Commission staff working document accompanying the communication from the Commission 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}
Date: 2009-10-07
Institutions: European Commission
Subjects: economic growth, economic policy, economic recession, economic situation, euro area, monetary crisis, report

EN 

EN 

EN 

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 7.10.2009 
SEC(2009) 1313 

COMMISSION STAFF WORKING DOCUMENT 

accompanying the 

COMMUNICATION FROM THE COMMISSION 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 

This  report  was  prepared  in  the  Directorate-General  for  Economic  and  Financial  Affairs  under  the 
supervision  of  Marco  Buti,  Director-General.  Executive  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 Paternoster, 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 provided 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 gratefully 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 Economic 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 

2 

 
Introduction 

1.  Macroeconomic Developments 

1.1.  ECONOMIC SITUATION AND PROSPECTS 

1.2.  MONETARY AND FINANCIAL DEVELOPMENTS 

1.3. 

FISCAL DEVELOPMENTS 

1.4. 

LABOUR MARKET DEVELOPMENTS 

1.5.  COMPETITIVENESS DEVELOPMENTS 

2.  Macroeconomic Policies 

2.1. 

INTRODUCTION 

2.2.  MONETARY POLICY 

2.3. 

FINANCIAL MARKET POLICIES 

2.4. 

THE EUROPEAN ECONOMIC RECOVERY PLAN (EERP) 

2.5. 

FIRST ASSESSMENT OF NATIONAL MEASURES TAKEN UNDER THE EERP 

3. 

The External Dimension 

3.1. 

THE GLOBAL NATURE OF THE CRISIS 

3.2.  RECENT DEVELOPMENTS IN THE EURO EXCHANGE RATE 

3.3.  GLOBAL IMBALANCES – AN UPDATE 

3.4.  REFORMING THE INTERNATIONAL FINANCIAL ARCHITECTURE 

3.5. 

THE FINANCIAL CRISIS AND THE GLOBAL ROLE OF THE EURO 

4. 

Economic Governance In Times Of Crisis 

4.1. 

THE EMU@10 REPORT IN THE LIGHT OF THE CRISIS 

4.2. 

THE BROADENING AND DEEPENING OF MACROECONOMIC SURVEILLANCE 

4.3.  RECENT DEVELOPMENTS IN FINANCIAL MARKETS GOVERNANCE 

4.4. 

THE CONTINUING ENLARGEMENT OF THE EURO AREA 

LIST OF TABLES 

1.1. 

Industrial production in the euro area (year-on-year change) 

2.1.  Euro-area public interventions in the banking sector (in % of GDP) 

2.2. 

First year GDP effects of fiscal stimulus amounting to 1% of GDP 

2.3. 

Total fiscal stimulus over 2009 and 2010 by Member State (in % of GDP) 

2.4.  Overview of structural reform measures relevant to national recovery programmes 

3.1.  GDP growth in major economies 

3.2.  Current account balances of major economies (as % of GDP) 

3.3.  Countries and territories with exchange rate regimes linked to the euro (as of 30 June 2009) 

6 

8 

8 

12 

17 

21 

23 

27 

27 

29 

32 

39 

45 

52 

52 

56 

58 

59 

61 

64 

64 

66 

67 

71 

9 

36 

40 

45 

46 

53 

59 

62 

3 

 
 
 
LIST OF GRAPHS 

1.1.  World trade and manufacturing Purchasing Managers Index (PMI) 

1.2.  GDP losses across recessions, euro area 

1.3.  Contribution to GDP growth, euro area 

1.4.  Euro-area money market rates (1 Oct 2007 to 30 June 2009) 

1.5.  10-year government bond yields, euro area (1 Jan 2007 to 30 June 2009) 

1.6.  Euro-area yield curve slope (Jan 2007 to June 2009) 

1.7.  Corporate bond spreads per rating, euro area (1 Jan 2007 to 30 June 2009) 

1.8.  Monetary Financial Institutions lending in the euro area (January 2000 to May 2009) 

1.9.  Composite Financing Cost Indicators (CFCI) for the euro area (March 2003 to April 2009) 

1.10.  Stock price index and implied volatility (Stock price: Jan 2007 = 100) 

1.11.  Harmonised index of consumer prices (HICP), euro area 

1.12.  Breakdown of euro-area HICP inflation 

1.13.  Headline and structural budget balances in the euro area in 2008 

1.14.  Budget balances in the euro area (2007 levels and 2008 changes) 

1.15.  Structural balances in the euro area 

1.16.  Public debt-to-GDP ratios in the euro area 

1.17.  Cumulated change in public balance, euro-area countries (2007-2010) 

1.18.  Cumulated change in public debt, euro-area countries (2007-2010) 

1.19.  Euro-area employment growth and unemployment rate 

1.20.  Contribution of labour productivity and labour supply components to GDP growth, euro 

area 

1.21.  Nominal wage indicators, euro area 

1.22.  Compensation per employee, labour productivity and unit labour costs, euro area 

1.23.  Compensation per employee, labour productivity and unit labour costs by sectors in 2008, 

euro area 

1.24.  Current account positions, euro area, United States and China (1999-2008) 

1.25.  Compensation per employee, labour productivity and nominal unit labour costs (1999-2008) 

1.26.  Changes in intra euro-area Real Effective Exchange Rate (REER) 

1.27.  Current account positions, euro-area Member States (1999 to 2008) 

1.28.  Net foreign asset positions, euro-area Member States (1995-2007) 

1.29.  Evolution of current account positions, euro-area Member States (2008 to 2010) 

2.1.  Debt-to-GDP ratios of various economic sectors among select advanced economies 

2.2.  ECB interest rates and Eonia 

2.3.  Central banks' policy interest rates 

2.4.  Default risks of euro-area financial institutions 

2.5.  Equity prices in the euro area (January 2008 = 100) 

2.6.  Write-downs and capital injections of main euro-area financial institutions 

2.7. 

Interest rate spreads (OIS over three-month Euribor, Libor in percentage points) 

8 

9 

9 

12 

14 

14 

14 

14 

16 

16 

17 

17 

19 

19 

19 

20 

21 

21 

21 

22 

22 

22 

23 

23 

24 

25 

25 

25 

26 

27 

29 

32 

34 

34 

36 

37 

4 

 
 
 
2.8. 

Fiscal policy stance in the euro area 

2.9.  EERP - Measures aimed at supporting household purchasing power in the euro area (fiscal 

stimulus as % of country GDP, 2009-2010) 

2.10.  EERP - Labour market measures in the euro area (fiscal stimulus as % of country GDP, 2009-

2010) 

2.11.  EERP -Measures aimed at stepping up investment expenditure in the euro area (fiscal 

stimulus as % of country GDP, 2009-2010) 

2.12.  EERP- Business support measures in the euro area (fiscal stimulus as % of country GDP, 2009-

2010) 

3.1.  Capital flows to emerging and developing economies, annual flows 

3.2.  World trade and GDP growth (annual average growth rate) 

3.3.  Profiles of GDP growth in major economies (2007-2010) 

3.4.  Changes in EUR cross-rates since 02 Jan 2008 

3.5.  Euro exchange rates (daily data) 

3.6.  Euro real effective exchange rate (41 countries, CPI deflated) 

3.7. 

Foreign Exchange Reserves of which currency is known (at constant end-2008 exchange 

rates) 

3.8. 

Total international bonds outstanding, broad measure (at constant end-2008 exchange 

rates) 

LIST OF BOXES 

1.1. 

The housing correction in the euro area 

1.2. 

The crash of the US Investment Bank Lehman Brothers 

1.3.  Recent developments in food prices 

1.4.  How large are the risks of deflation in the euro area? 

2.1.  Banking crisis and growth: historical evidence 

2.2.  Unconventional monetary policy measures 

2.3.  Ongoing work on further bond market integration in the euro area 

2.4.  Government accounts and bank rescue schemes 

2.5.  2008/2009 council recommendations to the euro area in the context of the Lisbon strategy 

2.6. 

The community pillar of the EERP 

4.1.  Activities of the Eurogroup in 2008 and 2009 

4.2. 

The three new euro area Member States: Cyprus, Malta and Slovakia 

42 

47 

47 

48 

49 

52 

53 

53 

55 

57 

57 

63 

63 

10 

13 

15 

18 

30 

33 

38 

41 

43 

44 

68 

72 

5 

 
 
 
 
 
INTRODUCTION 

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 roots 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  epicentre  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.  Financial  institutions  became  saddled  with  illiquid 
holdings  in  their  portfolio  and  were  increasingly  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  bankruptcy  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-stretched  situation  of  banks'  balance 
sheets. 

Although the euro area was not at the origin 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  October  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 countries 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. 

6 

 
Introduction 

Although  the  economic  and  financial  shock  was  of  unprecedented  scope, 
policymakers learnt from the mistakes of the post-1929 period. They quickly 
introduced measures on an unprecedented scale to prevent 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 economic 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. 

7 

 
1.  MACROECONOMIC DEVELOPMENTS 

by 

characterised 

After  almost 

downturn  was 

1. 
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 
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  developments  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  2008,  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%). 

Financial 

intensified  sharply 

distress  materialised 

3. 
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, 
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. 

8 

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 
the  main 
industrialised  regions  and  in  many  emerging-
market economies. 

in 

Graph 1.1:  World trade and manufacturing Purchasing 

Managers Index (PMI) 

20

10

0

-10

-20

)
e
g
n
a
h
c
%
y
o
y
(

e
g
a
r
e
v
a

i

g
n
v
o
m
h
t
n
o
m
-
3

World trade (lhs)
World manufacturing PMI (rhs)

60

50

40

30

l

b
a
a
n
c
e

o
f

i

o
p
n
o
n

i

2001

2002

2003

2004

2005

2006

2007

2008

2009

Note: Data for world manufacturing PMI cover the period 
January 2001 to May 2009 
Source: CPB Netherlands Bureau of Economic Policy 
Analysis, EcoWin, Bloomberg. 

the 

With 

external 

5. 
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  second  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). 

 
 
 
 
 
 
 
 
 
Graph 1.2:  GDP losses across recessions, euro area 

)
s
t

i

n
o
p

e
g
a

t

n
e
c
r
e
p

n
i
(

k
a
e
p
m
o
r
f

e
g
n
a
h
c

0

-1

-2

-3

-4

-5

-6

realised

forecast

1974-1975 

1980-1982

1992-1993

current

Note: Data on past recessions exclude Slovenia and 
Slovakia. 
Source: Commission services. 

6. 
Euro-area  exports  were  hard  hit  by  the 
global  slowdown.  They  fell  by  more  than  7%  in 
the  fourth  quarter  of  2008  (-8%  for  goods  only), 
the  sharpest  quarterly  contraction  ever  (data  since 
1970).  With  the  pace  of  contraction  in  exports 
exceeding  that  of  imports,  the  contribution  of  net 
exports to real GDP became increasingly negative 
in  the  second half  of  2008,  reaching  almost  a  full 
percentage  point 
the  fourth  quarter.  The 
to 
unexpected  shock 
sizeable  involuntary  inventory  accumulation  and 
translated  almost  instantly  into  a  steep  decline  in 
industrial production (Table 1.1). 

to  exports  contributed 

in 

Graph 1.3:  Contribution to GDP growth, euro area 

s
t
n
o
p

i

e
g
a
t
n
e
c
r
e
p

n

i

5

4

3

2

1

0

-1

-2

-3

-4

-5

forecast

Private consumption
Investment 
Net exports

Public consumption
Inventories
GDP growth (yoy%)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Commission services. 

