(International Papers in Political Economy Series) Philip Arestis, Malcolm Sawyer (Eds.) - The Euro Crisis-Palgrave Macmillan UK (2012)

The Euro Crisis
International Papers in Political Economy Series

Series Editors: Philip Arestis and Malcolm Sawyer
This is the eighth volume of the new series of International Papers in Political
Economy (IPPE). The new series will consist of an annual volume with six to
seven papers on a single theme. The objective of the IPPE will continue to be the
publication of papers dealing with important topics within the broad framework
of Political Economy.
The original series of International Papers in Political Economyy started in 1993
and was published in the form of three issues a year with each issue containing
a single extensive paper. Information on the old series and back copies can be
obtained from Philip Arestis (e-mail: pa267@cam.ac.uk) and Malcolm Sawyer
(e-mail: mcs@lubs.leeds.ac.uk).
Titles include:
THE EURO CRISIS
NEW ECONOMICS AS MAINSTREAM ECONOMICS
21st CENTURY KEYNESIAN ECONOMICS
PATH DEPENDENCY AND MACROECONOMICS
CRITICAL ESSAYS ON THE PRIVATISATION EXPERIENCE
POLITICAL ECONOMY OF LATIN AMERICA

Recent Economic Performance
ALTERNATIVE PERSPECTIVES ON ECONOMIC POLICIES IN THE EUROPEAN

UNION
FINANCIAL LIBERALIZATION
Beyond Orthodox Concerns
International Papers in Political Economy

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The Euro Crisis
Edited by
Philip Arestis
Director of Research, Cambridge Centre for Economic and Public Policy, Department of
Land Economy, University of Cambridge, UK; and Professor of Economics, University
of the Basque Country, Spain
and
Malcolm Sawyer
Professor of Economics, University of Leeds, UK
Selection and Editorial Matter Philip Arestis and Malcolm Sawyer 2012
Individual Chapters Contributors 2012
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Contents
List of Tables vi
List of Figures viii
Preface x
Notes on Contributors xi
1 Can the Euro Survive after the European Crisis? 1

Philip Arestis and Malcolm Sawyer
2 The European Financial and Economic Crisis:
Alternative Solutions from a (Post-)Keynesian Perspective 35
Eckhard Hein, Achim Truger and Till van Treeck
3 Debt Sustainability Revisited 79
Yannis A. Monogios and Panagiotis G. Korliras
4 Greeces Sudden Faltering Economy: From Boom to
Bust With Special Reference to the Debt Problem 119
Evangelia Desli and Theodore Pelagidis
5 The Irish Tragedy 159
Yiannis Kitromilides
6 Portugals Best Way out of Economic Stagnation:
Institutional Reform of the Eurozone 195
Pedro Leao and Alfonso Palacio-Vera
7 The Economic Crisis in Spain: Contagion Effects and
Distinctive Factors 235
Jess Ferreiro and Felipe Serrano
Index 269
v
List of Tables
1.1 Budget/GDP and debt/GDP 6

1.2 Inflation rates 7
1.3 Current account positions and competitiveness 11
1.4 GDP growth and unemployment 11
2.1 Key macroeconomic indicators for imbalances, selected
Euro area countries, 19992007, average values 46
3.1 Assumptions adopted in the analysis 93
3.2 Base-case scenario 95
3.3 Optimistic scenario 96
3.4 Conservative scenario 97
3.5 Sustainable tax ratios in selected EMU economies
(20112016) 99
3.6 Short-term tax gap indicator in selected EMU
economies (20112010) 101
3.7 Medium-term tax gap indicators in selected EMU
economies (2012/2010 2016/2010) 102
3.8 IFS synthetic-recursive indicator for selected EMU
economies (20062010) 104
3.9 Summary of sustainability indicators for selected
EMU member states 105
4.1 Technical efficiency at country level, 19952008, % 125
4.2 Efficiency level for selected EU-15 member countries,
19952008, % 126
4.3 Macroeconomic indicators, millions of euros 135
4.4 Interest payment on debt and interest as a
percentage of GDP 148
4.5 Scenarios for debt dynamics (20112015), % 157
4.6 Scenarios for debt dynamics (20112015), % 157
6.1 Portugal, main macroeconomic indicators, 19992009 202
vi
List of Tables vii
6.2 Portugal, current account, per cent of GDP, 19962009 204

6.3 Portugal, current account, per cent of GDP,
20059 vs. 1999 205
6.4 Inequality of income distribution Gini coefficient,
19992008 219
6.5 Unemployment rates and CAs in the Eurozone, 2010 222
List of Figures
2.1 10-year government bond yields, selected countries,

January 2007May 2011 38
2.2 General government financial balance relative to GDP,
selected countries, 19952010 39
2.3 General government gross consolidated debt relative to
GDP, selected countries, 19952010 40
2.4 Sectoral financial balances relative to GDP, Spain,
19952010 41
2.5 Sectoral financial balances relative to GDP, Ireland,
19952010 42
2.6 Sectoral financial balances relative to GDP, Greece,
19952010 43
2.7 Sectoral financial balances relative to GDP, Germany,
19952010 44
2.8 Current account in billions ECU/euro, selected Euro area
countries, 19952010 45
2.9 Net foreign asset position relative to GDP, selected Euro
countries, 19952010 49
3.1 Sustainable tax ratios for Germany, Netherlands and
Finland 100
3.2 Sustainable tax ratios for Greece, Ireland and Portugal 100
3.3 Medium-term tax gap indicator for Germany, Netherlands
and Finland 102
3.4 Medium-term tax gap indicators for Greece, Ireland and
Portugal 103
3.5 IFS synthetic-recursive indicator for Greece, Portugal and
Germany 104
4.1 Real GDP growth rate: Eurozone and Greece 121
4.2 Demand injections 122
4.3 Credit expansion and private consumption, yearly
change, Greece 123
viii
List of Figures ix
4.4 Technical efficiency, 19952008 125

4.5 Inflation differential between Greece and Euro zone-13 128
4.6 Goods and services balances 129
4.7 Employment ratio for the population over 15 years of age 132
4.8 Net revenue, primary expenditure and interest expenditure
of Greek central government budget 134
4.9 Interest Cover of Greek general government 136
4.10 Greek debt-to-GDP ratio since 1991 and its decomposition 145
6.1 REER based on HIPC and ULC, 19952008 208
6.2 Inflation in Portugal and in the Eurozone, 19972010 208
6.3 The evolution of market shares (goods) in the EU-15,
19952009 209
6.4 Portugal, saving, investment and the current account,
19962009 211
6.5 The situation of the typical Portuguese tradable sector 213
6.6 Current account (per cent of GDP) 19922007 218
Preface
This is the eighth volume of the series of International Papers in Political

Economy (IPPE
( ). The series consists of an annual volume with six to
seven papers on a single theme. The objective of the IPPE continues to
be the publication of papers dealing with important topics within the
broad framework of Political Economy.
The original series of International Papers in Political Economyy started
in 1993 until the new series began in 2005 and was published in the
form of three issues a year with each issue containing a single extensive
paper. Information on the old series and back copies can be obtained
from the editors: Philip Arestis (e-mail: pa267@cam.ac.uk) and Malcolm
Sawyer (e-mail: mcs@lubs.leeds.ac.uk).
The theme of this eighth volume of seven papers is The Euro Crisis.
The papers in this volume were presented at the 8th International
Conference, entitled Developments in Economic Theory and Policy, held
at Universidad del Pais Vasco, Bilbao, Spain, 29 June1 July 2011,
which fully funded and supported special sessions to which the papers
included in this volume were presented. We are grateful to the organiz-
ers of the Bilbao conference for all the help and funding provided.
x
Notes on Contributors
PHILIP ARESTIS is Director of Research, Cambridge Centre for Economics

and Public Policy, Department of Land Economy, University of
Cambridge, UK; Professor of Economics, Department of Applied
Economics V, University of the Basque Country, Spain; Distinguished
Adjunct Professor of Economics, Department of Economics, University
of Utah, US; Senior Scholar, Levy Economics Institute, New York,
US; Visiting Professor, Leeds University Business School, University
of Leeds, UK; Professorial Research Associate, Department of Finance
and Management Studies, School of Oriental and African Studies
(SOAS), University of London, UK; and holder of the British Hispanic
Foundation Queen Victoria Eugenia British Hispanic Chair of Doctoral
Studies. He is Chief Academic Adviser to the UK Government Economic
Service (GES) on Professional Developments in Economics. He has
published as sole author or editor, as well as co-author and co-editor,
a number of books, contributed in the form of invited chapters to
numerous books, produced research reports for research institutes, and
has published widely in academic journals.
EVANGELIA DESLI is Assistant Professor of Economics at the Aristotle

