1. DG ECFIN Sustainable public finances in a turbulent EU economy Lucio PENCH Head of Unit, Fiscal policies in the euro area and the EU, European Commission, DG ECFIN Federal Planning Bureau «Potential Growth and Fiscal Challenges», Brussels 27 October 2009

2. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 2 Outline I. Direct costs of the crisis II. Indirect effects on growth III. Long term sustainability and ageing IV. Consolidation and policy responses to ensure sustainability

3. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 3 The public finance situation in the EU A looser fiscal stance

4. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 4 Fiscal costs of the financial crisis Direct fiscal costs and total fiscal costs

5. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 5 I. Fiscal costs of financial crises Direct Fiscal costs of past crises Past rescues of the banking sector have often been expensive

6. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 6 EU public interventions in the banking sector (in % GDP) Capital injections Guarantees on bank liabilities Relief of impaired assets Liquidity and bank funding support Total ApprovedEffectiveApprovedEffectiveApprovedEffectiveApprovedEffectiveApprovedEffective Total EU 2.71.724.67.80.90.83.22.331.112.5 Total euro area 2.71.720.57.81.11.01.00.425.210.9 25.Some selected countries Austria5.51.725.76.85.50.41.61.638.310.6 Belgium5.36.170.816.38.18.12N/AN/R84.230.6 Denmark6.12.4253.02.50.00.00.30.3259.45.2 France1.21.216.65.50.20.20.00.018.16.9 Germany4.42.018.67.21.41.40.00.024.410.6 Ireland6.66.5164.7164.70.00.00.00.0171.3171.2 Italy1.30.1N/A0.00.00.00.00.01.30.1 The Netherlands 6.46.834.37.73.93.97.51.652.020.0 Sweden1.60.248.511.00.00.012.60.062.711.2 United Kingdom 3.52.621.711.30.00.016.414.741.628.5 Notes: N/A: not available indicates that the amount is not available in the state aid decision N/R: not reported indicated that the amount was not reported by the Member States in its reply to the EFC questionnaire Source: Commission services Fiscal costs of financial the crisis Support to the banking system has focused on guarantees and liquidity measures

7. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 7 Upper bound estimate of 13% of GDP is in line with average past direct fiscal crises costs (13% of GDP). In individual Member States the direct fiscal costs risk to be much higher than this average. Crisis is costly for the taxpayer. Policies need to ensure that crises costs are contained and long-term sustainability maintained. Fiscal costs of the financial crisis Estimates of direct fiscal costs in the current crisis Estimates of direct fiscal costs in the current crisis (net of recovery rates) Based on effective measures Based on approved measures ARecapitalisation A.1 As of 21 October 20091.7%2.7% A.1.1 Loss rate (80%)1.4%2.2% A.2 Assuming a doubling of recapitalisation needs3.4%5.4% A.2.1 Loss rate (80%)2.7%4.3% BLiquidity and bank funding support2.3%3.2% B.1 Loss rate (10%)0.2%0.3% B.2 Loss rate (30%)0.7%1.0% C Govt. guarantees on bank liabilities and relief of impaired assets 1/ 8.6%25.5% C.1 Loss rate (15%)1.3%3.8% C.2 Loss rate (30%)2.6%7.7% TOTAL net fiscal costs Lower bound(=A.1.1+B.1+C.1)2.9%6.3% Higher bound(=A.2.1+B.2+C.2)6.0%12.9% Notes:1/ In percent of 2009 GDP (European Commission Spring Forecast 2009). Includes blanket guarantees (AT, ES, IE, NL) but not the potential shortfalls of deposit insurance schemes nor government guarantees where amounts have not been specified (e.g. BG, IT, PL, UK). Source: Commission services. (% of GDP) Risk scenarios for direct fiscal costs 2/

8. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 8 EERP: 1.8% of GDP discretionary stimulus measures in addition to large automatic stabiliser effects. Fiscal costs of the financial crisis Real economy support Discretionary fiscal stimulus measures in the EU(2009-10) 1/ 0.6 0.8 0.5 0.3 0.1 0.3 0.5 0.4 0.7 1.1 0.0 0.3 0.5 1.1 0.0 0.2 0.4 0.6 0.8 1.0 1.2 20092010200920102009201020092010 TotalRevenueExpenditure Public investment EU-27 Euro area Notes: 1/Figures for 2010 include permanent measures taking effect in 2009 plus measures taking effect in 2010.Source: European Commission

9. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 9 Government balances in 2007-10 in the Commission Services’ Spring 2009 Forecasts Fiscal costs of the financial crisis Automatic stabilisers and discretionary policies lead to large deficits

10. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 10 Large deficits lead to rapid increases in debt Change in debt as a share of GDP – Commission Spring 2009 forecasts

11. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 11 Large fiscal deficits contributed to public debt-to-GDP ratios ratcheting them up by 20 points of GDP, on average. This impact has taken a long time to reverse in the past. Total fiscal costs of past crises The effect of crises on debt

12. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 12 Critical challenges for the EU are to prevent reductions in potential growth from: Critical challenges for the EU are to prevent reductions in potential growth from:  Lower or unproductive investment due to risk aversion, credit constraints or government intervention  Permanent rebalancing of internal demand  Labour market hysterisis Past crises (e.g. SE and FI) show that policy responses matter Past crises (e.g. SE and FI) show that policy responses matter Different scenarios are possible i.e. a full return to earlier path, a permanent loss in level terms only or a permanent loss on growth rates Different scenarios are possible i.e. a full return to earlier path, a permanent loss in level terms only or a permanent loss on growth rates Case No 1: Full return to earlier path Case No 2: Permanent loss in GDP level Case No 3: Permanent loss on growth rates Potential growth in the aftermath of the crisis Impact of the crisis on potential growth

13. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 13 The path of actual and potential output in previous financial crises in Japan, Sweden and Finland

14. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 14 Hypothetical GDP trajectory for Belgium Pre-crisis: average annual growth of 2.3% Post-crisis: average annual growth of 1.4% By 2020 and going forward: GDP 11% lower

15. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 15 Fiscal sustainability Required consolidation to bring debt to 60% by 2020

16. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 16 Developments in debt up to 2020

17. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 17 EUEU15Belgium 200820602008206020082060 Fertility rate1.521.64 1.721.751.79 Life expectancy at birth – men76.084.577.284.876.784.4 Life expectancy at birth – women82.189.082.689.182.388.9 Old age dependency ratio255326512646 Net migration flows (thousands)168380416477505123 Net migration flows (% population)0.30.20.40.20.50.2 Some background figures on demographics

18. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 18 Budgetary costs of population ageing Costs set to increase substantially but with wide variation between countries Pension spendingHealthcare Long-term care, unemployment and education Total 2010 Change 2010 to 20602010 Change 2010 to 20602010 Change 2010 to 20602010 Change 2010 to 2060 Poland10.8-2.14.10.84.20.119.1-1.1 Estonia6.4-1.65.11.13.20.414.8-0.1 Latvia5.10.03.50.53.60.812.31.3 EU-2710.22.36.81.46.10.923.24.6 EA11.22.76.81.36.41.124.55.1 Belgium10.34.5 7.7 1.1 8.9 1.0 26.8 6.6 Slovenia10.18.56.81.76.22.423.112.7 Greece11.612.55.11.35.22.221.916.0 Luxembourg8.615.35.91.15.41.719.918.2

19. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 19 Fiscal sustainability Fiscal sustainability Sustainability gaps (S2 in percent of GDP) (latest available unpublished, data)

20. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 20 Fiscal sustainability IBP: required adjustment given the initial budgetary position LTC: required adjustment given the long-term change in age-related expenditure Decomposition of the S2 indicator

21. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 21 Fiscal sustainability Comparing the sustainability gaps in 2009 and 2006

22. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 22 Examples of debt and consolidation in Belgium Trajectory of debt as a share of GDP based on different levels of consolidation

23. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 23 Time to design exit strategies? EU Council - 17 September EU Council - 17 September “Exit strategies need to be designed now and implemented in a coordinated manner as soon as recovery takes hold, taking into account the specific situations of individual countries.” Pittsburgh Summit – 24-25 September Pittsburgh Summit – 24-25 September “ We will prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a cooperative and coordinated way, maintaining our commitment to fiscal responsibility.” Informal ECOFIN – 1-2 October Informal ECOFIN – 1-2 October “ In order to anchor expectations and reinforce confidence, it is necessary to start designing and communicating credible exit strategies, even if implementation will have to wait.” IMFC Statement – Istanbul 4 October IMFC Statement – Istanbul 4 October “As the recovery takes hold, we are committed to work together in articulating and implementing credible and coordinated exit strategies for the withdrawal of public support for the financial sector, orderly unwinding of monetary policy support, and fiscal consolidation needed to underpin long-term sustainability.” ECOFIN Council – 20 October ECOFIN Council – 20 October “The Council agrees that preparing a coordinated exit strategy for exiting from the broad-based policies of stimulus is needed.... The Council underlines that an early design and communication of such a strategy would contribute to underpinning confidence in our medium-term policies and to anchor expectations”

24. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 24 ECOFIN Council 20 October 2009 Designing fiscal exit strategies Withdrawal of stimulus should be timely. Consolidation should start in 2011 at the latest, with some countries needing to consolidate earlier. Withdrawal of stimulus should be timely. Consolidation should start in 2011 at the latest, with some countries needing to consolidate earlier. Consolidation will need to go well beyond the benchmark 0.5% of GDP per annum. Consolidation will need to go well beyond the benchmark 0.5% of GDP per annum. Important additions: Important additions:  Strengthened national budgetary frameworks to underpin credibility of consolidation.  Measures to support long-term fiscal sustainability  Strengthening of structural efforts to enhance productivity and support long term investment

25. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 25 What do we know about how to consolidate successfully? Extensive literature on the subject including Alesina and Perotti (1995), Public finances in EMU 2007, Kumar et al. (2007). Extensive literature on the subject including Alesina and Perotti (1995), Public finances in EMU 2007, Kumar et al. (2007). Consolidations based on expenditure cuts tend to be longer lasting Consolidations based on expenditure cuts tend to be longer lasting  Especially true if also focus on structural reforms increasing work incentives and public sector efficiency  Tax based consolidation tends to work better if it is gradual and starts from a lower level Gradual adjustments have proven more effective (Public finances in EMU 2007) Gradual adjustments have proven more effective (Public finances in EMU 2007)  Often accompanied by structural reforms Improvements in the fiscal institutions can be important complements to consolidation Improvements in the fiscal institutions can be important complements to consolidation  Countries with existing strong institutions consolidate more effectively Difficult macroeconomic and public finance starting points can be catalysts for successful consolidations Difficult macroeconomic and public finance starting points can be catalysts for successful consolidations

26. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 26 The quality of the public finances in Belgium Note: a higher value indicates outcomes more conducive to long-term growth

27. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 27 Belgium – what choices are available? Reducing expenditure? Reducing expenditure?  Government spending is high, so possibility to reduce it  Efficiency gains also possible Increasing tax? Increasing tax?  Tax and SS revenues high and relatively inefficient  Increasing them further could be costly and hard Structural reforms? Structural reforms?  The tax system has strong disincentives to work in it Pension changes for the long term? Pension changes for the long term?  Scope to change the pension system but can only be a part of the answer

28. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 28 How to reduce the cost of ageing over time Stockholm strategy from the 2001 European Council Stockholm strategy from the 2001 European Council Reduce debt to allow pre-financing Reduce debt to allow pre-financing  Would need to be in addition to reversing debt increases due to crisis  Could only be achieved very gradually  Might add to global imbalances Increase employment rates and productivity Increase employment rates and productivity  Can accompany fiscal consolidation  May not reduce the cost of ageing much due to accrual of pension rights Reform pension, healthcare and long-term care systems Reform pension, healthcare and long-term care systems  Shifting to private provision also has risks  Adequacy of provision must be ensured to make any changes effective  Raising retirement ages is a serious consideration

29. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 29 Exit ages from the labour market

30. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 30 How can changes to the labour market or pension structure aid sustainability?

31. DG ECFIN L. Pench, Head of Unit, Fiscal policies in the euro area and EU European Commission, Economic and Financial Affairs 31Conclusions Crisis has had both a direct and indirect impact on public finances Crisis has had both a direct and indirect impact on public finances Increase in government debt substantial and worrying Increase in government debt substantial and worrying The existing challenge of ageing looms large over the future The existing challenge of ageing looms large over the future Exiting the crisis will be a delicate exercise Exiting the crisis will be a delicate exercise Measures addressing both medium-term deficits and long- term increases in the cost of ageing are required Measures addressing both medium-term deficits and long- term increases in the cost of ageing are required