) and a higher unemployment rate (5.9% in Malta; 9.5% in Slovakia). 
Graph: Convergence to the euro area: GDP in PPS Table: Recent macroeconomic performance
(euro area=100) (annual percentage change) 
4555657585
2002 2003 2004 2005 2006 2007 2008indexCyprus
Malta
Slovakia
 2006 2007 2008
GDP 4.1 4.4 3.7
Inflation 2.2 2.2 4.4
General government 
balance (as % of GDP)-1.2 3.4 0.9
GDP 3.2 3.6 1.6
Inflation 2.6 0.7 4.7
General government 
balance (as % of GDP)-2.6 -2.2 -4.7
GDP 8.5 10.4 6.4
Inflation 4.3 1.9 3.9
General government 
balance (as % of GDP)-3.5 -1.9 -2.2Cyprus
Malta
Slovakia
 
Source:  Commission services Source:  Commission services 
These countries are small o pen economies, hi ghly inte grated in terms o f trade and finance to the euro
area.  Malta and Cyprus are the two smallest economies in the euro area, contributing respectively 0.06% an d
0.18% to euro-area GDP, and 0.13% and 0.24% to its population. Slovakia accounts for 0.73% of the euro-
area GDP and 1.65% of its population. Trade with the euro-area represents about 53% of total trade of Cyprus 
and about 45% in Malta and Slovakia. In addition, a large share of foreign direct investments comes from theeuro-area 
(42% for C yprus, 43% in Malta and 74% in Slovakia in 2007 ).