University of Thessaloniki, Greece. Her research interests are in the
areas of economic growth, convergence and efficiency. She has pub-
lished a number of articles on those topics in refereed journals such as
the American Economic Review, Manchester School, Cambridge Journal of
Economics and Journal of Post Keynesian Economics.
JESS FERREIRO is Associate Professor in Economics at the University

of the Basque Country, Bilbao, Spain, and an Associate Member of the
Centre for Economic and Public Policy, University of Cambridge. His
research interests are in the areas of macroeconomic policy, labour
market and international financial flows. He has published a number of
articles on those topics in edited books and in refereed journals such as
the American Journal of Economics and Sociology, Economic and Industrial
Democracy, conomie Applique, Ekonomia, European Planning Studies,
International Journal of Political Economy, International Labour Review,
International Review of Applied Economics, Journal of Economic Issues,
Journal of Post Keynesian Economics, and Transnational Corporations.
xi
xii Notes on Contributors
ECKHARD HEIN is Professor of Economics at the Berlin School of

Economics and Law. Previously he was a Senior Researcher at the
Macroeconomic Policy Institute (IMK), Hans Boeckler Foundation,
Dsseldorf, and a Visiting Professor at Carl von Ossietzky University
Oldenburg, the University of Hamburg and at Vienna University of
Economics and Business. He is a member of the coordination commit-
tee of the Research Network Macroeconomics and Macroeconomic
Policies (FMM) and a managing co-editor of Intervention. European
Journal of Economics and Economic Policies. His research focuses on
money, financial systems, distribution and growth, on European
economic policies and on post-Keynesian macroeconomics. He has
published in the Cambridge Journal of Economics, European Journal of the
History of Economic Thought,
t International Review of Applied Economics,
Metroeconomica, Review of Political Economy, and Structural Change and
Economic Dynamics, among others. His latest monograph on Money,
Distribution Conflict and Capital Accumulation: Contributions to
Monetary Analysis was published with Palgrave Macmillan.
YIANNIS KITROMILIDES is Visiting Research Fellow at the Centre

for International Business and Sustainability, London Metropolitan
University. He has previously taught at the University of Greenwich,
University of Westminster, University of Middlesex, and at the School
of Oriental and African Studies, University of London. His main
research interests include economics of climate change, economic
policy-making, nationalization of banking, and the shortcomings and
limitations of deficit reduction policies. In the latter field he published
two articles in 2011 in the Journal of Post Keynesian Economics and in the
International Journal of Public Policy.
PANAGIOTIS KORLIRAS is Professor of Economics at the Athens

University of Economics and Business, and Chairman of the Board and
Scientific Director of the Centre of Planning and Economic Research, in
Athens, Greece. He has taught at the University of Pittsburgh, USA, and
the Universit dAix-Marseille, France. He has served as Deputy Governor
of the Bank of Greece, member of the Monetary and Economic Policy
Committees of the EU, and President and Managing Director of the
Ionian and Popular Bank (now merged with Alpha Bank). His original
work was in the area of non-Walrasian macroeconomics, and he has
published articles and books in the fields of macroeconomics, monetary
economics and fiscal policy.
PEDRO LEO is Aggregated Professor of Economics at the School of

Economics and Management, Technical University of Lisbon (ISEG-UTL).
Notes on Contributors xiii
His research focuses on money, macroeconomic policy, business cycle

and growth. He is the author of a number of articles on those topics in
edited books and in refereed journals such as the International Review of
Applied Economics, Economic Modellingg and the Journal of Economics. He has
authored one book in Industrial Economics and co-authored another in
Monetary Economics. He is currently very active in the Portuguese eco-
nomic policy debate.
YANNIS MONOGIOS is Research Fellow and Head of Fiscal Policy and

Financial Markets at the Centre of Planning and Economic Research in
Athens, Greece and a Delegate at the OECDs Senior Budget Officials.
He has served as an Adviser at World Bank Group Headquarters in the
USA and as a Special Adviser and a member of the Council of Economic
Advisers at the Greek Ministry of Economy and Finance. Before that he
held posts as Manager and Senior Economist in Piraeus Bank in Greece
and as a Lecturer at the Department of Economics, University of Athens.
He has published domestically and internationally in refereed journals
and he has been the author of numerous economic articles and research
reports on public finance and the financial markets.
ALFONSO PALACIO-VERA is Lecturer in Economics at Universidad

Complutense de Madrid, Spain. His research interests are in the areas of
post-Keynesian Economics, Monetary Economics and Macroeconomics.
He has published a number of papers in international academic
journals including the Journal of Post Keynesian Economics, Cambridge
Journal of Economics, Review of Political Economy, Eastern Economic Journal,
International Review of Applied Economics, Journal of Economic Issues and
Metroeconomica. He has also published several book chapters in books
published by Edward Elgar Publishing Ltd and Palgrave Macmillan.
THEODORE PELAGIDIS is Professor of Economics at the University

of Piraeus. He has been a visiting Fulbright and Onassis scholar at
Columbia University (2008), and a Senior Fellow at LSE (2010). He spe-
cializes in Political and European Economics. He has published more
than 40 articles in professional journals such as, the Journal of Economic
Policy Reform, Journal of Policy Modeling, Cambridge Journal of Economics,
International Review of Law and Economics, Review of European Economic
Policy (Intereconomics), Journal of Post Keynesian Economics, Challenge, The
Magazine of Economic Affairs, Industrial Relations, Review of International
Studies, Current Politics and Economics of Europe, Economy and Society,
International Review of Economics and Business, Cahiers Economiques de
Bruxelles, Actualite Economique, Review dAnalyse Economique, Journal of
Economic Studies, European Journal of Law and Economics, Ekonomia, Human
xiv Notes on Contributors
Resources Development International, etc. He is co-editor of the Welfare State

and Democracy in Crisis, Ashgate, 2001, and co-author of Understanding the
Crisis in Greece. From Boom to Bust,
t Palgrave Macmillan, 2011.
MALCOLM SAWYER is Professor of Economics, Leeds University
Business School, University of Leeds, UK. He was until recently Pro-
Dean for Learning and Teaching for the Faculty of Business, University
of Leeds, UK. He is managing editor of the International Review of Applied
Economics, on the editorial board of a range of journals and editor of the
series New Directions in Modern Economics. He has published widely
in the areas of post-Keynesian and Kaleckian economics, industrial
economics and the UK and European economies. He has authored 11
books and edited 18, has published over 70 papers in refereed journals
and contributed chapters to over 100 books.
FELIPE SERRANO is Professor in Economics at the University of the

Basque Country, Bilbao, Spain. He is the Head of the Department of
Applied Economics V at the University of the Basque Country. His
research interests are in the areas of social security, the welfare state,
labour market, innovation and economic policy. He is the author of
a number of articles on those topics in edited books and in refereed
journals such as Economies et Socits, Ekonomia, European Planning
Studies, Industrial and Labor Relations Review, International Labour Review,
International Review of Applied Economics, Journal of Economic Issues,
Journal of Pension Economics and Finance and Journal of Post Keynesian
Economics.
ACHIM TRUGER is Senior Researcher for Public Economics and Tax Policy
at the Macroeconomic Policy Institute (IMK), Hans Boeckler Foundation,
Dsseldorf, Germany. He is a member of the coordination committee of
the Research Network Macroeconomics and Macroeconomic Policies
(FMM) and a managing co-editor of Intervention. European Journal
of Economics and Economic Policies. He has taught Public Economics
and Macroeconomics at the Universities of Cologne and Oldenburg,
Germany. His research interests include Macroeconomic Policy, Fiscal
Policy and Tax Reform. He is currently very actively researching on eco-
nomic forecasting and on the German economic policy and tax reform
debate. He has co-authored five books and co-edited more than 20. He
has published a number of papers in refereed journals and more than
100 articles in economic policy-oriented journals and books.
TILL VAN TREECK is Senior Researcher for Economic Policy at the