The 

ongoing 

deceleration 

7. 
in 
construction  investment  was  amplified  by  the 
sudden  fall  in  business  investment.  Construction 
investment  decelerated 
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 
to  missing  demand  and 
response  of 

throughout  2008 

firms 

1. Macroeconomic Developments 

utilisation 

profits.  Capacity 

decreasing 
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 
the 
availability of capital. 

lending  standards  have 

reduced 

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, 
in 
mirroring 
financial markets. 

the  poor  return  on 

investment 

Table 1.1: 

Industrial production in the euro area (year-
on-year change) 

Euro area
Germany
France
Spain
Italy

August 2008
-1.9
1.5
-1.9
-8.4
-3.1

May 2009
-17.0
-17.9
-13.8
-20.5
-19.8

Source: Commission services. 

the  worst 

9. 
Activity  contracted  further  during  the 
first  quarter  of  2009.  GDP  dropped  by  2.5% 
quarter-on-quarter, 
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. 
inventories  significantly, 
Businesses  cut 
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. 

their 

9 

 
 
 
 
 
 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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 first 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 

average for 2001-2007

2008

e
g
n
a
h
c

y
l
r
a
e
y

12

9

6

3

0

-3

-6

-9

-12

s
t

i

n
o
p

e
g
a

t

n
e
c
r
e
p

n

i

0.8

0.0

-0.8

-1.6

-2.4

-3.2

-4.0

average for 2001-2007

2008

ES

FR

IE

IT

FI

NL

DE

US

IE

ES

FR

FI

IT

NL

DE

EA

US

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  Study1  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 
five  years),  prices  correct  by  about  25%.
subsequent  phase  of  contraction  (lasting  around 

(Continued on the next page) 

10 

 
 
 
 
 
 
 
 
 
 
 
 
1. Macroeconomic Developments 

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 Noord 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  Association
meetings in San Francisco, January 3, 2009. 

their 

forecast  points 

10. 
The  Commission  services'  spring  2009 
economic 
the  recession 
to 
through  2009,  before  growth 
continuing 
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 
trade  openness, 
degrees  (depending  on 
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  contraction  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  whole,  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 
expansionary 
impact 
macroeconomic policies. 

the 

by 

of 

is, 

however, 

characterised 

financial  markets 

12. 
The  growth  outlook  for  the  euro-area 
by 
economy 
exceptional  uncertainty.  While 
the  ambitious 
policy  actions  taken  by  governments  and  central 
banks since last autumn have prevented a systemic 
and 
financial  meltdown, 
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 economy 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 

11 

 
 
 
European Commission 

Annual Report on the euro area - 2009 

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 
in 
investment  bank  Lehman  Brothers 
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  the  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) 

%
n

i

6

5

4

3

2

1

0

i

n

b
a
s

i

s

i

p
o
n
t
s

200

150

100

50

0

Money market rate (lhs)

Money market spread (rhs)

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

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 

spread,  measured  as 

interbank 

the  

12 

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 
the  gap  between  unsecured  and 
June  2009, 
collateralised 
rates  had 
interest 
decreased substantially to less than 50 basis points, 
although  it  still  remained  higher  than  prior  to  the 
financial  crisis.  Despite 
stabilisation, 
investor confidence has not fully recovered, given 
the  uncertainties  about  valuation,  counterparty 
risks and the evolution of the deleveraging process. 

short-term 

some 

15. 
Long-term interest rates fell in response 
to  the  escalation  of  the  crisis.  The  German 
10-year Bund yield increased 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 
in  economic  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). 

improvement 

increased 

throughout 

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, 
2008 
steadily 
(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 
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  future  borrowing  needs,  as 
well  as  the  general  increase  in  liquidity  premia. 
Since  then,  spreads  have  narrowed  markedly,  but 
remain elevated by historical standards. 

became 

 
 
 
 
 
1. Macroeconomic Developments 

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 solution 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  measures  to  ease  liquidity  strains  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  since  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. 

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, increased by almost 400 basis 
points  between  mid-October  2008  and  June  2009 

(Graph  1.6).  The  steepening  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. 

13 

 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

Graph 1.5: 

10-year government bond yields, euro area 
(1 Jan 2007 to 30 June 2009) 

though the risk premium visibly increased also for 
these issuers. 

6.5

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2.5

%
n

i

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09

Source: Source: EcoWin. 

IE

EL

IT
ES
FR

DE

and 

increasing 

expectations 

18. 
Spreads  of  corporate  bond  yields  also 
increased  during  the  financial  crisis.  Gloomier 
economic 
risk 
discrimination caused markets for corporate bonds 
to  dry  up  in  2008.  Credit  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  beginning  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  declined  over  2008,  even 

Graph 1.6: 

Euro-area yield curve slope (Jan 2007 to June 
2009) 

%
n

i

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Note: Spread between the 10 years and the 3 months spot 
rates.  
Source: ECB 

14 

Graph 1.7:  Corporate bond spreads per rating, euro area 

(1 Jan 2007 to 30 June 2009) 

AAA
AA

A
BBB

500

450

400

350

300

250

200

150

100

50

0

s
t

i

n
o
p

s

i

s
a
b

n

i

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

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) 

Non-financial corporations

Households

16

14

12

10

8

6

4

2

0

-2

%
n

i

,
e
g
n
a
h
c

y
-
o
-
y

Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Source: EcoWin. 

A  significant  turnaround  took  place  in  the  fourth 
quarter  of 2008. The  annual growth rate  for  loans 
to  the  private  sector  decelerated  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 Survey for the euro area. 

 
 
 
 
 
 
 
 
 
 
1. Macroeconomic Developments 

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  pace  due  to  a  slowdown  in  the  growth  of  food  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  competition  at  EU  and  national  level  and  target  those 
practices and restrictions that are particularly harmful; 

–  Review  potentially-restrictive  regulations  at  national  and/or  EU  level.  This  exercise  is  ongoing  in  the 
context of the retail market monitoring exercise and the transposition of the Services 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  markets  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)  Report on the Competitiveness of the European Agro-Food Industry, 17 March 2009.

(Continued on the next page) 

15 

 
 
                                                           
 
European Commission 

Annual Report on the euro area - 2009 

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. 

Graph 1.9:  Composite Financing Cost Indicators (CFCI) 
for the euro area (March 2003 to April 2009) 

Graph 1.10:  Stock price index and implied volatility (Stock 

price: Jan 2007 = 100) 

Non-financial corporations

Households

6

5

4

3

%
n

i

x
e
d
n

i

120

100

80

60

40

20

0

Eurostoxx 50 (lhs)

Implied volatility (rhs)

200

150

100

50

0

i

n
%

Mar-03

Mar-05

Mar-07

Mar-09

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Source: Commission services. 

Source: EcoWin. 

corporations 

20. 
The  overall  cost  of  finance  for  both 
and 
euro-area  non-financial 
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),  the  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. 

prices 

Stock  market 

21. 
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). 

the 

From  March  onwards,  stock  markets  regained 
some  ground,  but  volatility  remained  elevated 
reflecting  uncertainty  about 
impact  of 
economic  policy  actions.  Still,  as  of  end-June 
2009,  the  Euro  Stoxx  50  had  declined  by  45% 
compared  to  end-2007.  While  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 

16 

 
 
 
 
  
 
 
1. Macroeconomic Developments 

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 consumer prices (HICP), 

euro area 

Headline HICP

HICP excluding energy & unprocessed food

%
n

i

,

e
g
n
a
h
c

y
-
o
-
y

4

3

2

1

0

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

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  September-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 remained 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. 

Graph 1.12:  Breakdown of euro-area HICP inflation 

5

4

3

2

1

0

-1

-2

Non-en. ind. goods
Unproc. food
Services

Energy
Processed food
Headline HICP

5

4

3

2

1

0

-1

-2

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

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 gradual 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. 

(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). 

(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. 

17 

 
 
 
 
                                                           
                                                           
European Commission 

Annual Report on the euro area - 2009 

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 that 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  largely  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  inflation  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    
growth order (year-on-year change, May 2009) 

Graph B. Contribution of base effects to euro area  
HICP inflation (in percentage points, January 2009 to 
April 2010) 

No of categories

Combined HICP weight

25

20

15

10

5

0

-4% to -3%
< -4%

-3% to -2%

-2% to -1%

-1% to 0%

0% to 1%

1% to 2%

2% to 3%

3% to 4%

30

25

20

15

10

5

0

>4%

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Source: Commission services. 

Source: Commission services. 

18 

 
 
 
 
 
 
 
 
 
1. Macroeconomic Developments 

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) 

2

0

-2

-4

-6

-8

8
0
0
2

n

i

e
c
n
a
a
b

l

c

i
l

b
u
p

n

i

e
g
n
a
h
C

PT

FR

EL

DE

NL

SK

AT

IT

EA16

MT

BE

SI

LU

FI

CY

ES

IE

to 

the  economic  downturn, 

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 reached 1.9% of GDP, up 
by 1.3 percentage point of GDP from 2007 (Graph 
1.13).  Due 
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 

-4

-2

0

2

4

6

Structural budget balance
Headline budget balance

Public balance in 2007 (in % of GDP)

Source: Commission services. 

Ireland. For Greece, EDP proceedings 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 

P
D
G

f
o
%

4

0

-4

-8

BE DE IE EL ES FR IT CY LU MT NL AT PT SI SK FI EA16

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 
the  Netherlands 
0.9% 
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 

in  2008).  Conversely, 

P
D
G

f
o
%
n

i

4

3

2

1

0

-1

-2

-3

-4

-5

-6

-7

-8

Structural balance in 2008

Medium term objective

AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK

Source: Commission services. 

towards 

Progress 

29. 
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  adjustment.  With  a  view  to 

19 

 
 
 
 
 
 
 
 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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  having  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 

2007

2008

2010

Maastricht 
reference 
value

P
D
G

f
o
%
n

i

120

100

80

60

40

20

0

AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK

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 

20 

income 

corporate 

income  and  wealth,  the  latter  not  least  due  to 
rapidly  declining 
taxes. 
Compared  to  the  plans  presented  in  the  2007 
the  Stability  and  Convergence 
updates  of 
Programmes,  significant  nominal  expenditure 
overruns  came 
revenue 
together  with 
shortfalls. 

large 

revenue 

Government 

32. 
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  (Portugal,  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 
revenues 
recorded 
(Finland,  Austria  and  Germany).  The  Netherlands 
benefited from stronger non-tax gas revenues. 

better-than-expected 

tax 

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  large  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  compensation  of  employees  and 
intermediate consumption pushed current spending 
upwards. 

the  recession 

34. 
Public  finances  are  expected  to  be  hit 
in  2009  and  2010. 
hard  by 
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 

Graph 1.17:  Cumulated change in public balance, euro-

1.4. 

LABOUR MARKET DEVELOPMENTS  

area countries (2007-2010) 

2008/2007

2009/2008

2010/2009

MT
EL
IT
SK
PT
FR
AT
DE
BE
EA
CY
LU
NL
SI
FI
ES
IE

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2

in percentage points of GDP

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  next  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) 

CY
MT
SK
LU
FI
SI
IT
EL
DE
AT
BE
NL
EA
PT
FR
ES
IE

2008/2007

2009/2008
2010/2009

-20

-10

0

10

20

30

40

50

60

in percentage points of GDP

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). 

