Euro area policy options to combat the debt crisis Christian Dreger, DIW Berlin

Euro area outlook Period of low growth ahead in the euro area – Stagnation or recession in core countries (Germany 0.2, France 0.2, Spain -0.3, Italy -0.2) – German growth vulnerable, almost 50 percent of exports delivered to euro area countries Fiscal consolidation due to government debt crisis reduces growth perspectives – Low confidence and high unemployment limit expansion of domestic demand in most countries – Consolidation period might be long lasting, especially in Southern countries

Spillovers to global economy Euro area crisis risk for sustainable development of global economy – China heavily affected by crisis, no stand-alone pillar for global growth – Postpone economic reforms in emerging markets Higher risk for protectionism and disintegration in global economy – Race towards currency depreciation, exports become more important in growth strategies Stagnation difficult to combat, as policy measures seems to be exhausted

Public debt and GDP growth Negative impact of debt to GDP ratio on per capita GDP growth in euro area – Especially in periods of non-sustainable debt – Effects are not detected for non EA countries – See Dreger and Reimers (2012) Participation in monetary union may entail specific risk for its members Higher risk of sovereign default due to no bail out rule, prohibition of ECB to finance governments Improved system of macroeconomic governance

Fiscal consolidation strategy Population ageing implies higher financial burden on social security systems – Pressure especially in pensions and healthcare Long run growth perspectives can improve if public finances are on sustainable path – Increased reliability of plans of households and firms – Willingness to consolidate underpinned by fiscal pact Benefits related to the long run, short and medium run effects are negative Consolidation strategy indispensable, but need to be extended by other measures to ensure its success

Towards a new policy mix Sustained consolidation over long periods not very plausible – Voters will not re-elect their governments Collective austerity measures can undermine the EU2020 strategy – Short run effects limit long term growth perspectives Less strict consolidation may stimultate growth in euro area – Option exists especially in healthy countries – Special economic zones to reintroduce growth in the Southern states

Role for monetary policy Fiscal expansion can increase risk premia in financial markets – Not feasible without support from monetary side Governments issue debt in a currency beyond their control – Cannot guarantee the repayment of debt Lower confidence in financial markets can raise interest rates to levels high enough to make any country insolvent Lender of last resort for the individual countries

Lender of last resort Should buy bonds in capital markets when solvent countries come under attack – Outright monetary transactions (OMT) started Sep 2012 – No spirals of eroding confidence and higher interest rates – Lender acts if interest rates reach critical levels – Control by ESM might serve as an obstacle for countries EFSF/ESM funds may assist, but no major role – Size not sufficient, designed for crisis at the periphery – Increasing size could lead to lower country ratings – Conditionality implies overshooting of reforms if market rates are driven by speculative runs

Redesigning the EU budget Structural funds not optimally used in past – Effects on economic convergence unclear, evidence depends on empirical methods – Despite additionality principle, funds seem to crowd out national activities – Funding agriculture has high opportunity costs – Co-financing impediment in periods of consolidation Potential conflict between convergence and growth – Poor institutions in suffering countries Stronger evaluation of growth effects required

Conclusions Integrated euro area approach to combat the debt crisis – Precondition is decision to keep the euro area as it is – Better coordination than fiscal packages in financial crisis Implementation of a new policy mix on the agenda – Less tight fiscal consolidation in healthier states – Fiscal union can reduce adjustment capacities to respond to country-specific shocks – Stimulus programs in the Southern member states – ECB as a lender of last resort for euro area countries – Common budget focuses on growth, less on convergence