Macroeconomic Policy Institute (IMK), Hans Boeckler Foundation,
Notes on Contributors xv
Dsseldorf, Germany. He is a member of the coordination committee of

the Research Network Macroeconomics and Macroeconomic Policies
(FMM) and a managing co-editor of Intervention. European Journal of
Economics and Economic Policies. He has taught macroeconomic policy
at the University of Hamburg, Germany. His research interests include
macroeconomic theory and policy, European economic policies and
applied econometrics. He has published in the Cambridge Journal of
Economics, Metroeconomica, Review of International Political Economyy and
Review of Political Economy, among others.
1
Can the Euro Survive after the
European Crisis?
Philip Arestis
University of Cambridge and University of the Basque Country
Malcolm Sawyer
University of Leeds
Abstract: The great recession has highlighted a range of problems

with the euro project, but these problems and difficulties are related
to some fundamental weaknesses of the euro. The convergence criteria
established by the Maastricht Treaty focused on nominal rather than
real variables, failed to relate to issues such as current account posi-
tions. There are well-known difficulties of macroeconomic policies
under the Stability and Growth Pact including its deflationary nature
and the one size fits all problem of imposing common deficit require-
ments on all countries. Problems with the EMU monetary policy are
also discussed before the economic performance of the euro area
countries is briefly reviewed with attention paid to the differential
inflation rates. Also accounted for are the changes in competitiveness
as well as the current account deficits, and their implications for the
future of economic performance within the euro area, and the euro
itself. The nature of the reforms and their impact on the operations
of the euro area are examined. The political limits (including those
arising from the nature of the Treaty of Lisbon) and the ideological
constraints (associated with the neo-liberal agenda) on serious reforms
are discussed from which the general conclusion is that the needed
reforms are extremely urgent, but unfortunately they will not be car-
ried through. This discussion also includes consideration of the possi-
ble role for a substantial EMU-level fiscal policy and some other aspects
of political integration. It is concluded that the deep-seated problems
are unlikely to be resolved, casting a dark shadow over the future of
the euro.
1
2 The Euro Crisis
Keywords: Economic and monetary union, euro, stability and growth

pact, fiscal policy, monetary policy, competitiveness, current account
imbalances, political integration
JEL Classification: O52, E60
1 Introduction
The euro has been operating since 2002 (and since 1999 if the period as
a virtual currency is included). Its introduction was technically accom-
plished and the switch over was perceived to have met few problems,
though there were some perceptions that prices rose when the euro
was introduced (a perception which does not show up in the statistics).
Although there have been occasional rumblings against it, there has not
until very recently been any concerted effort for a country to withdraw
from the euro and revert to a national currency, but the financial and
budgetary crises in a number of countries have brought withdrawal of
some from the euro as a seriously considered option.
The European Central Bank (ECB) launched the single currency (euro)
in 1999 alongside with the foundation of the Economic and Monetary
Union (EMU). The euro replaced the national currencies for all trans-
actions at the beginning of 2002 for 12 countries, namely Austria,
Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,
Netherlands, Portugal and Spain. This meant that three countries,
namely Denmark, Sweden and the United Kingdom, of the then 15
members of the European Union did not join the euro. The European
Union (hereafter EU) expanded in May 2004 with ten new member
countries, eight from Central and Eastern Europe countries (CEEC)
(Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovenia,
Slovakia) plus Cyprus and Malta. There was a subsequent expansion
with Bulgaria and Romania joining in January 2007. Of the new (2004)
member states, five have since adopted the euro, namely Slovenia
(2007), Cyprus and Malta (2008), Slovakia (2009) and Estonia (2011).
The economic performance of the euro area countries during the
decade or more of the euros existence, as briefly surveyed below, has
been rather lack-lustre even before the financial crisis struck economic
growth has been sluggish, inflation has remained low though often
breaking the 2 per cent target, and unemployment has remained high,
as indicated below. There have been continuing disparities in economic
performance in terms of unemployment and standards of living, which
Philip Arestis and Malcolm Sawyer 3
are highly significant as measures of economic well-being, and the

framework of the euro area has little to address them. But for the future
operation and indeed survival of the euro area the differences in infla-
tion, in budget deficits and in current account positions may be much
more significant as further discussed below.
The great recession that emerged in August 2007 has highlighted
severely many of the economic problems to which we have just alluded
for the euro area countries. The sharp increases in budget deficits as the
economies slowed and tax revenues plummeted meant that the limits
of the Stability and Growth Pact (SGP) were breached. Fortunately, the
immediate response was generally to accept those breaches but it was
not long before the calls for concerted action in terms of reduction of
budget deficits and fiscal consolidation started. The danger now is that
attempts by countries to cut their budget deficits will have cumulative
negative effects on employment and growth and have little actual effect
on budget deficits. The Greek tragedy and the crises in Ireland and
Portugal, though, have exposed very obviously a number of these prob-
lems, which have also led to the question of the euros survival. A partic-
ular problem related to the Greek tragedy, which is even more closely
related to the euro, is the attitude of the European Central Bank (ECB)
that refuses to consider a restructuring of Greek debt; and it is thought
to be the only party involved that rejects outright the idea of Greek debt
restructuring. Such attitude could easily produce serious problems for
the euro and it could result in its collapse.1 The ECB insists that Greece
is given more bailout loans for more austerity measures in Greece. In
fact, the ECB is hostile to any form of debt restructuring, threatening
to deny Greek banks access to ECB refinance operations; such a threat
if implemented would clearly force Greece out of the euro area.2 Greece
cannot pursue austerity measures continuously, especially so in view of
the worsening economic situation in the country. The options for sort-
ing out the sovereign debt are seriously constrained. Withdrawal from
the euro area could thereby become inevitable. The consequences for
such withdrawal for the euro could be serious.
We address these issues in this contribution where we first visit,
in section 2, the convergence Maastricht criteria, which were built
into the euro project. This is undertaken to illustrate the nature of
the euro project and also to indicate how some problems (such as
current account deficits in many Mediterranean countries) were left
unaddressed at the start of the project and have now come to under-
mine the edifice of the EMU. Section 3 briefly visits the issues of the
EMU fiscal and monetary policies. This latter section highlights some of
4 The Euro Crisis
the policy faults, which lie at the heart of the euro. Section 4 highlights
key features of the economic performance of the EMU members since
the formation of the euro by concentrating on the 12 initial members
of the union. Section 5 deals with adjustment processes and optimal
currency area considerations before section 6 turns to the question of
whether the euro can be saved, where it is argued that the constraints
of the Treaty of Lisbon and the neo-liberal framework, within which
most of the countries of the EU operate, are likely to preclude relevant
policy changes initiated let alone implemented. This is likely to consign
many countries with a choice between remaining members of the euro
and economic prosperity. We also review a number of policy considera-
tions, sections 710, leading to suggestions for major policy changes,
which could enable the euro to function effectively. The latter possibil-
ity is discussed further in section 11, before concluding comments are
provided in section 12.
2 The convergence criteria
The Maastricht Treaty laid down criteria that should be met by those
seeking to join the euro, and indeed all the countries that met the crite-
ria were obliged to join, though Denmark and the UK secured opt-outs
from that obligation.3 The convergence criteria were set in nominal
terms (relating to inflation and interest rates for example) with no
mention of real convergence (in terms of, for example, output per head
or unemployment rates) or even of the convergence of business cycles
across countries. These convergence criteria are now largely of historic
interest, though they are still relevant for those EU countries which
may seek to join the euro in the future. But the convergence criteria
do provide some insights into the nature of the euro project and to
which elements were deemed significant and important; and by omis-
sion those which were not so deemed.
The criteria include a budget deficit and a government debt criterion
designed to establish fiscal responsibility in the eyes of the financial mar-
kets and had no underlying rationale. The independence of the national
central banks on an operational and political level was also on the list of
these criteria. In terms of countries meeting the criteria, it must be said
that with the exception of the inflation rate and the interest rate, they
were not met as comfortably as it might have appeared initially. In fact a
great deal of fudging took place (see, for example, Arestis et al. 2001).
The adoption of a national independent Central Bank, as a forerun-
ner for inclusion into the European System of Central Banks with the
European Central Bank at its apex, signalled the adoption of a neo-

