FISCAL POLICY AND FINANCIAL STABILIZATION Jean-Luc Schneider

•The fiscal-financial nexus •The fiscal trade-offs •The medium-term challenges Outline 2

• Banks balance sheet  Higher sovereign spreads – Stress test + recognition of non-performing loans (SSM) – Recapitalisation – Backstop funding • Euro exit risk  Impaired monetary transmission – OMT – Structural reforms to address the sources of imbalances • Lower growth  Higher consolidation needs – Monetary policy – Medium-term consolidation plan + choice of instruments – Structural reforms to foster potential growth The fiscal-financial nexus: three adverse feedback loops 3

• Debt stabilisation can be more or less frontloaded • To meet a long-term taget, debt must be curbed relatively early The fiscal trade-offs: gross debt 4 Source: Rawdanowicz, L. (2012), “Choosing the Pace of Fiscal Consolidation”, OECD Economics Department Working Papers, No. 992.

• Over-consolidation is needed to reduce debt • Backloading involves higher total (and over-) consolidation • Framework stability concerns suggest frontloading The fiscal trade-offs: structural primary balance 5 Source: Rawdanowicz, L. (2012), “Choosing the Pace of Fiscal Consolidation”, OECD Economics Department Working Papers, No. 992.

• Frontloading involves high short-term costs • Backloading becomes costlier after some years • Unemployment concerns suggest “middle-loading” The fiscal trade-offs: output gap 6 Source: Rawdanowicz, L. (2012), “Choosing the Pace of Fiscal Consolidation”, OECD Economics Department Working Papers, No. 992.

Fiscal requirements across countries Average tightening required over to reach 60% gross debt (as a share of GDP) 7 Source: OECD calculations

The usual cost of high debt Spread between long-term and short-term interest rates versus gross government debt in % of GDP (average ) 8 Source: OECD calculations

The current cost of high debt Sovereign bond spreads compared to benchmarks (basis points over German bonds, September 2012) 9 Source: OECD calculations

The medium-term challenges: a diversity of imbalances (as a share of GDP, average ) 10 Source: OECD calculations

The medium-term challenges: competitiveness adjustment 11 Relative unit labour costs (changes from 1998 to 2007 and from 2007 to 2011, percentage points) Source: OECD calculations

The medium-term challenges: Fiscal consolidation and structural reforms 12

FISCAL POLICY AND STABILIZATION Jean-Luc Schneider