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 2007 (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 

Employment growth (lhs)

Unemployment rate (rhs)

2

1.6

1.2

0.8

0.4

0

%
n

i

,
e
g
n
a
h
c

y
-
o
-
y

2004Q1

2005Q1

2006Q1

2007Q1

2008Q1

Source: Commission services.  

10

9

8

7

6

i

n
%
o
f

t
h
e

l

a
b
o
r

f
o
r
c
e

lag 

Typically,  employment  reacts  with  a 
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 
the 
internal 
recession  hit  manufacturing  hard, 
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 
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. 

the  fourth  quarter.  Although 

(-0.8% 

2009 

in 

36. 
A  sharp  reduction  in  hours  worked  has 
from 
prevented 
(Graph  1.20).  Euro-area 
increasing 
unemployment  stood  at  7.5%  in  2008,  unchanged 

unemployment 

the 
faster 

rate 

21 

 
 
 
 
 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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  unemployment.  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 

%
n

i

,
e
g
n
a
h
c

y
-
o
-
y

4

2

0

-2

-4

-6

-8

-10

GDP per hour worked
Population 15-64
Activity rate
Employment rate
Hours worked per person employed
GDP

2008Q3

2008Q4

2009Q1

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 the 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  labour  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  accounts  data,  compensation  per 
employee  includes  wages  and  salaries  and  social  security 
contributions. 

22 

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 

5

4

3

2

1

%
n

i

,

e
g
n
a
h
c

y
-
o
-
y

Labour Cost Index
Compensation per employee
Negotiated wages

0
2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1

Source: Eurostat for Labour Cost Index and compensation 
per employee, ECB for Negotiated wages. 

together  with 

the  deterioration 

Taken 
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 

Labour productivity (inverted scale)
Compensation per employee
Nominal unit labour costs

%
n

i

,
e
g
n
a
h
c

y
-
o
-
y

5

4

3

2

1

0

-1

-2

2006Q1

2006Q3

2007Q1

2007Q3

2008Q1

2008Q3

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  gradually  weakened  over  the 

(4)  Negotiated  wages  measure  the  outcome  of  collective 
bargaining  in  terms  of  basic  pay  or  salary  (i.e.  excluding 
bonuses). 

 
 
 
 
                                                           
 
 
 
 
 
 
                                                           
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  productivity  (1.7%  year-on-
year).  A  breakdown  by  sectors  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 
in  higher  productivity  growth  and 
resulted 
relatively  contained  labour  costs  pressures  in 
response 
in  Spain  did 
the  crisis.  Only 
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. 

to 

Graph 1.23:  Compensation per employee, labour 

productivity and unit labour costs by sectors in 
2008, euro area 

10

8

6

4

2

0

-2

-4

%
n

i

,
e
g
n
a
h
c

y
-
o
-
y

Industry

Construction

Market 
services 
NACE G-I

Market 
services 
NACE J-K

Labour productivity (inverted scale)
Compensation per employee
Nominal unit labour costs

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

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 intermediation and real estate. 
Source: Commission services. 

is 

outlook 

Labour  market 

39. 
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  2010.  While  the  slack  in 
the  labour  market  should  lead  to  a  significant 
deceleration  in  nominal  wages  (to  slightly  below 
+2%  in  2009  and  +1.5%  in  2010),  very  subdued 
consumer  price  growth  might  imply  that  real 

1. Macroeconomic Developments 

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 position (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) 

Euro area 

United States
China

P
D
G

f
o
%
n

i

11

9

7

5

3

1

-1

-3

-5

-7

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

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 positive 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 increase in unit labour costs 

(5)  Theoretically,  above-average  demand  in  a  given  country 
should push costs and prices upwards.  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 towards the euro-area average. 

23 

 
 
 
 
 
 
 
                                                           
European Commission 

Annual Report on the euro area - 2009 

lead 

in  productivity, 

implies  competitiveness  adjustment.  However, 
such  cost  and  price  increases,  if  not  offset  by 
increases 
to  prolonged 
competitiveness  losses  and  build-up  of  domestic 
imbalances. Evidence shows that in some Member 
States  wage  growth  has  been  outpacing 
productivity  growth 
(Spain, 
Portugal,  but  also  Belgium,  Ireland,  Italy)  (Graph 
1.25). 

for  some 

time 

Graph 1.25:  Compensation per employee, labour 

productivity and nominal unit labour costs 
(1999-2008) 

Labour productivity (inverted scale)
Compensation per employee
Nominal unit labour costs

%
n

i

,
s
e
g
n
a
h
c

l

a
u
n
n
a

e
g
a
r
e
v
a

9

7

5

3

1

-1

-3

-5

BE DE IE EL ES FR IT CY LU MT NL AT PT SI SK FI

Source: Commission services. 

imbalances 

Distinguishing  between 

42. 
'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 
in  some  Member 
macroeconomic 
States.  The  harmful 
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  cyclical  differences  have 
played  a  relatively  minor  role  in  driving  the 
divergences  in  external  performance.  Differences 
to  be 
inflation  have 
in  growth  and 
significant and persistent, leading to large changes 
in  Member  States'  relative  competitive  positions,  

factors 

tended 

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). 

Differences 

43. 
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 
significant 
(REER).  The 
divergences  with  Germany 
13% 
competitiveness  and  Spain  losing  almost  20% 
since 1998. 

indicator 

gaining 

shows 

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 
(Germany,  Luxembourg, 
account 
Austria,  Netherlands,  Finland), while others have 
seen large or very large deficits (primarily Greece, 
Spain, Portugal and Cyprus but also Ireland, Malta, 
Slovenia, Slovakia). 

surpluses 

(6)  The  Balassa-Samuelson  hypothesis  predicts  that  price 
levels  will  increase  when  relative  productivity  rises  in  the 
tradable sector. If prices in the 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 producing non-tradables will rise 
and the general price level will thereby increase. 

(7)  For  more  details  see  Quarterly  Report  on  the  Euro  Area 
Vol.  8  N°1  (2009),  "Special  report:  Competitiveness 
developments within the euro area". 

24 

 
 
 
 
 
 
                                                           
                                                           
Graph 1.26:  Changes in intra euro-area Real Effective 

Exchange Rate (REER) 

%
n

i

20

15

10

5

0

-5

-10

-15

1998-2008

1998-2010

DE FI AT FR BE SI

IT

IE NL MT PT EL CY ES SK

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 
in  a 
comparatively  moderate  deficit  (France,  Italy  and 
Belgium). 

in  surplus  or 

remains 

Graph 1.27:  Current account positions, euro-area Member 

States (1999 to 2008) 

P
D
G

f
o
%
n

i

10

5

0

-5

-10

-15

-20

1999

2008

CY EL PT ES MT SI SK IE FR IT BE AT FI LU NL DE

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  large  current  account  deficits  in 
some Member States has been the build-up of large  

1. Macroeconomic Developments 

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) 

P
D
G

f
o
%
n

i

35

15

-5

-25

-45

-65

-85

-105

1995
2007

EL

PT

ES

SK

AT

IT

FR

DE

BE

NL

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  convergence  in  current  account 
positions  is  moderate  and  asymmetric  across  the 
euro-area Member States (Graph 1.29). 

25 

 
 
 
 
 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

Graph 1.29:  Evolution of current account positions, euro-

area Member States (2008 to 2010) 

P
D
G

f

o
%
n

i

2

-3

-8

-13

-18

2008

2010

CY EL PT ES MT SI SK IE FR IT BE AT FI LU NL DE

Note: Net lending (+) and borrowing (-) from national 
accounts for all Member States except LU (balance of 
current transactions 
Source: Commission services 

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  question. 
Evidence  shows  that  competitiveness  adjustment 
in  the  euro  area  is  working  but  could  be  slow. (8) 
Countries  with  greater  adjustment  needs  are 
labour  market 
generally  facing  product  and 
rigidities  above  the  euro-area  average,  rendering 
the  process  of  regaining  price  competitiveness 
more  difficult  in  terms  of  length  and  economic 
cost. 

the  countries 

in 

that 

forecast 

suggests 

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 
the  ongoing 
adjustments  in  current  account  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 
and 
cost 
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 

unemployment 

terms 

of 

in 

for 

47. 
This  divergence  in  competitiveness  has 
implications  both  for  the  functioning  of  EMU 
economic  governance.  Persistent 
and 
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 
the 
economic  governance  aspect 
to 
competitiveness  dimension  are  discussed 
in 
Chapter 4, Section 2. 

related 

(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. 

26 

 
 
 
 
 
                                                           
2.  MACROECONOMIC POLICIES 

an  overview  and 

48. 
These  are  testing  times  for  economic 
policies.  The  exceptional  character  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 
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. 

'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 
liquidity 
the  crisis.  Ample  global 
root  of 
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 

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  breathtaking  pace  the  real  economy 
during  the  fourth  quarter  of  2008.  Business 
surveys, closely followed by hard indicators, such 
as 
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. 

industrial  production  and  external 

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  lenders  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 
endogenous 
ignored 
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), 
that 

the  possibility 

the 

(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. 

)
0
0
1

=
7
8
9
1

i

,
d
e
t
h
g
e
w
P
D
G

-

,

%
n
i
(

Government
Households
Financial institutions
Nonfinancial corporations

350

300

250

200

150

100

50

0

Mar-87 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05 Mar-08

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, 
financial 
thanks 
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. 

enhanced 

the 

to 

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 
the  real  economy.  The  ensuing 
reduction  in  working  capital  for  non-financial 
companies  leads  to  higher  default  rates  in  the 

to 

27 

 
                                                           
 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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 
recessions 
triggered  by  banking  crises  are  deeper  and  last 
longer  than  normal  recessions  (see  Box  2.1).  The 
economy  is  in  need  of  a  mutually  supporting  mix 
of financial and economic policies. 

shows 

that 

of 

took 

action 

repair 

immediate 

Regulatory 

53. 
financial 
supervision  is  a  prerequisite  for  policy-makers. 
Initial  policy  action 
the  form  of  fast 
interventions  by  central  banks  to  compensate  for 
the  liquidity  shortfall  on  money  markets.  This 
be 
had 
necessary 
to 
complemented  by  a  comprehensive 
set  of 
regulatory  reforms  to  remove  sources  of  pro-
cyclicality in the financial sector (see Section 2.3). 
In  addition,  the  credit  channel  had  to  be  repaired 
through  extensive  support  schemes  for  banks, 
ranging  from  recapitalisations  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. 

28 

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. 

There 

is  a  particular  need 

56. 
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 
fiscal 
policymaking. 

time-consistent 

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 

not  affecting  the  supply  of  credit  within  the  euro-
area economy. 

Graph 2.2: 

ECB interest rates and Eonia 

ECB minimum bid rate
ECB marginal lending facility
ECB deposit facility
Overnight interbank rate (Eonia)

7

6

5

4

3

2

1

%
n

i

0
Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

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 (Graph 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, 
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%. 

the  Governing  Council 

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  bank  to  address  market 
tensions  via  enhanced  liquidity  provision  to  the 
banking  system.  From 
the  US 
investment bank Bear Stearns in mid-March to the 
end  of  summer  2008,  the  ECB  accommodated 
higher 
larger 
liquidity  demand  by  allocating 
volumes in its main weekly refinancing operations. 

the  fall  of 

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  announced,  the  combined 
stimulus would amount to some five trillion dollars 
by 
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. 

the  end  of  2010.  This 

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 
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. 

inflationary  pressures.  As 

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  was  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, 
to  non-financial 
companies, was still growing at a healthy rate. This 
suggested  that  tensions  on  financial  markets  were 

in  particular 

and 

(11)  Harmonised Index of Consumer Prices. 

