2011 9 10

GDP GDP GDP Taylor Rule (comovement of interest rate and inflation)

Types and Sources of Shocks

Productivity shock Interest rate shock Financial shock Earthquake, tornado, etc

 Fiscal Expansion
tax reduction of 150 bln (1% GDP) in 2008
Two-thirds for private individuals One-third for firms Welcomed by IMF and prominent economists

Troubled Asset Relief Program (TARP)

Asset purchases from financial institutions to support the financial sector.

 American Reinvestment and Recovery Act; further 787 billion dollar (5% GDP) of fiscal stimulus
tax cuts for both households and business transfers to households funding for states and infrastructure projects

European Economic Recovery Program

Cumulative discretionary fiscal impulse of about 1.5% GDP 1.2% GDP coming directly from the Member States Potential free-riding problem solved at the European level

Quantitative easing by FED and Securities Markets Program of ECB

What should we do next? Fiscal Consolidation

Fiscal consolidation is a policy aimed at reducing government deficits and debt accumulation. Composition: increased tax and reduction of public expenditure

On the Needs of Fiscal Consolidation

GDP 10% Acquisitions from financial sector acquisitions from financial sector

Criteria: Maastricht Treaty, deficits < 3% of GDP and debt levels < 60% of GDP in EMU

 (long-run sustainability):
Rise in public spending on pensions, health and long-term care Average is 5.2% GDP Though wide dispersion In some instances public debt projected to rise above 800%

spill-over from private sector indebtedness when government is forced to rescue spill-overs
Direct spill-overs via international trade Bilateral loans and guarantees provided by supranational institutions increase public good character of consolidation Stronger linkages private sector financial institutions

 Increase in contingent liabilities In particular guarantees to the banking sector Capital injections Guarantees on bank liabilities Relief of impaired assets Liquidity and bank funding support Add to public debt when they materialise Adds to uncertainty about sustainability of public finances higher interest, in particular with lack of transparency

Effects of Fiscal Consolidation

GDP , distortionary taxes. Depending on the fiscal instrument used, fiscal consolidation may have pronounced distributional effects

Channels
Expectation view I: increase in taxes now means that future increase can be smaller net present value tax burden stimulates economy avoid even worse budgetary crisis in future

Expectation view II: positive signals for international capital market increase confidence of investors and lower risk.

Channels
Labour market view focuses on spending composition

Taxes after-tax wage unions demand higher pre-tax wages employment and shadow value capital capital accumulation and growth Public employment relaxes labour market and weakens union power reservation utility of union members downward pressure on equilibrium real wage rate Unemployment benefits/other transfers similar effects

Channels
If stabilisation perceived as credible perceived likelihood of public debt default interest burden more secure value of bond holdings may stimulate consumption. In addition interest rate charged to firms and consumers may fall. Large budgetary cuts resolve uncertainty on specifics of impending adjustment precautionary savings Reductions in social expenditure and wage government consumption are politically difficult to enact signal of governments resolve private sector confidence that fiscal problems will be overcome


2004: Greece admitted to have entered euro-zone on wrong budgetary figures April 2009: Greek minister of Finance refused to clarify financial situation July 2009: projected 2009 deficit was raised from 3.7% to 5-6% GDP October 21, 2009: update of deficit projection 2009 to 12.5% November 5, 2009 : update of deficit projection 2009 to 12.7%

 May 3, 2010: agreement Greece, EC, ECB and IMF on 3year program of economic and financial policies. May 3, 2010: ECB announces to accept Greek debt as collateral irrespective of its rating. May 7, 2010: Spread on Greek debt exceeds 1000 basis points. May 7, 2010: Council adopts Decision on conditions for financial assistance program (110 billion) Weekend May 8 and 9, 2010: Agreements on European Financial Stabilisation Facility (EFSF) and European Financial Stabilisation Mechanism (EFSM)


GDP still shrinking Deficits continue to be high and debt still rising rapidly. Greece is lagging behind the agreed adjustment package Eventually, restructuring seems inevitable Systemically relevant banks may need to receive public capital injections and need to raise equity.

Debt restructuring:
Becomes necessary if both capital markets and European governments refuse to provide further funding Key questions: Is there any realistic prospect that additional loans will be repaid? If not, should one restructure now or postpone it till later? Note extra funding may buy time to work out a solution. Contracts mostly written under local law legal obstacles seems manageable

Types of adjustment: several options

Voluntary roll-over of debt (Vienna initiative applied to Eastern Europe) Temporary solution only Pursuasion of sufficient number of creditors Postpone the maturity date of the debt (reprofiling) Lower the coupon rate on the debt Reduce nominal value of debt

Consequences of debt restructuring

Direct: Losses on rescue package by other governments Losses for ECB needs to be recapitalised Estimated 50 bln. direct holdings Estimated 90 bln. as collateral via repos Banks need to write off some of their assets risk of bankruptcy (especially Greek banking sector)

Consequences of debt restructuring

Indirect:
Confidence in support of other vulnerable countries is undermined borrowing difficulties spill over to these countries new demand for support while there is only limited capacity. Credit-default swaps may trigger payments

 Europes sovereign debt crisis?

EMU : Investors European Resolution Mechanism
Guide market expectations effectively about the steps to be taken during the resolution (so avoid excess volatility in financial markets). Provide governments with a game plan for this situation. Resolve credibility problem of unconditional no-bail-out clause: need to set clear rules for how default will evolve. Set clear rules for involving creditors in the resolution.

Global Imbalance
Increased dispersion in CA balance Increased persistence in CA imbalance

Policy issues
Increase domestic spending in surplus countries. For example, China, Germany, Japan. Reduce domestic spending in deficit countries. For example, US.