EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS

1. EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS Macroeconomic management in times of crisis: the European experience Paul van den Noord Economic Adviser DG ECFIN European Commission

2. Structure of the presentation • Anatomy of the crisis • Root causes of the crisis • The crisis from a historical perspective • Economic consequences of the crisis • Impact on potential growth • Impact on labour market and employment • Impact on budgetary positions • Impact on global imbalances • Impact on internal imbalances and competitiveness • Policy responses • A primer on financial crisis policies • Crisis control and mitigation • Crisis resolution and prevention 2

3. Anatomy of the crisis1. The root causes 3

4. Macroeconomic roots Complacency of policy makers (belief in Great Moderation) Abundant global liquidity diverted to real estate (global imbalances) Rapid credit growth, high leveraging Microeconomic roots Originate and distribute model Complex and opaque financial products Conflicts of interest of rating agencies Incentives for short-run risk taking Incentives to move assets off balance sheet Maturity mismatches Weaknesses in supervision and regulation Moral hazard Root causes of the crisis Powerful domino effects and feedback loops when bubbles pop 4

5. Magnitude of the crisis can be replicated with DSGE model (QUEST). Parameters determining the risk premia for households and the interbank market were chosen such that the model can roughly match the observed orders of magnitude of the bond spread and the spreads in the interbank market. Asset losses reduce bank equity and increase the leverage position of banks. Bank equity depletion leads to an adverse shift in the supply curve for bank funding. The bank has to pay a risk premium on interbank loans and deposits. Price for raising new bank capital also increases, which they shift onto investors by increasing loan interest rates. Model predicts GDP to plummet by some 4% in first year, which corresponds to our latest (and previous) forecast for 2009. Root causes of the crisis 5

6. Root causes of the crisis • Trough in the contraction of GDP (4.5%) well below the average of historical crises. • Slower rebound of consumption growth in the current crisis. • Housing and business investment also more affected in the current crisis. 6

7. Anatomy of the crisis2. Historical perspective • Great Depression is the right benchmark • But it served also as a great lesson • Financial meltdown avoided • Monetary policy eased aggressively • Substantial fiscal stimulus • No large scale protectionism 7

8. Historical perspective GDP a during three global crises 8

9. Historical perspective World average of own tariffs for 35 countries, 1865-1996, un-weighted average, per cent of GDP 9

10. Historical perspective The response of world trade during the crises of 1929-1933 and 2008-2009 10

11. Economic consequences of the crisis1. The impact on potential output 11

12. Case No 1: Full return to earlier path Case No 2: Permanent loss in GDP level Case No 3: Permanent loss on growth rates 1. The impact on potential output Critical challenge for the EU are to prevent reduction in potential growth from lower or unproductive investment due to risk aversion, credit constraints or government intervention and labour market hysterisis Past crises (e.g. Sweden and Finland) show that policy responses matter 12

13. 1. The impact on potential output 13

14. 1. The impact on potential output 14

15. Economic consequences of the crisis2. Impact on labour market and employment 15

16. 2. Impact on labour market and employment 16

17. 2. Impact on labour market and employment ‘Atypical’ workers bear the brunt of the recession Easier stance of EPL for atypical contracts protects ‘insiders’ 17

18. Economic consequences of the crisis 3. Impact on budgetary positions 18

19. 3. Impact on budgetary positions 19

20. 3. Impact on budgetary positions 20

21. 3. Impact on budgetary positions 21

22. 3. Impact on budgetary positions 22

23. 3. Impact on budgetary positions 23

24. Economic consequences of the crisis 4. Impact on global imbalances 24

25. 4. Impact on global imbalances Correction of the current account deficit of the US associated with deleveraging Unlikely to be matched by an equivalent correction of the current account surpluses of the emerging market economies (China). If so the euro area will have to bear the brunt of the adjustment. 25

26. Economic consequences of the crisis 5. Impact on internal imbalances and competitiveness 26

27. 5. Impact on internal imbalances and competitiveness Adjustment triggered by the crisis Two opposite cases in the euro area: Spain and Germany 27

28. 5. Impact on internal imbalances and competitiveness Adjustment triggered by the crisis An example from Eastern Europe 28