29 

 
  
                                                           
 
European Commission 

Annual Report on the euro area - 2009 

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 

Spain (1980-1987)

USA (1990-1998)

Finland (1989-1998)

Japan (1997-2006)

Sweden (1989-1998)

Norway (1986-1997)

Duration of downturn (1)
(quarters)
R
12

Ratio
2.3

R&B
28

Cumulative output loss
(% pts of GDP)
R
-6.0

Ratio
1.7

R&B
-10.1

Recovery half-life (2)
(quarters)
R
4

Ratio
0.5

R&B
2

32

28

32

28

35

13

15

16

11

9

2.6

1.9

2.0

2.5

3.9

-11.4

-40.6

-12.3

-16.7

-34.8

-6.2

-5.2

-7.3

-4.3

-6.5

1.8

7.9

1.7

3.9

5.4

5

14

3

7

1

3

5

4

3

1

2.0

2.6

0.8

2.3

1.0

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) 

30 

 
 
 
 
 
 
                                                           
 
2. Macroeconomic Policies 

Box (continued) 

Graph 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 

74Q3 downturn
80Q1 downtun
92Q1 downturn
08Q1 downturn

108

106

104

102

100

98

96

94

92

104

100

96

92

88

84

80

74Q3 downturn
80Q1 downtun
92Q1 downturn
08Q1 downturn

0

1

2

3

4

5

6

7

8

9

10

11

0

1

2

3

4

5

6

7

8

9

10

11

Quarters from peak of economic cycle

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 equivalent 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. 

Graph C: Priv ate consumption across 
recessions, euro area

74Q3 downturn
80Q1 downtun
92Q1 downturn
08Q1 downturn

110

108

106

104

102

100

98

96

0

1

3

5
2
Quarters from peak of economic cycle

6

4

7

8

9

10

11

Source: Commission services. 

Reinhart, C. and Rogoff K. (2009), 'The Aftermath of Financial Crises', NBER Working Papers, No. 14656. 

The  ECB  also  raised  the  volume  allotted  in  its 
three-month refinancing operations and introduced 
six-month  refinancing  operations,  as  from  April 
2008. 

in 
These  policies  were 
stabilising  money  markets,  with  the  differential 
between  the  Eonia  (effective  overnight  interest 

successful 

largely 

rate)  and  the  ECB's  key  policy  rate  remaining 
close to zero. 

The  ECB 

responded  decisively 

63. 
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 

31 

 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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  asset-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 
long-term  refinancing 
442 billion 
operation with a maturity of 12 months, carried out 
as a fixed-rate tender with full allotment. 

its  first 

in 

Graph 2.3:  Central banks' policy interest rates 

7

6

5

4

3

2

1

0
Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

ECB minimum bid rate
US federal funds target rate

Bank of England benchmark 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 
these 
the 
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). 

same 

time, 

64. 
The ECB recently added unconventional 
measures  to  its  policy  arsenal.  Following  its 
Governing  Council  meeting  on  7  May  2009,  the 

(13)  The  Eurosystem's  balance 

(12)  The  decision  was  subsequently  reversed  in  order  to 
encourage banks to resume trading in the interbank market 
the 
consolidated  balance  sheet  of  the  ECB  and  the  National 
Central Banks which are part of the euro area. 

sheet  consists  of 

(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. 

32 

to  purchase  euro-denominated 
ECB  agreed 
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 the 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 markets. 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 

framework 

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 
for 
supervisory 
financial services, which was highlighted by the de 
Larosière 
(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. 
lending  and 
initiatives 
borrowing), 
to  reduce 
excessive short-term risk-taking (e.g. initiatives on 
to 
financial 
remuneration 
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 

to  foster  responsible 

services)  and 

incentives 

improve 

report 

in 

to 

(15)  Outstanding  debt  securities  amounted  to  81%  of  GDP  in 
the euro area in 2007 as against 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 

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  provide  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 will, 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, 
longer 
maturities  against  collateral  which  includes  assets 
whose markets are temporarily impaired. 

to  banks  at 

involves 

lending 

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 
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-

international 

(16)  Banks  purchased  them  either  directly  or  through  complex 
sponsored  structured  investment  vehicles  (SIV),  mostly 
located in offshore centres. 

Graph: Central banks' balance sheet size 
(in % of GDP)

European Central Bank
Federal Reserve System
Bank of England

Dec-07

Apr-08

Aug-08

Dec-08

Apr-09

25

20

15

10

5

0
Aug-07

Source:  Commission serv ices.

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  suffered  from  the  growing 
defiance of investors. As a result, the perception of 
default 
successive  waves,  as 
evidenced  through  the  prices  of  credit  default 

increased 

in 

33 

 
                                                           
 
 
 
European Commission 

Annual Report on the euro area - 2009 

swaps (17)  and  other  financial  instruments  (Graph 
2.4).  Reduced  expectations  on  banks'  profitability 
over  the  medium  term  became  apparent  from 
equities 
September 
underperformed  the  all-equity  stock  price  index 
(Graph 2.5). 

2008 

bank 

on, 

as 

Graph 2.4:  Default risks of euro-area financial institutions 

subordinate financials
senior

400

300

200

100

s
t

i

n
o
p

s

i

s
a
b

n

i

0
Jan-08

May-08

Sep-08

Jan-09

May-09

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  cushions  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. 

34 

Graph 2.5: 

Equity prices in the euro area (January 2008 = 
100) 

120

100

80

60

40

20

0

Financials (lhs)
EuroStoxx50 (lhs)
Relative value of financials (rhs)

40

30

20

10

0

-10

-20

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Note: A negative value means that the financial sector is 
under-performing the overall stock index 
Source: EcoWin, Commission services. 

to  be  pro-cyclical,  as 

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) 
in  many  financial  market  segments 
liquidity 
proved 
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 
rescue 
measures. 

embarked  on 

large-scale 

targeted 

Immediate  policy  steps 

68. 
the 
provision  of  liquidity  and  capital,  coverage  of 
deposit  guarantees  schemes  and  accounting 
relief.  On  12  October  2008,  an  extraordinary 
Eurogroup  Summit  at  the  level  of  Heads  of  State 
and  Government  spelled  out  six  principles  and 
objectives for a coordinated 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; 

 
 
 
                                                           
 
(v) 

Apply accounting rules more flexibly; 

Enhance  cooperation  and 

(vi) 
exchange. 

information 

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  critical  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 the 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; 

State-backed 

bank 
(ii) 
liabilities  to  allow  banks  to  tap  private  debt 
markets in order to refinance their lending activity; 

guarantees 

on 

Asset  relief  schemes  in  order  to  relieve 
(iii) 
banks'  balance  sheets  of  illiquid  assets  under 
specific conditionalities; 

Increased access to liquidity from Central 
(iv) 
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:  

2. Macroeconomic Policies 

Coverage of the schemes both in terms of 
institutions 

instruments/markets  and 

(i) 
financial 
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 

Pricing  aspects,  conditionality  and  exit 

(iv) 
strategy. 

the 

2008, 

71. 
Rescue  packages  are  subjected  to  State 
aid  control.  Although  the  EC  Treaty  generally 
prohibits State aid, it leaves room for a number of 
policy  objectives  for  which  State  aid  can  be 
considered  compatible,  for  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 
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 
to 
assessing restructuring aid given by Member States 
to  banks.  The  approach 
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. 

its  approach 

is  based  on 

35 

 
European Commission 

Annual Report on the euro area - 2009 

Table 2.1: 

Euro-area public interventions in the banking sector (in % of GDP) 

Capital injections

Guarantees on bank 
liabilities

approved
5.0
5.3
0.0
0.0
1.2
4.4
2.0
6.6
1.3
6.9
0.0
6.4
2.4
0.0
0.0
0.0
2.7

effective
1.7
6.1
0.0
0.0
0.8
1.6
1.5
4.2
0.0
7.9
0.0
6.4
0.0
0.0
0.4
0.0
1.4

approved
25.7
76.6
0.0
27.7
16.6
18.6
6.1
225.2
NA
12.4
0.0
34.3
10.0
0.0
32.8
9.3
20.7

effective
5.1
16.3
0.0
0.0
4.5
7.1
1.2
225.2
0.0
NR
0.0
7.7
3.3
0.0
0.0
3.2
8.7

Relief of impaired asset
approved
effective
0.4
0.4
4.2
10.1
0.0
0.0
0.0
0.0
0.2
0.2
0.4
1.4
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
3.9
3.9
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.6
1.1

Liquidity and bank funding 
support

Total

approved
1.6
NA
0.0
0.0
0.0
0.0
3.3
0.0
0.0
0.9
0.0
7.5
0.0
0.0
0.0
2.8
1.0

effective
1.5
NR
0.0
0.0
0.0
0.0
1.8
0.0
0.0
0.9
0.0
7.5
0.0
0.0
0.0
1.8
0.8

approved
32.8
92.0
0.0
27.7
18.1
24.4
11.4
231.8
1.3
20.2
0.0
52.0
12.5
0.0
32.8
12.1
25.4

effective
8.7
26.7
0.0
0.0
5.6
9.1
4.6
229.4
0.0
8.8
0.0
25.4
3.3
0.0
0.4
5.0
11.5

2.6

1.5

24.8

8.1

0.8

0.4

2.9

2.6

31.2

12.6

Austria
Belgium
Cyprus
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Malta
Netherlands
Portugal
Slovakia
Slovenia
Spain
Euro Area
Memo item
EU-27

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. 

from 

other 

start 
forms 

recapitalisation  measures 

Italy  notified  guarantee  schemes  in  the  first  place 
and 
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 
(guarantee, 
the 
measures 
recapitalisation, 
equity 
of 
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 

Graph 2.6:  Write-downs and capital injections of main 
euro-area financial institutions 

Write downs

Capital injections

250

200

D
S
U
n
o

i
l
l
i

b

n

i

150

100

50

0

3Q2007

4Q2007

1Q2008

2Q2008

3Q2008

4Q2008

1Q2009

Source: Bloomberg, Commission services. 

72. 
Member  States  allocated  sizeable  public 
to  banking  rescue  packages.  State 
means 
guarantees and liquidity support measures were the 
most  widely-used  measures  in  the  early  phase  of 
these  plans.  Member  States  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  Netherlands  and  Portugal 
notified guarantee schemes only, while France and 

36 

 
 
 
  
 
 
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) 

Euro area

USA
UK

s
t
n
o
p

i

s

i

s
a
b

n

i

400

350

300

250

200

150

100

50

0

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

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. 

Still,  global  banks  have 

74. 
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. 

2. Macroeconomic Policies 

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 
securities 
assets.  Banks' 
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. 

issuance  of  debt 

The medium-term perspective: regulatory reforms 

issues  – 

77. 
In October 2007, the Ecofin Council laid 
down  a  roadmap  to  tackle  the  shortcomings  of 
the  existing  regulatory  framework.  It  focused  on 
transparency,  valuation, 
four  main 
prudential  oversight  and 
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). 

the 

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  

37 

 
 
 
                                                           
European Commission 

Annual Report on the euro area - 2009 

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  adaptability  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.  Competition  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 negotiated fee, will subscribe to its bond issues and then sell them to other retail or institutional investors.  