liberal agenda (Arestis and Sawyer 2006a, 2006c; Lucarelli 2004). The
requirements for budget deficit below 3 per cent of GDP and public debt
below 60 per cent were signals of the fixation with the budgetary posi-
tion, though in practice the 60 per cent limit was not attained by many
who joined and the 3 per cent limit reached in a number of cases only
through the use of creative accounting (Arestis et al. 2001). The require-
ments for the interest rate and inflation rate in a country to be close to
the average achieved in the three countries with lowest inflation had
an inherent rationale. It was that after the formation of EMU, a single
interest rate regime would apply and a common inflationary experience
would be required for the successful continuation of the euro. A stabil-
ity of a countrys exchange rate relative to the other countries of the
EMU had a similar intuitive appeal since the exchange rates of the EMU
countries were about to be locked together.
3 Fiscal and monetary policy in the EMU4
The key features of the Stability and Growth Pact (SGP) are as follows:
the first is the idea that national governments should aim for their
budgets to be in balance or small surplus over the course of a business
cycle and not to exceed 3 per cent of GDP in any given year; and the
second is that the ECB acting independently uses interest rate policy to
achieve price stability. National fiscal policy is subject to the requirements
of the SGP (with no fiscal policy at the level of the EU with a balanced
budget requirement and EU expenditure set at somewhat over 1 per cent
of EU GDP). The official rationale for the SGP is twofold. The first is that
a medium-term balanced budget rule secures the scope for automatic
stabilizers without breaching the limits set by the SGP. Second, since
a balanced budget explicitly sets the debt ratio on a declining trend,
it reduces the interest burden and improves the overall position of the
government budget. Underlying the approach to SGP, though, is the
notion of sound public finances. The European Commission (2000) is
emphatic on this issue: Achieving and sustaining sound positions in
public finances is essential to raise output and employment in Europe.
Low public debt and deficits help maintain low interest rates, facilitate
the task of monetary authorities in keeping inflation under control and
create a stable environment which fosters investment and growth ...
The Maastricht Treaty clearly recognises the need for enhanced fiscal
discipline in EMU to avoid overburdening the single monetary author-
ity and prevent fiscal crises, which would have negative consequences
6 The Euro Crisis
for other countries. Moreover, the loss of exchange rate instrument

implies the need to create room for fiscal policy to tackle adverse eco-
nomic shocks and smooth the business cycle. The stability and growth
pact is the concrete manifestation of the shared need for fiscal disci-
pline (p. 1).
The figures in Table 1.1 indicate that over the period 20027 the
budget deficit for the euro area as a whole averaged under 2 per cent of
GDP. Although this period of six years may not be a complete business
cycle the figure is nevertheless suggestive that the overall intention of
budgets in balance or small surplus was not attained. The same table
also indicates that four of the initial 12 euro area members breached the
3 per cent of GDP upper limit on budget deficits. It is clear from this
table that there are three groups of countries: one group includes those
countries that had deficits above the 3 per cent SGP ceiling in their
budget throughout the period; another group which, although having
deficits it was a small percentage of GDP; and a third group that had a
surplus over the period. The euro area as a whole, though, had a deficit
throughout the period. The imposition of an upper limit of 3 per cent
of GDP on the size of the budget deficit and the declaration of the aim
Table 1.1 Budget/GDP and debt/GDP
Budget Budget Budget Budget Debt/ Debt/

position/ position/ position/ position/ GDP GDP (%)
GDP (%) GDP (%) GDP (%) GDP (%) (%) 2010
Average 2008 2009 2010 2007
200207
Austria 1.85 0.5 3.5 4.4 63.1 75.9
Belgium 0.60 1.4 6.1 4.9 88.0 102.5
Finland 3.40 4.2 2.7 3.3 45.5 58.4
France 3.15 3.3 7.6 7.4 70.9 92.4
Germany 2.68 0.1 3.0 4.0 65.3 79.9
Greece 5.07 7.8 13.7 8.3 108.5 129.2
Ireland 1.07 7.3 14.2 32.3 29.4 104.9
Italy 3.22 2.7 5.2 5.0 117.2 131.3
Luxembourg 1.08 3.0 0.7 2.2 7.6 21.0
Netherlands 1.12 0.5 5.4 5.8 61.1 74.6
Portugal 3.67 3.0 9.4 7.3 68.8 92.9
Spain 0.63 4.2 11.1 9.2 42.3 72.2
Euro Area 1.27 2.0 6.2 6.3 70.9 91.6
Average (12)
Source: Calculated from OECD, Economic Outlook (various issues).

Table 1.2 Inflation rates
Annual inflation Annual inflation Annual

rate 200208 rate 2009 inflation rate
2010
Austria 2.1 0.4 2.9
Belgium 2.3 0.0 2.1
Finland 1.8 1.6 1.4
France 2.2 0.1 1.6
Germany 1.9 0.2 1.0
Greece 3.7 1.3 4.7
Ireland 2.9 1.7 1.6
Italy 2.6 0.8 1.5
Luxembourg 3.1 0.0 2.6
Netherlands 2.2 1.0 0.8
Portugal 2.7 0.9 1.4
Spain 3.3 1.4 1.5
Euro Area Average (12) 2.6 0.4 2.9
of a balanced budget over the cycle represented a significant tightening

of the fiscal position as compared with the 3 per cent of GDP target for
the budget deficit in the Maastricht Treaty convergence conditions. In
those conditions, the 3 per cent was to be achieved at a particular point
in time: under the SGP the 3 per cent limit is to be exceeded only under
extreme conditions. The figures for 2008 begin to worsen and the ones
for 2009 and 2010 clearly well exceed the 3 per cent limit, with the
exception of Luxembourg.
The general requirement that the budget be in balance or small surplus
over the course of the business cycle is more deflationary than it sounds
when allowance is made for inflation and the deficit is calculated in real
terms. For example, with a 60 per cent debt to GDP ratio, inflation of
2 per cent per annum would mean that the real value of the outstand-
ing debt declined by 1.2 per cent of GDP, and hence in real terms a
balanced budget in nominal terms equates to a 1.2 per cent of GDP
surplus. There is also an essential contradiction between the 60 per cent
debt to GDP ratio and a balanced budget. It can readily be shown that
a persistent overall budget deficit (that is including interest payments
on government debt) of d (relative to GDP) would lead to public debt
/g where g is the nominal rate of growth.5 Taking as an
stabilizing at b = d/g
example g = 0.05 (a 5 per cent growth rate built up from say 2 per cent
8 The Euro Crisis
real growth and 2 per cent inflation) then the debt ratio would be 20
times the deficit ratio. In that example a 60 per cent debt ratio would
be consistent with a persistent 3 per cent deficit ratio indeed that pre-
cise calculation was given as a justification for the 3 per cent deficit, 60
per cent debt target in the convergence criteria.
The ECB and the national central banks of the EMU countries
comprise the European System of Central Banks (ESCB), and the ECB
was endowed with the responsibility for the single monetary policy
that is independent from political influence (ECB 2004, p. 12). The
ESCB Treaty, Article 105 (1), states that the primary objective of the
ESCB shall be to maintain price stability and that without prejudice
to the objective of price stability, the ESCB shall support the general
economic policies in the Community with a view to contributing to
the achievement of the objectives of the Community as laid down in
Article 2. Table 1.2 shows that inflation in the euro area has generally
been above the 2 per cent level, with the exception of 2009, albeit by
a relatively small amount, and averaged 2.6 per cent over the period
20028. Only Finland and Germany managed an inflation rate of less
than 2 per cent during that period; the 12 euro area average of inflation
rose to 2.9 per cent in 2010. Furthermore, it is the differences in infla-
tion between countries that have plagued the euro area. This has meant
that a country with a relatively low (high) inflation rate has a relatively
high (low) real interest rate since there is a common nominal interest
rate anchor as set by the ECB applying across the EMU. Thus, monetary
policy has operated in a perverse manner with low real rates applying
where inflation is relatively high, running counter to the presumptions
of inflation targeting that high inflation is met by high real rates of
interest to dampen demand.
The ECB may appear to have been rigid, especially when compared
with the Bank of England and the US Federal Reserve System (Fed). If
we take the period of the great recession since August 2007, the US
Fed has aggressively reduced interest rates over the period; the Bank of
England has behaved in a similar, if less aggressive, manner. The ECB
has not behaved in such a fashion. There has been great reluctance to
reduce interest rates even in obvious circumstances. It is true that the
ECB adopted a wait and see approach, at the beginning of the great
recession, before following the other two central banks. Focusing more
closely in terms of the period near but after August 2007, the reaction
of the ECB was relatively modest. Initially, the upsurge in inflation
convinced the ECB to keep interest rates relatively high for a long time,
and this was especially so in July 2008 when there were already signs of
economic slowdown. Subsequently, the ECB was slow to push interest

