contraction in economic activity brings with it a permanent output loss. this is reflected in significant downward revisions to estimates of potential output and potential output growth. these revisions imply a reassessment of the spending that governments can afford given a lower structural level of tax receipts. the european commission ’ s estimate is that the “ cyclical component ” of the euro area government deficit will amount to about 1. 4 % of gdp this year and 1. 9 % next year. this is less than one third of the overall projected deficit! assuming that fiscal stimulus measures can be easily unwound may also prove a little optimistic. even if a tax cut or a subsidy is announced as temporary, this does not mean that cancelling it will be less unpopular. and even when stimulus measures are unwound, the resulting impact on the deficit will be limited. even net of stimulus measures, the projected structural deficit for the euro area would still be almost 4 % of gdp in 2010 according to the european commission. the most reasonable assumption is that, for the most part, the sizeable government deficits that are likely to build up this year and next will not be self - correcting. instead, they will need to be corrected through policy actions. * * * the challenge for fiscal policy at this juncture is to appropriately calibrate the timing and speed of this adjustment. in this respect, we should not forget that fiscal policies in emu do not operate in a vacuum. governments are bound by their obligations under the treaty and the stability and growth pact. all the more so now, as monetary authorities consider their exit strategy from the crisis, it is essential that fiscal policies are conducted within a predictable, medium - term oriented framework. the treaty and the stability and growth pact provide for a degree of flexibility under the current, special circumstances. the european commission has expressed its view that member states incurring excessive deficits due to the crisis should be allowed to implement corrective action in a time frame consistent with the recovery of the economy. but this should not lead to corrective action being unduly delayed. fiscal adjustment needs to start with and not later than the economic recovery. and when more normal economic conditions return, consolidation efforts will need to be substantial. just how substantial these efforts need to be can be illustrated by way of a simple, numerical example. let us assume that the current projections of the european commission until 2010 turn out to be correct. let us assume that from 2011 onwards annual output growth

euro area, output contracted on a cumulated basis by more than 4 % over the third quarter of 2008 and the first quarter of 2009, driven mainly by a sharp fall in investment and net exports. the latest data indicates a stabilisation in economic activity for the euro area as a whole in the second quarter of 2009. and most forecasters now expect a modest recovery in the course of 2010. but if central banks and governments had not acted as they have done over the past year, the financial crisis would have been even more intense and the recession would have been deeper. the fiscal costs of the crisis as things stand now, the fiscal costs of the economic and financial crisis are expected to be considerable. in 2007, euro area general government borrowing amounted to around half a percent of gdp. in its spring 2009 forecast, the european commission projected that government borrowing in the euro area would rise to 5. 3 % of gdp this year and 6. 5 % next year. the euro area government debt ratio, which stood at 66 % in 2007, is projected to rise to 84 % in 2010. 13 out of 16 euro area governments are projected to breach the 3 % of gdp deficit reference value of the maastricht treaty. and all are at risk of doing so next year. these figures reflect the impact on public finances of the contraction in economic activity. they also reflect the costs of discretionary fiscal stimulus measures adopted in many countries. but the cost of providing public support to the financial sector is only reflected to a very limited extent in these projections. according to information collected within the eurosystem, the impact of public interventions on euro area government debt, as recorded in the national accounts this year, is likely to be something in the order of 3 % of gdp. and the impact on the euro area government deficit is likely to be negligible. but the scale of government support to the financial sector is far greater than these figures suggest. according to the european commission, as of the end of march 2009, the amount of funds made available under approved measures amounted to around 35 % of euro area gdp. of this amount, around 11 % of gdp has already been turned into effective support, in terms of actual recapitalisations, asset purchases and so on. the difference between the total amount of funds made available and the impact actually recorded in government deficit and debt statistics reflects the considerable uncertainty regarding the true fiscal costs of the bank rescue packages. roughly speaking, in cases where governments actually