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. First, 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 
the  Commission  submitted  a 
October  2008, 
proposal 
the 
European  Parliament  in  April  2009)  to  amend  the 
Capital Requirements Directive (CRD) introducing 
important changes so that: 

the  Council  and 

(adopted  by 

38 

 (i) 
National supervisory authorities will have 
a  better  overview  of  the  activities  of  cross-border 
banking groups; 

There  will  be  clear  EU-wide  criteria  for 

(ii) 
assessing the quality of bank capital;  

Rules  on 

(iii) 
tightened.  

securitised  debt  will  be 

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 
re-
securitisations; 

diligence 

complex 

highly 

for 

(ii)  strengthen the  capital  requirements  for market 
risks in the trading books; 

 
 
                                                           
 
(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. 

regulatory 

An  adequate 

80. 
framework 
should  cover  all  relevant  areas  of  the  financial 
system. Parallel efforts have been undertaken with 
reference 
the 
financial sector: 

to  other  relevant  segments  of 

On  3  July  2009, 

(i)  
the  Commission 
published a Communication that explores ways to 
stability  of 
transparency  and 
improve 
derivatives markets. 

the 

(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 that 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. 

to 

institutions 

Since pay and bonus systems inside many 
(iii) 
financial 
encourage 
tended 
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 
In 
prevent  excessive 
addition,  the  proposed  amendments  of  the  CRD 
which  were  unveiled  in  July  2009  would  impose 
binding  principles 
remuneration 
for 
practices in banks and investment firms. 

risk-taking  behaviour. 

sound 

(iv) 
Finally,  the  Commission  adopted  on  29 
April  2009  a  Communication  concerning  investor 
retail 
the 
protection 
investment products. 

field  of  packaged 

in 

2. Macroeconomic Policies 

2.4. 

THE  EUROPEAN  ECONOMIC  RECOVERY 
PLAN (EERP) 

in 

81. 
The European Economic Recovery Plan 
constitutes  Europe's  integrated  response  to  the 
the  financial  and  economic  crisis 
crisis.  As 
intensified, 
its 
the  Commission  presented 
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  cushioning  the  blow  of  the 
recession  in  the  short  term  by  swiftly  stimulating 
demand,  boosting  consumer  confidence  and 
lessening 
the  economic 
downturn.  At  the  same  time,  the  EERP  promotes 
Europe's 
to 
measures 
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  human  cost  of 

reinforce 

needed 

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  and  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  fiscal  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 

39 

 
European Commission 

Annual Report on the euro area - 2009 

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 governments to structure and adopt 
measures,  and  effectively  disburse  funds.  These 
lags  explain  why  the  EERP  had  to  be  launched 
steering  national 
quickly  with  a  view 
governments 
and 
coordinated  measures.  Rapid  action  would  boost 
demand,  defuse  the  risk  of  vicious  circles  and 
complement other action taken. 

to 
taking 

towards 

resolute 

limited 

Targeted  measures  must 

85. 
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 
impact  on  potential 
positions  without  much 
growth.  With  necessarily 
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 
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). 

to  spend  most  of 

likely 

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,  commitments  to  reverse  the 
impact  of  the  fiscal  stimulus  must  be  taken  and 
made  credible  enough  to  maximise  effectiveness. 

Measures  must  have  built-in  reversibility  features 
so 
to 
that  Member  States  can  switch  back 
consolidation  course  when  economic  recovery 
picks up steam. 

Table 2.2: 

First year GDP effects of fiscal stimulus 
amounting to 1% of GDP 

Fiscal measure

Permanent 
stimulus

Temporary 
stimulus (one 
year)

Temporary with 
monetary 
accommodation (1)

Investment 
subsidy
Government 
investment
Government 
consumption

Consumption tax

Government 
transfers
Labour tax
Corporate profit 
tax

0.46

0.84

0.36

0.37

0.22

0.48

0.32

1.37

1.07

0.99

0.67

0.55

0.53

0.03

2.19

1.40

1.40

0.99

0.78

0.68

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 
imbalances  should  also 
external  or  domestic 
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 
a  desired  purpose  without 
jeopardising  the  sustainability  of  its  financial 
position or the stability of the economy' (20). 

for 

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.  Therefore  such  countries  are  not 

(19)  Roeger  W.,  in't  Veld  J. 

'Fiscal  policy  with  Credit 
Constrained  Households,'  European  Economy  Economic 
Papers 357, January 2009. 

(20)  For  more  information  see  European  Economy  X/2009 

'Public finances in EMU – 2009'. 

40 

 
                                                           
 
 
 
                                                           
2. Macroeconomic Policies 

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  market  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  impaired  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 assets 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 public 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 organized 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. 

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 
revenues 
and  unemployment  benefits.  Tax 

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 
larger 
by  fiscal  authorities.  Because  of 

the 

41 

 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

in 

the  EU  (in  2008 

government  sector 
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. 

Supporting  households' 

89. 
purchasing 
power relies both on automatic stabilisers and on 
discretionary  measures.  Against  the  background 
of  a  decline  in  private  consumption  for  2009, 
that  support  household  disposable 
measures 
income  and  purchasing  power  help  to  sustain 
consumption  and  aggregate  demand.  They  also 
provide  income  support  for  groups  hit  hardest  by 
the downturn. 

capital 

90. 
Bank  rescue  packages  are  also  a 
component  of  the  overall  fiscal  stimulus  (see 
Section 2.2). Bank guarantees, asset relief schemes  
and 
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  the  need  for  appropriate 
exit strategies. 

injections 

have 

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 

42 

them against the following objectives, well in line 
with the SGP principles: 

ensuring the reversibility of measures that 

(i) 
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 
to 
GDP  over  2009  and  2010.  According 
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 whole. 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 
in 
Washington and London (see Chapter 3). 

the  G-20  Summits 

the  outcome  of 

Graph 2.8: 

Fiscal policy stance in the euro area 

4

3

2

1

0

-1

-2

-3

-4

Change in CAPB
GDP growth

2004

2005

2006

2007

2008

2009

2010

Note: Commission services' spring forecast for 2009 and 
2010. CAPB: Cyclically-adjusted primary balance. 
Source: Commission services. 

The structural arm of the EERP 

for 

93. 
The European Economic Recovery Plan 
calls 
'increased  efforts 
implement 
the  Lisbon 
structural  reforms  envisaged 
strategy'. While the main aim of structural reforms  

to 
in 

 
 
 
2. Macroeconomic Policies 

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  borders,  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. 

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  provide  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 
and 
distributional effects in the short term that mitigate 
the  economic  and  social  impact  of  the  downturn. 
Moreover,  adherence 
to  ambitious  structural 
reform  agendas  can  enhance  the  credibility  of 
short-term  policy  responses 
the  economic 
slowdown. In this respect, the country-specific and 
euro-area  Member  State  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. 

have  macroeconomic 

can 

to 

94. 
should 
Labour  market  measures 
combine immediate policies reacting to the rapid 

losses 

deterioration of employment 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 
that  were 
in  sectors  and  firms 
fundamentally  sound  prior  to  the  crisis.  Policies 
to 
that  promote  mobility 
expanding 
unemployment 
insurance  and  active  labour-market  programmes 
will 
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. 

from  contracting 

adequate 

facilitate 

sectors, 

95. 
Investment  measures  have  the  potential 
to influence trend growth. Private investment has 
been  hit  hard  in  the  current  economic  climate. 
Investment  growth  is  forecast  to  remain  negative 
in  2010.  Against  this  background,  investment  

43 

 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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 Parliament 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 European 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 projects 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 adapt 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  Cars"  PPP  initiative  (EUR  1  billion)  focuses  on  the 
development  of  renewable  and  non-polluting  energy  sources,  safety  and  traffic  fluidity  in  the  automotive 
field. 

44 

 
 
 
 
the 

relatively 

measures  lay  the  groundwork  for  a  stronger 
recovery for two reasons. Firstly, economic growth 
would  be  positively  influenced  in  the  short  run, 
large  multiplier  effects 
given 
associated  with  increased  investment.  Secondly, 
over the longer run, higher investment can remove 
various  impediments  to  growth  and  enable  faster 
improve.  From  a 
recovery  when  conditions 
competitiveness 
well-designed 
perspective, 
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. 

In 

96. 
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-ordinated  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 result, in the euro area, the 

2. Macroeconomic Policies 

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 includes 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  deterioration  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 support 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) 

AT
BE
CY
DE
EL
ES
FI
FR
IE
IT(1)
LU
MT
NL
PT
SI
SK

Euro Area

Total
3.6
0.8
0.1
3.3
0.0
2.9
3.8
1.0
1.0
0.0
2.6
3.2
1.9
1.0
1.1
0.1

1.8

2009-2010
Expenditure
0.8
0.5
0.0
1.2
0.0
1.6
1.0
0.7
0.6
0.0
0.1
2.7
0.8
1.0
0.9
0.0

0.8

Revenues
2.8
0.3
0.0
2.1
0.0
1.3
2.8
0.3
0.4
0.0
2.5
0.5
1.1
0.0
0.2
0.1

1.0

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 

45 

 
 
 
European Commission 

Annual Report on the euro area - 2009 

should 

improve 

Member  States  to  the  Commission:  (i)  22%  are 
supporting households' purchasing power; (ii) 25% 
are buttressing investment activity; (iii) 32% are in 
industrial  sectors,  businesses  and 
support  of 
companies; 
the 
(iv)  21% 
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 

Support 

100. 
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. 

being 

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 
easily 
of 
advantage 
implemented  and  unbiased 
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  adjusted  social  security 

transparent, 

46 

contributions  paid  by  employees  (for  example 
Germany and the Netherlands). 

Table 2.4: 

Overview of structural reform measures 
relevant to national recovery programmes 
Breakdown of measures by category
(number of measures)

Supporting 
household 
purchasing 
power

Supporting 
investment 
activity

Supporting 
industrial sectors, 
businesses and 
companies

Supporting the good 
functioning of 
labour markets

AT
BE
CY
DE
EL
ES
FI
FR
IE
IT
LU
MT
NL
PT
SI
SK
EA
In %

17
11
6
12
5
17
6
18
3
9
8
1
3
8
0
4
128
22%

14
9
7
14
6
11
6
12
6
10
7
3
17
7
10
6
145
25%

18
16
5
13
5
36
4
21
2
8
8
5
14
16
9
12
192
32%

8
17
5
8
9
14
12
12
3
7
2
2
7
6
5
8
125
21%

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  measures  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 
in  a  context  of  high, 
less  of  a  concern 
crisis-induced, unemployment. 

Labour market measures 

103. 
The  financial  crisis  and  the  ensuing 
global  downturn  are  beginning 
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 

to 

 
 
 
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) 

3

2

1

0

2.6

2.4

2.2

2.1

1.0

0.9

0.5

0.5 0.5

0.1

0.0

0.0

0.2

0.0

0.1

0.0 0.0

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 
small 
proportion of the total discretionary fiscal impulse 
(Graph 2.10) but can be quite cost-effective in the 
present circumstances. 

represent  a 

in 

104. 
Flexible working time arrangements are 
several  Member  States. 
being  adopted 
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 
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.  

(Austria,  Germany, 

France, 

should 

Training  and  active 

105. 
labour  market 
policies 
structural 
ensure 
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 

that 

2. Macroeconomic Policies 

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  detrimental  increase  in  long-term 
unemployment. 