rates down. In the event, when the banking crisis began to infect the
real economy very seriously, interest rates were cut by a total of 225
basis points up to January 2009 and eventually to 1 per cent in May
2009. The reduction in interest rates by 225 basis points was done in
four steps within a historically short period of time. But it was not as
bold as that of other central banks. In any case, it has been raised to 1.25
per cent in April 2011. Nor has the ECB pursued Quantitative Easing
(QE) as, for example, the Federal Reserve System or the Bank of England.
Although it has resisted QE, the ECB has, nonetheless, pioneered other
types of policies. Under the phrase Enhanced Credit Support (ECS), the
ECBs policy has been one of providing unlimited liquidity to banks at
its rate and under covered bonds. Covered bonds are securities that usu-
ally attract top triple-A ratings. They are also a major source of mortgage
finance in the EMU. They are, thus, safe securities since, in the event
of default, investors have redress to the issuers balance sheet; they are,
thus, of low risk of default. The ECB broadened the collateral it accepts
in June 2009, when under the ECS scheme it extended the maturity
of the collateral to up to 12 months. The reason for such a policy as
opposed to QE is that, in addition to the low risk, in Europe conven-
tional loans comprise the bulk of credit so that using covered bonds,
which are issued by banks, could potentially affect bank lending. The
banking system plays a much bigger role in providing finance in Europe
than in, for example, the US and the UK.
The Treaty of Lisbon, and its forerunners, bars the monetization of
member governments deficits and debts. It is permissive but not man-
datory for the ECB to act as a lender of last resort. The general practice
is for a central bank to act as a lender of last resort and to operate
such that sound financial paper is discounted at the pre-announced
discount rate and exchanged for base money. Banks can then obtain
reserves from the central bank in exchange for sound financial paper.
Such paper would include (but not always limited to) government debt.
The ECB announced soon after the bailout of Greece in May 2010 that
it would only accept sound financial assets.
4 Economic performance in the euro area
The economic performance of the euro area countries are briefly

reviewed in terms of growth, unemployment, inflation and current
account, as well as the extent to which the requirements of the SGP
were met. Particular attention is paid to the differential inflation rates,
10 The Euro Crisis
the changes in competitiveness and the current account deficits, and

their implications for the future of economic performance within the
euro area and the euro itself. The patterns of current account deficits
and surpluses are linked with unemployment, lack of competitiveness
and budget deficit issues.
Tables 1.3 and 1.4 provide summary data relevant for economic per-
formance of the euro area. The data in both tables relate to the decade
since the euro was launched as a real currency. Three main points
emerge:
(i) there were large and continuing current account imbalances

between the EMU countries; especially and persistently so the large
external surpluses and deficits coexisted in the core and peripheral
countries respectively. The same situation continues over the years
20027 and subsequently in 2008, 2009 and 2010 (see Table 1.3).
Those imbalances were not the subject of surveillance within the
framework of the SGP;6
(ii) there were substantial differences between countries in terms of
changes in unit labour costs (see Table 1.3). The implied changes
in competitiveness, and economic policies; in terms of the loss of
competitiveness it is estimated to be between 25 per cent and 30
per cent for Greece, Ireland, Portugal and Spain since the creation
of the EMU in January 1999. It is clear that economic convergence,
crucially in terms of costs in this instance, has not materialized;7
(iii) the growth rates for the periods 19912000, 20007 and for
200810 vary significantly among the 12 euro area countries; the
unemployment rate also differs significantly among countries, but
worsens by 2010 in a number of countries, especially so in Greece,
Ireland, Portugal and Spain.
The growth performance of the euro area during the 2000s was some-
what below the growth of the 1990s (as indicated in Table 1.4) although
the global economy was growing rather faster. The growth figures in that
time run through to 2007, whereas, of course, if 2008, 2009 and 2011
were included the comparison between the 2000s and 1990s would be
even less favourable to the euro project. Unemployment did fall dur-
ing the mid-part of the 2000s but the great recession wiped out those
gains. The figures in Table 1.3 indicate that current account positions
vary substantially between countries with most Southern European
countries having substantial deficits whereas Northern European coun-
tries (with the exception of France) have surpluses.
11
Table 1.3 Current account positions and competitiveness
Current Current Current Current Change in

account/GDP account/ account/ account/ unit labour
(%) Average GDP (%) GDP (%) GDP (%) costs (%)
200207 2008 2009 2010 200108
Austria 2.53 3.3 2.7 2.6 3.50
Belgium 3.05 1.9 0.8 1.0 11.96
Finland 5.50 2.9 2.7 1.5 4.33
France 0.13 1.9 1.9 2.2 7.66
Germany 4.62 6.7 4.9 5.1 5.37
Greece 8.75 14.7 11.4 10.5 17.02
Ireland 2.33 5.6 3.0 0.3 34.55
Italy 1.63 3.6 3.2 3.3 9.73
Luxembourg 10.42 5.3 6.7 7.8 9.48
Netherlands 6.52 4.3 4.6 5.3 11.41
Portugal 9.07 12.6 10.3 10.3 7.44
Spain 6.42 9.7 5.5 5.5 16.49
Euro Area 0.58 0.8 0.4 0.2 11.58
Average (12)
Table 1.4 GDP growth and unemployment
GDP GDP GDP Unemploy- Unemploy-

growth growth growth ment rate (%) ment rate (%)
19912000 200207 20082010 2000 2010
Austria 2.3 2.48 0.03 3.6 4.3
Belgium 2.3 2.13 0.07 6.9 7.7
Finland 2.9 3.45 1.47 9.6 8.4
France 2.1 1.87 0.27 9.0 9.5
Germany 1.7 1.30 0.17 7.5 7.1
Greece 2.3 4.13 1.63 11.2 15.9
Ireland 7.7 5.40 3.83 4.2 14.7
Italy 1.6 1.05 1.80 10.1 8.3
Luxembourg 4.6 4.60 0.33 2.2 5.5
Netherlands 3.2 1.98 0.10 3.0 5.0
Portugal 2.7 1.00 0.33 4.0 12.4
Spain 2.8 3.38 1.00 11.1 20.7
Euro Area 3.0 1.88 0.70 8.5 10.0
Average (12)

12 The Euro Crisis
The protracted weak performance of the euro area can be attributed

to two main factors: the incomplete integration of the financial system
and to the absence of a central authority to deal with crises (IMF 2011).
The IMF on to warn that the EMU is vulnerable to another systemic
banking crisis in view of the sovereign debt problem in some distressed
peripheral euro area member countries.8 Such a situation could easily
produce contagion to the core euro area and to the EU, but more so in
emerging Europe. This is so, the IMF (2011) suggests, in view of banks
in the core periphery countries being significantly exposed to the euro
area periphery. Under such circumstances, restructuring the sovereign
debt of the distressed peripheral countries could produce a systemic
risk to the entire EMU, thereby risking a second credit crunch (IMF
2011). We elaborate further on the aspects mentioned above.
The data in Tables 1.2 and 1.3 indicate something of the scale by
which relative prices and relative unit labour costs have changed, when
the nominal exchange rates of the national currencies of the original
EMU member states were locked together. One interpretation of those
changes could be that they represent the adjustment of real exchange
rates between EMU member countries in the face of a combination of
inappropriately set nominal exchange rates (back in 1998 for most)
and shocks. But that overlooks the prevailing current account deficits
when the euro was formed and some tendency for the current account
deficits to persist and widen.
We would draw the following conclusions from the analysis in this
section. First, the record of achieving the targets of the EMU has not
been a particularly good one, with inflation target persistently missed
albeit by a small amount, and national budget deficits frequently
exceeding 3 per cent of GDP. Second, the economic performance
in terms of growth and unemployment has been lack-lustre. Third,
there are clear problems of differential inflation, of major changes in
competitiveness and the persistence of large current account imbal-
ances. However, the overall conclusion then is that the economies of
the euro area have not been performing particularly well, and that
the financial crisis has highlighted problems at the heart of the euro
project. This would clearly suggest that it may very well be the case
that the time has arrived for the euro to be replaced or disappear.
Under the circumstances and the problems highlighted in this sec-
tion, three questions emerge. The first question is whether the euro
can still be saved. If the answer is negative, then the second question
follows. Could reforming the institutional set-up of the euro save it?
If the answer is positive then the third question evolves around the
precise institutional changes that could potentially save the euro. We