29. 5. Impact on internal imbalances and competitiveness In current account surplus countries net exports contract most 29

30. 5. Impact on internal imbalances and competitiveness Downturn steepest in Member States with largest imbalances? 30

31. Policy responses 31

32. Policy responses:1. A primer on financial crisis policies 32

33. Policy responses 2. Crisis control and mitigation 33

34. Policy responses: 2. Crisis control and mitigation 34

35. Policy responses: 2. Crisis control and mitigation 35

36. The policy response: 2. Crisis control and mitigation 36

37. Policy responses 2. Crisis control and mitigation 37

38. Policy responses 2. Crisis control and mitigation 38

39. Policy responses: 2. Crisis control and mitigation 39

40. Policy responses: 2. Crisis control and mitigation What about automatic stabilisers? 40

41. Policy responses: 2. Crisis control and mitigation Small government + large current account deficit = crisis vulnerability Big government + large current account surplus = crisis vulnerability 41

42. Resolution Cleaning up the banking system Exit from fiscal stimulus and fiscal consolidation Exit from monetary policy stimulus Prevention Macro-prudential surveillance Micro-prudential surveillance and regulation Structural reform Policy responses 3. Crisis resolution and prevention 42

43. Policy responses 3. Crisis resolution: multiple exit strategies • Exit sequencing • Fiscal stimulus • Financial support • Business support • Labor market support • Monetary stimulus • Restoring fiscal sustainability • Restoring growth potential • Reducing imbalances in a lasting manner • Dealing with social impact • Coordination: globally and within Europe 43

44. The fiscal exit What do we know about how to consolidate successfully? • Need to focus on expenditure, but tax increases may be unavoidable • Combine gradual adjustment and structural reform • Improvements in fiscal institutions help • Crisis can be a catalyst for successful consolidation 44

45. The fiscal exit ECOFIN Council 20 October 2009: Designing fiscal exit strategies • Timely withdrawal of stimulus • not too early, not too late • Consolidation as of 2011 • if recovery proves self-sustained • >0.5% of GDP per annum • Focus on longer-term goals 45

46. The monetary exitWhy, How and When? • WHY: Inflation is a monetary phenomenon in the long run Main inflationary risks stem from: 1) record low interest rates 2) excess (global) liquidity 3) potential de-anchoring of inflation expectations • HOW: Exit from conventional and unconventional measures can be decoupled …but technically speaking, interest rate increases easier to engineer • WHEN: Too early exit may hamper recovery Too late exit may lead to: 1) inflationary pressures and/or asset price bubbles (at macro level) 2) interbank market distortions (at micro level) 46

47. The monetary exit Challenges Ahead • Communication about the exit should be an integral part of the exit strategy • Timing and pace of the exit: How to judge them properly? Trade-off between the necessary stimulus in the short run and the need to maintain price and financial stability in the medium to long run => gradualism prudent but not necessarily the optimal strategy • Coordination between central banks on the one hand, and monetary and fiscal policy on the other hand • Exit is more an art, than a science 47

48. The financial exitConsensus view • General agreement that the economic and financial situation has not stabilised to a point where the banking sector could live without any public support… • …but broad agreement that a clear strategy should be built and communicated in anticipation of the full recovery….. • …based on principles agreed by the ECOFIN in December 2009 48

49. The financial exit ECOFIN principles • Public support schemes to phased out on co-ordinated basis • Timing of exit to take account of a broad range of macro-financial elements and country specificities • Typically, the phasing out of support should start with government guarantees • Exit must take into account the legal framework, including the relevant state aid decisions, • Withdrawal of state support should take into account the legitimate interest to minimize the potential loss of public money 49

50. Business support exit • Main types of crisis support to businesses • Support schemes with clear sectoral focus • Direct subsidies • Access-to-finance support • Risks of late withdrawal are most pronounced in the case of sector-specific support schemes • “Beggar-thy-neighbour” effects • Damage to the level playing field of the Single Market • Delays in needed structural adjustment • Risks of early withdrawal are most pronounced in the case of access-to finance support • Banks may not yet be able to meet rising corporate credit demand precisely as the recovery takes hold • Increased corporate defaults may result with feedback into banks’ balance sheets 50