Graph 2.10:  EERP - Labour market measures in the euro 

area (fiscal stimulus as % of country GDP, 
2009-2010) 

0.5

0.4

0.3

0.2

0.1

0.0

0.5

0.4

0.2

0.3

0.2

0.1

0.0

0.1

0.1

0.1

0.0

0.0 0.0

0.0 0.0 0.0

0.0

AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK EA16

Note: EA excluding Luxembourg.  
Source: Commission services 

to  boost 

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 
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  crisis  (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  contributions  for  both  employers 
and  employees.  In  the  same  vein,  Belgium  has 
extended 
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. 

inter-sectoral 

the 

47 

 
 
European Commission 

Annual Report on the euro area - 2009 

the 

incentives 

Improving 

107. 
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 

to  public 

investment 

in  physical 

108. 
Nearly  all  euro-area  Member  States 
have  announced  measures  aimed  at  supporting 
infrastructure.  The 
investment 
in 
prominence  attached 
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.  Implementation  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,  Spain,  France  and  Portugal). 
A significant number of measures provide support 
to  the  building  sector  without  being  linked  to 
energy  efficiency  improvements.  In  cases  where 
the housing market has experienced a bubble such 

48 

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) 

2.5

2.0

1.5

1.0

0.5

0.4

0.2

0.0

2.5

1.0

0.9

0.9

0.4 0.4

0.5

0.4 0.4

0.0

0.0

0.0 0.0 0.0

0.0

AT BE CY DE EL ES FI FR IE IT LU MT NL PT SI SK EA16

Source: 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 construction and renewable energy 
markets and are in line with long-term objectives. 
They  will  help  minimise 
insolvencies  of 
companies  in  the  eco-innovation  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 
like  Austria, 
energy  consumption.  Countries 
Germany  and  Finland  have  reinforced  guarantees 
and  agreements  with  national  public  financial 
institutions  to  provide  loans  and  other  financial 
risk-covering 
European 
Investment Bank has also announced a substantial 
increase  in  its  lending  in  2009  and  2010  for  low-
carbon and energy-saving infrastructure projects. 

instruments. 

The 

 
takes 

the  form  of 

111. 
(R&D) 
Research  and  Development 
measures  can  increase  productivity  growth  and 
competitiveness. R&D measures generally account 
investment  measures. 
for  a  small  share  of 
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 
loans  (Germany, 
Austria),  R&D 
tax  credits  (Germany,  Spain, 
Ireland, the Netherlands), depreciation rule (France 
and  Germany)  and  direct  subsidies  (Austria, 
Germany, Finland). The preliminary 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 
the  Netherlands,  reinforcing  support 
well  as 
instruments  to  stimulate  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' 
'catching-up 
and 
countries' (21). 

innovators'  and 

'moderate 

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  severely  affected  European 
businesses 
through 
industries, 
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  individual  country  level, 
see Graph 2.12. 

firstly 

and 

(21)  This  terminology  is  taken  from  the  European  Innovation 

Scoreboard. 

2. Macroeconomic Policies 

Graph 2.12:  EERP- Business support measures in the euro 

area (fiscal stimulus as % of country GDP, 
2009-2010) 

1.8

1.2

0.6

0.6

0.0

1.5

0.8

0.3

0.0 0.0 0.0 0.0

0.0 0.0

0.6

0.3

0.2

0.2 0.1

0.3

0.0

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  guarantees,  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 
(the  Netherlands, 
in  others 
Portugal,  Greece  and  Spain).  Already  in  2008, 
Germany implemented a corporate tax reform that 
reduced  the  corporate  tax  rate  from  25%  to  15%, 
which 
for 
corporations over the period 2008-2012. 

is  providing 

substantial 

relief 

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 
the 
Netherlands  and  Belgium  sped  up  government 
bills.  Some  Member  States  have  also  moved  to 

and  Portugal, 

payments, 

49 

 
                                                           
European Commission 

Annual Report on the euro area - 2009 

ensure  that  financial  sector  problems  do  not 
undermine  financing  and  insurance  of  foreign 
trade. 

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. 

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  state  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. 

have 

implemented 

117. 
Sector-specific  measures  focused  on  the 
industry.  Ten  euro-area  countries 
automotive 
(Germany,  Spain,  France,  Italy,  Cyprus, 
the 
Netherlands,  Luxembourg,  Austria,  Portugal  and 
Slovakia) 
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  Slovakia 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 

50 

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 
in  countries 
business  environment,  especially 
where  doing  business  was  less  easy  before. 
Significant 
business 
environment  can  be  expected  from  a  rapid  and 
thorough implementation of the Services Directive 
and 
the 
Directive.  

in  services  going  beyond 

improvements 

reforms 

the 

in 

to 

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, 
the  crisis,  structural  reforms  were 
prior 
the  French  services  sector, 
implemented 
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. 

in 

Overall  assessment  of  national 
recovery measures 

economic 

The 

States’ 

findings 

preliminary 

121. 
are 
encouraging.  Member 
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  stimuli,  temporary support 
to  hard  hit  sectors  and 
to 
seem 
vulnerable 

groups.  Most  measures 

targeted  support 

 
2. Macroeconomic Policies 

2010.  Moreover,  there  is  a  degree  of  focus  on 
energy  efficiency,  although  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 
adverse 
repercussions  on  R&D  spending,  and  in  turn  be 
detrimental to potential growth. 

significant 

have 

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  operate  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 macroeconomic divergences 
(see Section 1.5). 

the 

Overall, 

preliminary 

125. 
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. 

significant  monetary 

temporary, targeted and timely, although there are 
some  questions  relating  to  the  reversibility  of  a 
number  of  policies.  The  stimulus  package  - 
and 
alongside 
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 
reform 
obvious  cases  of 
measures. 

rolling  back  past 

easing 

122. 
As  regards  progress  with  recovery 
measures in specific areas, the following insights 
can be drawn: 

from 

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 
shooting  up.  Overall, 
however, labour market measures only represent a 
small  proportion  of  the  total  discretionary  fiscal 
impulse.  Given 
in 
unemployment, and the large 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. 

the  sharp  projected  rise 

As regards investment, a welcome finding 
123. 
is  that  new  or  accelerated  spending  on  public 
investments  forms  a  significant  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 

51 

 
 
3. 

THE EXTERNAL DIMENSION 

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  environment  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  measures  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 

in 

127. 
the 
The  financial  crisis  started 
advanced  economies…  After  the  bursting  of  the 
US  sub-prime  bubble  the  crisis  spread  rapidly 
through  financial  channels  to  other  advanced 
economies.  Tightening 
conditions 
caused  economic  activity  to  slow  down  and 
advanced  economies  fell  into  recession  in  the 
fourth quarter of 2008. 

financing 

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 
their  home 
countries.  Internal  imbalances  in  some  emerging 
markets, veiled previously by favourable financing 
conditions,  became  exposed,  adding  to  investors' 
risk aversion. 

financing  problems 

in 

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 unprecedented and illustrated the 
depth  of  international  trade  linkages  due  to  the 

52 

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 

Direct investment, net
Private portfolio flows, net
Other private capital flows, net

D
S
U
n
o

i
l
l
i

b

n

i

800

600

400

200

0

-200

-400

-600

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: IMF World Economic Outlook database. 

in  2010.  According 

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 
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 recover somewhat faster from 
economic  doldrums  as  they  might  benefit  more 
from the expected gradual recovery in trade. 

to 

the  real  estate  bubble  and 

131. 
The  US  economy  entered  a  severe 
recession in the second half of 2008. The bursting 
of 
the  ensuing 
breakdown of the sub-prime mortgage market had 
acute  consequences 
real  economy. 
for 
Tightened  financial  conditions  and  large  capital 
losses  depressed  consumer  confidence  and 
consumption.  Savings,  which  had  been  on  a 

the 

(22)  The  largest  quarterly  decrease  recorded  thus  far  was 

-11.1% in the first quarter of 1975. 

 
 
 
                                                           
3. The External Dimension 

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. 

seen  since  the  Asian  financial  crisis.  In  2009,  the 
Japanese  economy  is  expected  to  contract  by 
-5.3%  (after  -0.7%  in  2008)  and  to  stagnate  in 
2010. 

Graph 3.3: 

Profiles of GDP growth in major economies 
(2007-2010) 

e
g
n
a
h
c

r
e

t
r
a
u
q
-
n
o
-
r
e
t
r
a
u
q

2

1

0

-1

-2

-3

-4

Euro area

USA
Japan

Graph 3.2:  World trade and GDP growth (annual average 

Source: Commission services' spring forecast. 

growth rate) 

2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3

%
n

i

12

9

6

3

0

-3

-6

-9

-12

Trade volume of goods and services
GDP, constant prices

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: Commission services, IMF. 

in  external  demand. 

132. 
The  Japanese  economy  was  hit  hard  by 
Initially 
the  collapse 
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 
its 
dependence  on  exports,  the  economy  went  into 
recession in mid-2008 as demand from the EU and 
intensified  and 
US  collapsed.  The  recession 
broadened to all sectors of the economy. Corporate 
conditions 
profits  were 
eroded, 
deteriorated,  and  a  negative  feed-back 
loop 
financial  sectors 
between 
materialised.  The  downturn  affected  the  labour 
market,  and  unemployment  surged  to  levels  not 

the  crisis.  Due 

real  and 

financial 

the 

the 

to 

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  decelerated  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 
fiscal  stimulus 
programme unfolded. 

large 

Table 3.1: 

GDP growth in major economies 

World
USA
Japan
China
Russia

2008
3.1
1.1
-0.7
9.0
5.6

2009
-1.4
-2.9
-5.3
6.1
-3.8

2010
1.9
0.9
0.1
7.8
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 into 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%, 

53 

 
 
 
 
 
European Commission 

Annual Report on the euro area - 2009 

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  

The  crisis 
to 

135. 
triggered  energetic  policy 
International 
support  growth. 
responses 
coordination of policy stimuli was crucial in order 
to  ensure  effective  policy  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 
fostering  a 
instrumental 
to  policy 
worldwide 
stimulus  (see  Section  3.4).  As  a  consequence,  in 
most  large  economies  (advanced  and  emerging 
alike),  policy  actions  were  taken  to  support 
demand. 

coordinated 

approach 

in 

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 
for  other  existing  social 
programmes. The rest of the stimulus has financed 
cuts in personal income tax. 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.  

funding 

US  monetary  policy  was 

137. 
loosened 
aggressively.  Continuing  the  cycle  of  interest  rate 
cuts from the preceding year, the Federal Reserve 
gradually  reduced  the  federal  funds  target  rate 

54 

to 

tight 

financial  conditions. 

unconventional  measures 

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 
ease 
taking 
inappropriately 
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 

 
government  announced  a  first  policy  package 
responding  to  the  crisis  in  August  2008.  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 
to  provide  credit 
measures  were  designed 
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 
primary  deficit  is  now  projected  to  exceed  2%  of 
GDP  in  Fiscal  Year  2011,  and  debt  is  forecast  to 
progressively approach 200% of GDP. 

the  economic  situation, 

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. 

The  arsenal  of  policy 

141. 
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% 

3. The External Dimension 

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  performance  of  private 
consumption  is  unlikely  due  to  uncertainties  for 
employment prospects. 

to 

142. 
The  bulk  of  the  fiscal  stimulus  was 
allocated 
infrastructure  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 surpluses are likely to remain 
high in 2009 and in the following years. 