now deal with these questions.
5 Adjustment processes and Optimal Currency Area

considerations
The ideas on the Optimal Currency Area (OCA) had rather little influence
on the formation of the euro.9 Baldwin and Wyplosz (2009), for example,
argue that The negotiators who prepared the Maastricht Treaty did not
pay attention to the OCA theory (p. 345). The same source also poses the
question of whether Europe is an optimum currency area with the answer
that most European countries do well on openness and diversification,
two of the three classic economic OCA criteria, and fail on the third one,
labour mobility. Europe also fails on fiscal transfers, with an unclear ver-
dict on the remaining two political criteria (p. 340). It is clear that EMU
is not fiscally integrated. Taxpayers in one country do not pick up, for
example, any of the costs of a bank bailout of another country. It is also
true that while citizens of the EMU have the legal right to move freely in
any of the member countries in search for employment, in practice citi-
zens are much less geographically mobile than in countries like the US, for
example. A currency union that works coincides with a nation that has a
central government and a common language; EMU has neither.
The OCA literature clearly points out that a monetary union means
that the exchange rate between constituent members cannot be
changed in nominal terms. Hence, the possibility of using changes
in the exchange rate as a means of adjusting to economic shocks or
indeed to continuing difficulties is ruled out. There can, though, be
changes in the real exchange rate through a change in the relative prices
of constituent members. The OCA literature points to the possibility of
price flexibility as a device through which a country could adjust to an
economic shock. But the expectation would be that a negative shock
would be compensated by a fall in relative prices (of a country). In the
euro area it appears that there have been substantial changes in the real
exchange rate of countries, as relative prices of countries have changed
reflecting differential inflation between countries. But it is rather
unlikely that these changes in relative prices have been responses to
differential shocks and that those changes are an adjustment process. If
anything the changes in relative competitiveness have worsened rather
than lessened the disparities in current account positions.
The emphasis of the OCA approach was on the ability (or otherwise) of
an economy to adjust to shocks, where the adjustments were viewed in
14 The Euro Crisis
terms of market ones of price and factor mobility. What was little consid-
ered in the OCA, or other literature, was the consequence for an economy,
which joined the currency union with an economy that was unbalanced.
By the latter we mean an economy (or parts thereof ) that had high levels
of unemployment or one that had a large current account deficit. It is
then not a matter of asking how an economy could adjust to a shock (par-
ticularly a negative one) to restore full employment but rather whether
there is any prospect of an economy in a currency union escaping from
high levels of unemployment. In order to reach a lower level of unem-
ployment, the demand for the output of that economy has to be increased
faster than output increases in other EMU countries. This would generally
require that the productive capacity on which workers could be employed
would also have to be created. While there may be spontaneous increases
in investment, there are clear limits on the policy instruments available to
promote such investment. Further, those countries have to find additional
markets for their exports without the benefits of devaluation.
In a similar vein, an economy that enters into a currency area with a
current account imbalance lacks the ability to correct that imbalance.
When that economy is able to borrow to meet any deficit, and similarly
is willing to lend when there is a surplus, then the position would be
sustainable, though its debts would mount, which serves to undermine
that sustainability. But such an economy has to rely on borrowing from
overseas and being able to continue to do so. In our interpretation it
is difficulties arising from such borrowing that underlie many of the
problems of the EMU at present. Table 1.3, the column under Current
account /GDP (%), clearly demonstrates the problem to which we have
just referred. In 1999, the start year of the euro area, and also subse-
quently that is data for 2002 to 2010, all this data shows that current
account imbalances did prevail and are relevant even now.
The development of a substantial EU budget, which operates to make
fiscal transfers between the relatively rich and the relatively poor coun-
tries and to act as some form of stabilizer, that is, a country experiencing
a downturn receiving a greater inflow of funds, is a major policy way in
which concerns of OCA literature could be addressed. But the current
account imbalances would remain, which would seem to require mech-
anisms by which a country with a current account deficit can in effect
devalue in real terms, and hence a country with a surplus revalue. This
is not possible, of course, within the EMU area, while the experience of
the past decade in the EU area does not suggest that such adjustments
would readily occur; indeed, it appears that on the whole prices have
adjusted in a manner opposite to that.
6 Can the euro be saved?
There are two key features of the euro project that are highly relevant
when thinking about its future and whether the euro can continue in any-
thing like its present form and be associated with economic prosperity.
The first is an essentially neo-liberal policy framework (which has been
briefly outlined above; see also Arestis and Sawyer 2006c for extensive
discussion). This framework has been enshrined in law (most recently
in the Treaty of Lisbon) and the neo-liberal ideology has become deeply
embedded in the European political elite and the institutions of the
European Union (and nowhere more evident than in the European
Union). The second is that the single currency has been widely viewed
as the crowning pinnacle of economic integration in removing what
could be seen as the final barrier to free trade (different currencies and
the associated costs) after the removal of non-tariff barriers under the
Single European Act.
The major question here is how these two features of the euro project
interact with the operations of the euro and its problems, and more
how those two features may prevent the EMU project being changed in
order for the EMU to operate to provide economic prosperity across all
its member countries. In our view the policy framework within which
the EMU operates needs to be drastically changed, but to do so runs into
the major obstacles, political and ideological, to changing the policy
framework. Further, the euro has been a key element of the drive to
economic integration that any withdrawal of a country from the euro
would be a major defeat for the integration process.
The first feature was embedded in the Treaty of European Union
in its various forms and now cemented in the Treaty of Lisbon (The
Treaty on the Functioning of the European Union). Changes to the
Treaty of Lisbon require the unanimous agreement of the 27 member
countries, and since the changes required to support the euro involve
policies, which could be seen as moves towards political integration,
the possibilities of making those changes is close to zero. This indicates
not only the serious weakness of the policy framework, but also that
of embedding economic policies into a constitution, which is virtu-
ally impossible to change. It would also have to be recognized that the
dominant macroeconomic institutions in the EMU, notably the ECB
and the Directorate-General of Economics and Finance, appear to be
fully signed up to the neo-liberal agenda.10
With regard to the second feature, it was recognized by some advo-
cates of the euro, that there were many ways in which there was
16 The Euro Crisis
insufficient economic integration to support a single currency, but that

in the presence of a single currency, integration would continue to a
stage that did support a single currency. The conditions indicated by the
OCA literature could be seen as the nature of the integration-generating
movements in relative prices and permitting factor mobility.
We have previously argued (Arestis et al. 2003; Arestis and Sawyer
2006a, 2006b, 2006c) that in the absence of economic integration
monetary unions without political integration did not in general have
a good record of long-term survival. It is true, though, that those mon-
etary unions involving very small countries, for example, the Eastern
Caribbean Currency Union, which covers a total population of half a
million, had a better survival rate. It can also be argued that a monetary
union has one feature of political integration in the sense that it is gov-
ernments which determine what is treated as legal tender and accepted
as payment of taxes. In this sense, the need for a significant EMU fis-
cal policy is argued in the section that follows. The implementation of
such a policy does require that the levels of tax revenues and of public
expenditure, which come within the scope of EMU fiscal policy, and the
balance between them (i.e. the budget deficit/surplus), is settled at the
EMU-level. It is though also remarkable how little attention has been
paid by the EMU to the promotion of economic integration, which
would promote convergence of economic conditions between the mem-
ber countries, whether with respect to unemployment, positions in the
business cycle or common inflationary and changes in competitiveness
experience.
We now advance a range of macroeconomic policies and reforms
which we believe would substantially improve the economic perform-
ance and sustainability of the Economic and Monetary Union. But we
in no way underestimate the political, legal and ideological barriers,
which are raised against policy changes along the lines indicated. But
it is clear to us that the EMU cannot proceed with its current policy
arrangements, and for those who strive for economic integration in the
EU must realize that changes are urgently required to save the euro.
7 Fiscal policy
Two basic changes in the fiscal policy arrangements in EMU are required.
The first is the need for an EMU-level fiscal policy under which the scale
of the EMU budget would be greatly increased and the EMU would be
able to run budget deficits (or surpluses) to support the level of eco-
nomic activity within the EMU. The particular concern here is with
the euro area, and as such fiscal policy would be limited to EMU mem-
bers. The scale of such a policy has been variously put at 7 per cent
of GDP (Commission of the European Communities 1977), 5 per cent
(Huffschmid 2005, Chapter 16), 2 to 3 per cent of GDP (Currie 1997;
Goodhart and Smith 1993). An EMU fiscal policy would, in general,
only be able to address EMU-wide shocks. The present crisis could be
considered such an EMU-wide shock (though perhaps one on a scale
only experienced every several decades), but figures such as those sug-
gested above would not be on a scale to cope with such a shock, unless
combined with substantial deficits at the national level. The second is,
in effect, to permit each member country to set its fiscal stance in what
it judges to be its own best interests. There have always been concerns
of spill-over effects, whereby one countrys deficit affects the credit rat-
ings and interest rates faced by others. These concerns have been very
much overstated. In the absence of a substantial EU-wide fiscal policy
designed to achieve high levels of economic activity, each country has
to be free to pursue that objective (if it wishes to do so).
The proposition of functional finance (starting from Lerner 1943) is
that the budget deficit should be set with a view to ensure a high level
of economic activity and not tied to any notion of a balanced budget
(whether in current budget or total budget terms, whether on an annual
basis or over the business cycle). There is the well-known account-
ing relationship of (G T) = (Q X) + (S I) (where G is government
expenditure, T tax revenues, Q imports, X exports plus net income
from abroad, S private savings and I private investment). The scale of
the budget deficit (or indeed budget surplus) then depends on the size
of the current account deficit, private savings and investment at a high
level of economic activity. It then follows that the appropriate budget
deficit depends on the conditions surrounding the current account
(propensities to import, exports) and the net savings position (savings
minus investment). For a country with a current account deficit and a
tendency for savings to exceed investment would require a large budget
deficit, while in contrast for a country with a current account surplus,
and investment tending to exceed savings, a budget surplus would be
appropriate. This is the basis of the one size fits all problem, which
comes with the SGP. The shortcomings of the present SGP is that it
seeks to impose the same conditions on all countries regardless of their
broader economic circumstances and that it is a balanced budget (over
the cycle), which is imposed on all. The latter will inevitably lead to
deflationary tendencies in many countries without any compensating
stimulatory tendencies in other countries.
18 The Euro Crisis
It should be noted in the context of SGP rules and fiscal rules in more
general terms that they are very difficult if not impossible to enforce.
Yet they do exist, and as noted in the Economistt (14 May, 2011, p. 88),
there are 80 countries in 2011 that have fiscal rules, with only 7 in 1990.
Experience clearly shows that enforcement is difficult, if not impossible
see above for relevant SGP enforcement difficulties and failures. In any
case, SGP rules never prevented the debt crisis in the EMU. Fiscal rules
also entail the serious distributional effects for such rules that normally
reduce benefits, which severely hurt low-income groups.
The great recession has raised a host of issues regarding the merits
of fiscal policy and worries in certain quarters of debt-financed budget
deficits. In the EU/EMU it has raised another issue, which is con-
cerned with fiscal policy in the environment of a monetary union. We
have argued that monetary unions need an active fiscal policy that is
accompanied by fiscal transfers. The reason is simple enough. Regions
within the EU/EMU are hit by asymmetric shocks, which can only be
contained by inter-regional transfers, which substitute potentially for
capital and labour mobility. The EU/EMU lacks such a system, which is
desperately needed. In its absence it is conceivable that some member
countries may be compelled to exit the euro area.
8 European Central Bank: Monetary and financial policies
There is a need to make some fundamental changes to the operation