Graph 3.4:  Changes in EUR cross-rates since 02 Jan 2008 

USD/EUR

-3.8

JPY/EUR

-17.3

-7.6

-9.9

GBP/EUR

CHF/EUR

SEK/EUR

%
n

i

CNY/EUR

KRW/EUR

PHP/EUR

THB/EUR

30/06/09

30.1

14.9

14.7

12.2

9.4

-30

-20

-10

0

10

20

30

40

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. 

After  a 

long  period  of 

143. 
tightening, 
monetary policy was loosened 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,  and  the  strong  decline  in 
global  commodity  prices  drove  consumer  prices 

55 

 
 
European Commission 

Annual Report on the euro area - 2009 

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  end  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. 

to 

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 fiscal package ranged from 
cuts in oil export duties, reduced corporate income 
tax 
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. 

unemployment 

increased 

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  incurred  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. 

56 

3.2. 

RECENT  DEVELOPMENTS 
EXCHANGE RATE 

IN  THE  EURO 

in 

triggered  sudden 

the  second  half  of  2008, 

146. 
The  financial  crisis  increased  exchange 
rate  volatility  and 
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, 
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. 

Since  January  2008, 

147. 
the  euro  has 
depreciated  by  around  4%  against  the  US  dollar 
amid significant volatility. In the first half of 2008, 
the euro strengthened against 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 
interest  rate 
the  euro  area-US 
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). 

to 

148. 
The euro weakened substantially against 
the  yen.  Owing 
rate 
the 
differential,  the  euro  appreciated  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 

interest 

large 

 
in financial markets led to a significant increase in 
risk aversion among investors. 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  downturn  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) 

1.7

1.6

1.5

1.4

1.3

1.2

1.1

170

160

150

140

130

120

110

USD/EUR (lhs)

JPY/EUR (rhs)

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

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 
the  currencies  most  negatively 
been  one  of 
affected  since  the  onset  of  the  financial  market 
crisis.  After  a  sharp  depreciation  of  the  pound  in 
December 2008, the euro reached 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  yen)  in  order  to  invest  in  a 
currency offering high interest rates (e.g. the euro). 

3. The External Dimension 

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) 

0
0
1
=
8
0
0
2
-
4
9
9
1

e
g
a
r
e
v
a

120

110

100

90

80

70

1994

1996

1998

2000

2002

2004

2006

2008

Source: Commission services. 

i.e. 

terms, 

taking 

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 
the 
differences in consumer price 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.  

into  account 

57 

 
                                                           
 
European Commission 

Annual Report on the euro area - 2009 

3.3.  GLOBAL IMBALANCES – AN UPDATE 

Japan,  and  oil 

152. 
Global  imbalances  –  a  cause  for  global 
concern.  The  term  'global  imbalances'  refers  here 
to  the  pattern  of  current  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, 
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  activity.  Second,  as  the 
experience  of  the  financial  crisis  shows,  large 
global imbalances can contribute 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  fall  in  oil  prices  since 
August 2008. Table 3.2 shows that in 2008 current 
account  imbalances  narrowed  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,  the  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 narrowed from the peak of 

(24)  The  current  account  of  the  balance  of  payments  keeps  a 
record  of  all  current  transactions  (such  as  exports  and 
imports, tourist expenditure, dividend 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 (lower) than its production. 

58 

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 sharp 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-owned assets abroad. As 
this  phenomenon  is  temporary,  this  source  of 
improvement in the US income balance is unlikely 
to last. 

income 

records 

investment 

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 
flows, 
including  losses  from  asset  write-downs.  In  2008, 
the income surplus 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  deficit  showed  an  improving 
trend,  reflecting  the  relatively  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  1985.  The  marked  decline 

(25)  The  income  balance  is  a  subcomponent  of  the  current 
account  balance.  It  traces  net  income  deriving  from  direct 
investments, portfolio investments and other investments. 

 
                                                           
                                                           
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 
investment  receipts  (they 
of  falling  overseas 
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) 

USA
Japan
Euro area
UK
China

GCC 
countries

Russia

2005
-5.9
3.6
0.4
-2.6
7.2

27.4

11.0

2006
-6.0
3.9
0.3
-3.4
9.5

28.7

9.5

2007
-5.3
4.8
0.1
-2.9
11.0

25.1

5.9

2008
-4.7
3.2
-0.7
-1.7
10.5

27.2

6.1

Note: GCC stands for Gulf Cooperation Council. 
Source: IMF Spring 2009 World Economic Outlook and 
China's State Administration of foreign exchange. 

Surpluses 

of  most 

157. 
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 countries (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. 

some 

Despite 

rebalancing, 

158. 
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 
international 
commodity  prices  increase  again.  In  the  medium 
term, 
reduction  of  global 
imbalances  and  a  move  towards  a  more  balanced 
global  growth  path  will  be  essential  to  limit  the 
risks  of  another  crisis 
the  future.  IMF 
multilateral  consultations  in  2007  concluded  that 

takes  hold  and 

continuing 

the 

in 

3. The External Dimension 

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 
FINANCIAL ARCHITECTURE 

THE 

INTERNATIONAL 

in 

the 

(see 

Section 

international 

159. 
The  global  financial  crisis  exposed 
shortcomings 
financial 
architecture.  Fragmented  supervision  of  global 
financial  market  players  and  lack  of  macro-
prudential  oversight  prevented  early  detection  of 
the  mounting  financial  problems  and  delayed 
remedies 
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  insufficiently  flexible  exchange 
rate  policies 
in  some  key  emerging  market 
economies  contributed  to  the  build-up  of  global 
macroeconomic 
imbalances  and  asset  price 
inflation. 

2.3). 

the 

intensification  of 

the  financial  crisis 

The  global  nature  of 

160. 
crisis 
underlined the need for truly global action. After 
in 
the 
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 President 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  Presidency  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. 

59 

 
 
 
                                                           
European Commission 

Annual Report on the euro area - 2009 

As 

the 

further  details  of 

161. 
situation  was 
economic 
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 
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 
the 
reform, 
coordination  of  positions  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. 

supervisory 

facilitating 

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 
by 
comprehensive 
finance 
a 
international 
aim  of 
institutions  with 
supporting  credit,  growth  and  jobs  in  the  world 
economy (27). 

programme 

the 

163. 
level 
Decisive  measures  at  national 
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 

60 

measures  had  served  their  purpose,  the  stimulus 
provided would have to be gradually withdrawn by 
both fiscal and monetary authorities. 

and 

trade 

Open  markets, 

164. 
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 
to  reshape  global  financial 
ambitious  plan 
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 
Financial  Stability  Forum,  renamed 
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 
identify  global 
macroeconomic and financial vulnerabilities. 

to 

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 crisis 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 
represent 
leaders  endorsed, 

these  measures 

 
                                                           
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 provide 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. 

that 

the  need 

to  ensure 

168. 
 Multilateral  Development  Banks  will 
increase lending and other forms of finance. The 
the 
G-20  stressed 
Multilateral  Development  Banks  (MDBs)  were 
adequately financed to contribute 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 have  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 

3. The External Dimension 

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 
the  G-20 
domestically, 
agreements  on  all  fronts,  and  internationally,  by 
playing an active leadership role in the G-20. 

implementing 

by 

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  currencies.  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 well 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% respectively 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 

international  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,  which  explains  why  several 
practical  definitions  might  be  used  to  approximate  the 
concept.  The  broad  measure  might  overstate  the  euro's 
share in the international bond market. The narrow measure 
might understate it. 

61 

 
                                                           
European Commission 

Annual Report on the euro area - 2009 

Countries and territories with exchange rate regimes linked to the euro (as of 30 June 2009) 

Table 3.3: 
Region

European Union (non-euro area)

Candidate and potential candidate countries

Exchange rate regimes
ERM II

Euro-based currency board

Inflation targeting, but officially with a managed floating 
system with the euro as reference currency
Unilateral euroisation

Euro-based currency boards

Countries/territories
Denmark, Estonia, Latvia, Lithuania

Bulgaria

Czech Republic, Romania

Kosovo (1), Montenegro

Bosnia and Herzegovina

Managed floating with euro as reference currency (de facto 
pegs)

Croatia, Former Yugoslav Republic of 
Macedonia

Managed floating with euro as reference currency

Serbia

Euroisation authorised by a monetary arrangement

Monaco, San Marino, Vatican City, French 
territorial communities (2)

Euroisation without monetary arrangement

Andorra

Others

Peg arrangements based on the euro

Peg arrangements and managed floats based on the SDR and 
other currency baskets involving the euro

CFA franc zone (3), French overseas territories 
(4), Cape Verde, Comoros
Algeria, Azerbaijan, Belarus, Botswana, Fiji, 
Libya, Morocco, Myanmar, Russian Federation, 
Samoa, Seychelles, Syria, Tonga, Tunisia, 
Vanuatu

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. 

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 
geographical  proximity  or  with  some  historical  or 
institutional ties to euro-area countries. 

this  way  mainly  by  countries 

in 

in the wake of the crisis, the currency composition 
has remained broadly unchanged. 

trigger  a  decline 

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  imbalances  in  current  account 
the 
positions  would 
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 
international 
currency through the crisis. 

the  most 

important 

in 

171. 
The  financial  crisis  has  so  far  had  only 
limited 
the  relative  positions  of 
impact  on 
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 loans 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. 

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 currency 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 

62 

 
                                                           
 
 
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) 

80%

70%

60%

50%

40%

30%

20%

10%

0%

e
r
a
h
s

y
c
n
e
r
r
u
c

USD (constant FX rates)
EUR (constant FX rates)
Other currencies (constant FX rates)

1999

2002

2005

2008

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 
Furthermore, 
commodity 
historical  precedents  underline  the  gradual  nature 
of  currency  internationalisation (31).  For  instance, 
the  erosion  of  the  pound  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.  

quotations. 

price 

(31)  See  B.  Eichengreen: 

'Sterling's  past,  Dollar's  future: 
Historical Perspectives on Reserve Currency Competition', 
NBER Working Paper No. 11336, May 2005. 

3. The External Dimension 

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 system 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) 

60%

50%

40%

30%

20%

10%

0%

e
r
a
h
s

y
c
n
e
r
r
u
C

Euro
Yen

US dollar
Pound sterling

1999

2002

2005

2008

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  (SDR)  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 existing 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 organisations. Its value is based on 
a  basket  of  key  international  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. 

63 

 
 
                                                           
 
                                                           
4. 

ECONOMIC GOVERNANCE IN TIMES OF CRISIS 

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 
the  global  economic  situation  has 
released, 
deteriorated  dramatically.  The  global  crisis  is 
putting  the  Economic  and  Monetary  Union  to  the 
test  and  underscores  the  need  to  improve  its 
the 
governance  along 
EMU@10  Report.  This  chapter  recalls  its  main 
conclusions  and  recommendations  and  highlights 
light  of 
follow-up  work 
the  current 
the 
turmoil.  Section  4.1 
economic  and  financial 
stresses  how  recent  events  have  enhanced  the 
relevance  of  the  Commission's  EMU@10  Report. 
Section  4.2  reviews  the  work  carried  out  in  2008 
the  broadening  and  deepening  of 
regarding 
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. 

indicated 

lines 

the 

in 

in 

4.1. 

THE EMU@10 REPORT IN THE LIGHT OF THE 
CRISIS 

surveillance, 

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 
broaden 
and 
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. 

to 

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'. 