of the European Central Bank. The ECB, and the European System of
Central Banks (ESCB), has been established as an independent central
bank. Independence is to be interpreted in a political sense: When
exercising the powers and carrying out the tasks and duties conferred
upon them by the Treaties and the Statute of the ESCB and of the ECB,
neither the European Central Bank, nor a national central bank, nor any
member of their decision-making bodies shall seek or take instructions
from Union institutions, bodies, offices or agencies, from any govern-
ment of a Member State or from any other body. The Union institu-
tions, bodies, offices or agencies and the governments of the Member
States undertake to respect this principle and not to seek to influence
the members of the decision-making bodies of the European Central
Bank or of the national central banks in the performance of their tasks
(Article 130 of the Treaty establishing the European Community).
It is not independent in an ideological sense, and the ECB has fre-
quently advocated fiscal and other policies that are formally outside of
its remit but which conform to the anti-Keynesian approach of fiscal
consolidation, and advocacy of flexible labour markets. For example,

writing in December 2009, ECB (2009) argued that As regards fiscal poli-
cies, the Governing Council [of the ECB] re-emphasises how important it
is for governments to develop, communicate and implement ambitious
fiscal consolidation strategies in a timely manner. These strategies must
be based on realistic output growth assumptions and focus on structural
expenditure reforms, not least with a view to coping with the budgetary
burden associated with an ageing population. With regard to structural
reforms, most estimates indicate that the financial crisis has reduced the
productive capacity of the euro area economies, and will continue to do
so for some time to come. In order to support sustainable growth and
employment, labour market flexibility and more effective incentives to
work will be needed. Furthermore, policies that enhance competition
and innovation are also urgently needed to speed up restructuring and
investment and to create new business opportunities (p. 7).11 The inde-
pendence of a Central Bank has been based on ideas that politicians are
not to be trusted with key elements of macroeconomic policy particularly
in that elected politicians would favour expansionary policies with little
regard to the inflationary implications. This view in part has been based
on the idea of the Phillips curve and its different shape in the short and
long run. There is a short-run trade-off between economic activity and
inflation, which is absent in the long run in view of a hypothesized verti-
cal Phillips curve relationship (see Arestis and Sawyer 2004; Sawyer 2010,
for a critique of this position). However, the financial crisis has empha-
sized, to say the least, the need for financial stability as a key objective of
macroeconomic policy and of monetary policy. We would argue that the
financial stability objective should be a prime objective and the opera-
tional independence of the European Central Bank brought to an end.
The adoption of financial stability objective would, of course, require the
development of a range of policy instruments.12
The independence of the ECB would appear to preclude cooperation
and coordination between the different bodies responsible for aspects of
macroeconomic policies. Yet, in a world of multiple objectives (includ-
ing high levels of economic activity and employment, financial stabil-
ity, inflation, etc.) there is a need for multiple instruments, which are
operated by different authorities, and where there should be some coor-
dination. At present, it is more like subordination with monetary policy
taking pride of place and fiscal policy neutered by the lack of EMU fiscal
policy and the constraints of the SGP on national budget deficits.
Sub-national government can differ from national government with
respect to its debt and deficits in that the bonds of the sub-national
20 The Euro Crisis
government tier may not be accepted by the Central Bank as an accept-

able financial asset and its debt cannot be monetized, and further lacks
any ability to print money. The national government cannot itself
print money, but through its relationship with the Central Bank its
debt can be monetized, and in extremis, could require the Central Bank
to buy central government bonds in exchange for base money. In
effect, through its relationship with the Central Bank, a national gov-
ernment would never need to default on its own debt, provided that
the debt is denominated in the domestic currency. The arrangements
within the EMU leave a national member government in the position
of a sub-national tier in the sense that the ECB can decide whether
national debt is acceptable for financial-asset purposes and on what
terms. The position needs to be changed such that all financial assets
issued by EMU member governments are always accepted by the ECB.
The key reforms required with regard to the ECB are: (i) a reformula-
tion of the objectives of the ECB to include high and sustainable levels
of employment and economic growth and financial stability; (ii) the
ECB must be made accountable to the European Parliament, and its
statutes changed so that it can clearly be involved in the coordination
of fiscal and monetary policies, and indeed that ultimately it can take
instructions from other European bodies such as the Economic and
Financial Affairs Council (ECOFIN);13 (iii) the ECB operates with regard
to national governments within EMU in the ways in which a national
central bank would operate with regard to a national government,
and specifically be able to, in effect, monetize the debts of national
governments.
9 Inflation
The policies on inflation have been, as indicated above, at best, a lim-

ited success. We have argued that even this has been more by good luck
and probably due to globalization rather than through the efficacy of
the policy instrument (Arestis and Sawyer 2012). In our view, inflation
in the EMU (and elsewhere) is influenced only to a limited extent by
domestic policies (Angeriz and Arestis 2007, 2008; Arestis and Sawyer
2008). Although there has been an EMU level inflation policy operated
through the ECB, there are also inflation policies at the national level.
To a greater or lesser extent there are national policies on wage and
price determination. As seen above, whether for reasons of national
policies and/or differences in the price and wage setting institutions,
differences in national inflation rates have persisted.
Some of the proponents of the euro acknowledged that the condi-