64 

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 
the  European 
the  symbol  of 
has  become 
integration  process.  At 
the 
time, 
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. 

the  same 

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 
contingent 
debt  outstanding 
liabilities.  Against  this  background,  sustainability 
considerations  have  become  more  relevant  than 
ever. 
benefits 
considerably  from  the  sound  functioning  of  the 
Stability and Growth Pact, which provides a frame, 
an anchor and directions for deeper surveillance. 

Coordinated 

surveillance 

increased 

and 

to 

180. 
Broadening macroeconomic surveillance 
should address imbalances at an early stage. The 
surveillance  of  fiscal  policies  has  delivered 
immense  benefits 
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 

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 
for  closer 
economic  policy  coordination  as  well  as  broader 
and deeper surveillance and governance. 

the  need 

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 
for  strengthening 
out  an  ambitious  agenda 
in 
In 
economic  governance 
particular, 
the 
Parliament 
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 
supervisory 
architecture  and  called  on  the  Commission  to 
examine  the  creation  of  European  bonds  and 
develop a long-term strategy on this issue. 

the  euro  area. 

financial 

supports 

the 

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  past  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 mentioned 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 
the  regulatory  and 
system  and 
institutional  framework.  Second,  the  euro  area 

to  redesign 

(34)  Report  from  the  European  Parliament  A6-0420/2008  of 

28.10.2008. 

economy.  From 

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 
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 
(see 
Section 4.3). 

analysis 

in 

laid  down 

181. 
Global  crisis  resolution  accentuated  the 
external  policy  agenda 
the 
EMU@10  Report.  Global  macroeconomic 
imbalances  lay  at  the  root  of  the  crisis.  Although 
the  euro  area  enjoyed  balanced  economic 
fundamentals,  it  was  struck  with  considerable 
force  by  the  global  crisis  fallout.  The  euro  area 
cannot  afford  to  be  a  bystander.  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  respect,  the  EMU@10  Report 
'the  euro  area  must  build  an 
stressed 
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. 

that 

that 

the  Eurogroup  and 

182. 
EMU's  system  of  economic  governance 
has  been  tested  in  times  of  crisis.  The  EMU@10 
Report  stressed 
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 States 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 
the  EU 
dialogue  concerning  EMU  among 

(35)  'The euro@10: achievements and responsibilities' Remarks 
by  Jean-Claude  Trichet,  President  of  the  ECB,  at  the 
ceremony  of  the  European  Parliament  to  mark  the  10th 
anniversary of the euro, Strasbourg, 13 January 2009. 

65 

 
                                                           
European Commission 

Annual Report on the euro area - 2009 

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 the 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, 
price 
in 
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. 

notably 

terms 

of 

(36)  Opinion CESE 633/2009 of 24 March 2009. 

66 

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  Member  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 the 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 
the  EU's  surveillance 
implementation  under 
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, 
rules, 
such  as  national 
independent  fiscal  institutions  and  medium-term 
the 
budgetary 

frameworks. 

Second, 

fiscal 

in 

(37)  For  more  details  see  Quarterly  Report  on  the  Euro  Area 
'Special  report:  competitiveness 

Vol.  8  N°1  (2009), 
developments within the euro area'. 

 
                                                           
                                                           
4. Economic Governance In Times Of Crisis 

to 

response 

EU 
slowdown'. 
However, operational details on how to tackle the 
banking crisis remained evasive.  

the  economic 

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  the  European  Council  for 
the  EU  as  a  whole  on  15-16  October.  The 
European 
the 
establishment of a 'crisis cell', aimed at improving 
crisis  management  among  EU  Member  States 
through  measures  including  informal  warnings, 
information 
evaluation 
mechanism. 

announced 

exchange 

Council 

also 

and 

an 

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 spending and revenue systems 
were to some  extent covered. Third, progress was 
achieved  in  getting  Member  States  to  provide 
datasets 
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. 

government 

expenditure 

on 

4.3. 

RECENT  DEVELOPMENTS 
MARKETS GOVERNANCE 

IN  FINANCIAL 

The  crisis 

191. 
the  capability  of 
tested 
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. 

framework,  assistance 

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 
to 
distressed  financial  institutions  was  conducted  on 
an ad hoc basis in each country, 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  (France,  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 

194. 
The  Commission  reacted  speedily  to  the 
evolving  situation.  On  29  October  2008,  the 
Commission  issued  a  communication  paving  the 
way  for  a  coordinated  European  recovery  action 
plan.  The  Commission  initiative  called  for  a  new 
EU  architecture  for  financial  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  magnitude  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 
the  EERP  umbrella (39).  The 
decided  under 
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. 

67 

 
 
                                                           
European Commission 

Annual Report on the euro area - 2009 

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 

2008

January

February

April

May
September

October

November

December

January

February

March

April

May

The 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.

The 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.
The 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.
The EG discussed compensation schemes in the corporate sector.
The EG elected for a new mandate Jean-Claude Juncker at the head of the Eurogroup. 
Summit of the Eurogroup Heads of State and Governments in Paris. A declaration on a coordinated
action plan to fight the banking crisis is adopted.
Based 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 necessary
coordination for efficient use of investment at the current juncture. 
The EG discussed the Commission's European Economic Recovery Plan. It also decided to allow
automatic stabilisers to work fully in 2008 and 2009. 

2009

The 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. 
The EG expressed concerns about credit distribution to the real economy and affirmed its willingness
to monitor closely the situation.
The 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.
The 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. 
The 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. The
public deficit should come below the 3% reference value by 2013 instead of 2012.

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. 

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% 

68 

 
 
 
 
 
 
 
In  particular, 

of  EU  banking  assets  are  held  by  43  cross-border 
banking  groups. 
increasingly 
sophisticated  financial  products  are  increasingly 
dealt  with  on  a  pan-European  basis.  The 
Lamfalussy  approach,  started  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.  

identified 

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 
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 
the 
so-called  Level-3  Committees  of 
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 

4. Economic Governance In Times Of Crisis 

European Council of 19/20 March 2009 agreed to 
the de Larosière report as 'the basis for action'. 

information  pertaining 

198.  Macro-prudential  concerns  should  be 
effectively  catered  for.  The  de  Larosière  Group 
suggested establishing a new body – the European 
Systemic Risk Council (ESRC) – that would pool 
to 
and  analyse  all 
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 
that  a 
supervisor  has  not  responded  in  an  adequate 
manner. 

it  feels 

if 

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. 
the  application  of 
They  would  coordinate 
strong 
supervisory 
cooperation 
supervisors, 
including  recourse  to  binding  and  proportionate 
mediation in case of conflicts. 

standards  and  guarantee 
between 

national 

a 

for 

roadmap 

sketched  out 

200. 
A two-stage approach to implementation 
would  combine  harmonisation  of  rules  and 
powers and supervisory reforms. The de Larosière 
the 
Group 
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 set 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 
the 
Council, 
Commission.  In  addition,  a  review  clause  after 
three  years  would  examine  the  possibility  of 
merging banking and insurance authorities. 

the  European  Parliament  and 

69 

 
European Commission 

Annual Report on the euro area - 2009 

201. 
the  de 
The  Commission  endorsed 
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  decisions  at  the  June  2009 
European Council (40). The Communication set out 
the  functioning  and 
a  detailed  proposal  for 
composition  of  the  ESRC  and  the  ESFS.  It 
affirmed  the  leading  role  of  central  banks  in 
macro-prudential 
the 
supervision 
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. 

through 

The  three  existing  committees  of  supervisors 
would be  replaced  by  three 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 
the  highest-level 
supervisors 
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,  the  ESRC  and  the  three 
Authorities  would  report  to  the  Council  and  the 
European Parliament on a frequent basis. 

comprised  of 

Proposed  financial  governance  arrangements 
according  to  the  recommendations  of  the  De 
Larosière Group:  

European Systemic Risk

Council (ESRC)

Information on micro-

prudential developments

Early risk warning

European System of Financial Supervision (ESFS)

European 
Banking 
Authority

European 
Insurance and 
Occupational 
Pensions 
Authority

European 
Securities and 
Markets 
Authority

National 
Banking 
Supervisors

National 
Insurance 
Supervisors

National 
Securities 
Supervisors

in 

The  European  Council, 

202. 
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 
their 
of  whether 
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 
micro-prudential 
and 
components, should be fully in place in the course 
of 2010. 

supervisors  are  meeting 

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  the  President  of  the  Economic 
and Financial Committee. 

203. 
The  Commission  adopted  operational 
arrangements for the establishment of the ESRB 
and  the  ESFS.  On  23  September  2009,  the 
Commission  adopted  a  package  of  legal  texts 
underpinning  the  new  framework.  The  package 
comprises: 

(42)  The name was eventually chosen in lieu of ESRC. 

70 

 
 
                                                           
                                                           
4. Economic Governance In Times Of Crisis 

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  price  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 
survey 
conducted  in  January  2009,  90%  of  Slovaks  felt 
the  euro.  As  a  result, 
well-informed  about 
perceptions  of  changeover-related 
inflationary 
pressures were limited. 

Eurobarometer 

Flash 

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 
financial 
challenges 
crisis 
the 
is  decelerating 
environment.  While 
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. 

current 
inflation 

in 

a 

for 

A  proposal 

(i) 
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 
and 
the  ESRB 
recommendations. 

issue  warnings 

to 

(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 logistical support to the ESRB. 

three 

including 

Proposals 

(iii) 
regulations 
for 
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, 
following: 
(a) developing  proposals  for  technical  standards, 
respecting 
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 
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. 

(including 

regulation 

better 

rules 

the 

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, 
and 
fostered  by 
the 
structural  reforms  (see  Box  4.2).  With 

stability-oriented  policies 

(43)  COM(2009)499. 
(44)  COM(2009)500. 
(45)  COM(2009)501. 
(46)  COM(2009)502. 
(47)  COM(2009)503. 

71 

 
                                                           
European Commission 

Annual Report on the euro area - 2009 

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, inflation 
in Cyprus and Malta has been close to the euro-area average, standing at 2.9% in Cyprus and 2.7% in Malta 
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 were
on 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,  with 
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  in
Slovakia and since 2006 in Cyprus and Malta, but in the latter the deficit widened above the 3% threshold in
2008.  In  the  three  countries,  the  public  debt  as  a  share  of  GDP  declined  significantly  in  recent  years.  It
amounted 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%  in 
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% in
Slovakia) and a higher unemployment rate (5.9% in Malta; 9.5% in Slovakia). 

Graph: Convergence to the euro area: GDP in PPS 
(euro area=100) 

x
e
d
n

i

85

75

65

55

45

Cyprus
Malta
Slovakia

2002

2003

2004

2005

2006

2007

2008

Table: 
(annual percentage change) 

Recent 

macroeconomic 

performance

Cyprus

Malta

GDP
Inflation

General government 
balance (as % of GDP)

GDP
Inflation

General government 
balance (as % of GDP)

GDP
Inflation

Slovakia

General government 
balance (as % of GDP)

2006
4.1
2.2

-1.2

3.2
2.6

2007
4.4
2.2

3.4

3.6
0.7

2008
3.7
4.4

0.9

1.6
4.7

-2.6

-2.2

-4.7

8.5
4.3

10.4
1.9

6.4
3.9

-3.5

-1.9

-2.2

Source: Commission services 

Source: Commission services 

These  countries  are  small  open  economies,  highly  integrated  in  terms  of  trade  and  finance  to  the  euro
area. Malta and Cyprus are the two smallest economies in the euro area, contributing respectively 0.06% and
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 the
euro-area (42% for Cyprus, 43% in Malta and 74% in Slovakia in 2007).

72