tions to be in place for a successful single currency suggested by the
OCA literature were not present (at least to the degree needed) but that
the continuing process of integration under a single currency would
generate changes in the direction of those conditions. One of the con-
ditions of OCA is price flexibility, understood to mean that the general
level of prices in one country could change relative to those in other
countries within the currency union where there was a shock to the
relative standing of that country. Essentially, changes in the demand
or supply position would be compensated by corresponding changes to
relative prices. But it turned out that while there was, in a sense, price
flexibility between countries it was not in the manner envisaged. As can
be seen from Table 1.2, over the period 200208 inflation in Germany
did not increase as rapidly as in Greece, Portugal and Spain. Yet
Germany was running a current account surplus and Greece, Portugal
and Spain deficits. The differences in inflation also had perverse effects
in terms of inflation policy.
The continued differences in inflation experience undermine the
euro as the competitiveness of the relatively high inflation countries
deteriorate. There is clearly no EU level policy at present, which can
address this issue. One approach would be to assert that the pressures of
integration would lead to countries having to achieve similar inflation
rates. Even if that is so, similar inflation rates may well be combined
with different levels of unemployment. Paradoxically this commonality
of inflation rates could be engineered by national fiscal policy. There is
then a need for the development of some understanding between EMU
member countries on this issue.
10 Current account deficits and competitiveness
The data in Tables 1.2 and 1.3 indicate something of the scale by which
relative prices and relative unit labour costs have changed. A country
in a fixed exchange rate system, which is in the nature of a currency
union for participating countries, in dealing with cumulative dif-
ferential inflation and current account deficits can endure domestic
deflation (to reduce imports and perhaps lower domestic costs) or can
devalue its currency. The latter is ruled out by membership of EMU. So
it would appear that deflation is the only answer. Before dealing with
this proposition it is important to note that current account imbalances
among the EMU member countries were not considered in the proc-
ess of setting up the euro area (see Arestis and Pal 2009, for further
22 The Euro Crisis
details). However, more recently and in view of the great recession a

new mechanism for the prevention and correction of macroeconomic
imbalances has been proposed (European Council 2011). Economies
with problematic imbalances would be identified along with numerical
monitoring. Subsequent inspections would be undertaken to identify
the seriousness of the problem and recommendations would be pro-
posed. The latter could include corrective measures to be reviewed by
the Council subsequently. Economic sanctions would be applied if nec-
essary within the framework of the revised SGP or the new pact for the
euro (see section 11 below for further details on the revised SGP and
the new pact for the euro).
A current account deficit can interact with a budget deficit in the
following sense. As is well known from the identity (XQ) = (SI)
(TG), with the symbols as in section 7, a current account deficit and
a budget deficit will be related for a given net private savings position.
Other things being equal (that is, net private savings), then a larger
current account deficit would be associated with a larger budget deficit
(there is no causal link implied). The current account deficits on the
scale observed in a number of EMU countries are unlikely to be sus-
tainable as they require continual funding and likely to imply rising
external debts. Yet countries are locked into a fixed nominal exchange
rate system, where many have experienced a loss of competitiveness
and in effect rising real exchange rates. There have to be mechanisms
developed for the adjustments of those exchange rates, which would
seem to require a coordinated mechanism for the adjustment of the
prevailing exchange rates between member countries of the EMU and
for the generation of similar rates of inflation. It has also been argued
above that the ECB should relate to member governments and to their
financial liabilities in a manner similar to the ways in which a national
central bank would to a national government. These policy initiatives
involve many of the features of a political integration. It is on the lat-
ter aspect to which we turn our attention next. Before doing so it is
worth noting that another way of regaining the possibility of achieving
competitiveness is for the weak countries to reintroduce their national
currencies. Such a move would also enable these countries to manage
their public debts and avoid bankruptcy since they can under the new
circumstances print money and finance budget deficits in the proc-
ess. However, the latter solution entails the serious problem that the
accounts of non-residents are bound to be shifted to non-domestic bank
accounts that would lead to an outflow of capital with dramatic adverse
implications for the domestic banking sectors. The rescue packages,
described below in section 11, are designed to avoid problems of the

type to which we have just referred and also bail out weak countries to
prevent them from bankruptcies.14
The pattern of current account imbalances poses considerable diffi-
culties for EMU. The presence of trade deficits along with the statistics
on the evolution of unit labour costs and prices suggest that many,
particularly Mediterranean, countries suffer from a lack of competi-
tiveness and, in the context of a single currency area, an inability to
devalue. The pattern of current account deficits and surpluses implies a
corresponding pattern of capital account surpluses (i.e. borrowing) and
deficits (i.e. lending). Directly or indirectly capital is flowing from the
current account surplus countries to deficit countries, bearing in mind
that EMU has an entity close to balanced current account position.
In the era prior to the financial crisis, countries with current account
deficits were able to borrow readily from others to fund the deficit,
and indeed within the EMU to do so at relatively low rates of interest.
As noted above, for those countries with relatively high inflation, real
interest rates were particularly low or even negative. The major diffi-
culty with any current account deficit comes from the requirement to
continually fund the deficit, and the mounting debts and interest and
similar payments on the borrowing. The major challenge now facing
EMU is how to correct the pattern of surpluses and deficits, and to put
in place policies which will prevent similar severe imbalances reappear-
ing in the future.
There may be doubts on the effectiveness of devaluation in terms of
a nominal exchange rate depreciation leading to a sustained real depre-
ciation and the responsiveness of imports and exports to the changes in
prices involved with a devaluation. For a country with its own currency
devaluation would clearly be one response to current account deficit. In
a single currency area, a combination of slower or negative inflation in
the deficit countries and faster inflation in the surplus countries would
help to resolve the current account imbalances. But in EMU this would
involve a reversal of the patterns of inflation observed over the past dec-
ade and would be a lengthy process to generate the scale of changes in
relative competitiveness. Further, the process by which a deficit country
sought to generate low or negative inflation could well involve demand
deflation with the consequent loss of employment and output.
This last point leads us to the major point that a failure to correct
the current account imbalances would condemn the deficit countries
to many years of slow or negative growth, with spill-over effects on to
the surplus countries. The survival of the EMU in its present form and
24 The Euro Crisis
membership does depend on an ability to correct these imbalances.

The alternative is for some of the deficit countries to leave the euro
and reintroduce their national currency which would then most likely
depreciate against the euro, bringing some relief to the deficit. EMU
core countries are, however, determined not to allow this procedure. In
any case, there are doubts as to how far devaluation (whether through
depressing domestic prices within a single currency or through reintro-
duction of own currency with subsequent depreciation against the
euro) could rectify the current account deficits. The productive base of
the export industries of the countries concerned may simply lack the
capacity and/or markets to be able to expand production and sales suffi-
ciently in the face of devaluation to bring about the necessary changes.
The alternative would require a long-term plan to improve competitive-
ness and build an industrial base. This, however, is a long-term solution
and it is short-term solutions that are desperately required. In other
words, policies to enable the flow of funds from surplus to deficit coun-
tries, during the period of reconstruction, are required. How that could
be developed is the focus of the section that follows.
11 Political integration
A relevant question is the extent to which the recent changes at both

the EMU and the EU levels, especially so since the eruption of the great
recession in August 2007 and the subsequent euro area debt crisis, move
closer to a de facto political integration. To begin with the absence of
bailout mechanisms should be noted for it left the euro area completely
unarmed to deal with the debt crisis when it erupted. A series of ad
hoc measures have been initiated and introduced as we discuss in what
follows. It should also be noted that regulation and supervision of
the EMU financial system was grossly inadequate. We consider all the
aspects just touched upon in the rest of this section.
The European Commission called on 26 May 2010, and pledged on
8 June 2010, for new taxes to be imposed on all the continents banks.
The levies would form a set of national funds, managed by national
governments but under the aegis of a network of bank resolution funds
that could be used to disburse emergency money in case of a financial
crisis. It is thereby the banks not the taxpayers that would bear the
cost of such a crisis. This is a different arrangement from the proposed
European Financial Stability Facility (EFSF), formed on 1 July 2010 and
endowed with a 250 bn-euro fund, which was raised to 440 bn-euros at a
relevant meeting on 11 March 2011, and confirmed at another meeting
of the European Commission on 25 March 2011. This is intended to be

a temporary arrangement with an operational life of three years. It will
then be replaced by the European Stability Mechanism (ESM) to help
member indebted states when in acute cash flow difficulties; ESM will
then become permanent. It was also decided at the meeting of 11 March
2011, confirmed on 25 March 2011, that the new permanent bailout
mechanism should be able to lend up to 500 bn-euros through increased
guarantees from triple-A states and paid-in capital from those states
with weaker balance sheets in a subsequent meeting of the European
finance ministers it was agreed to lend 700 bn euros capital, of which 80
bn euros would actually be paid in; the rest would be callable capital.15
This facility aims to reassure financial markets and help out euro-area
member states struggling to issue sovereign debt and faced with bank-
ing troubles. In terms of the funding arrangements of both the EFSF
and ESM, however, the relevant decision has been postponed until June
2011. This was due essentially to the German negotiators who bowed at
the last minute to domestic political pressure and persistently proposed
a reduction of their contribution to the bailout mechanism. Under the
deal reached on 25 March 2011, euro area and other governments will
have to pay their share of capital over five years, instead of the four years
initially agreed.16 The rate of interest on new loans from this facility is
expected to be lower by up to 1 per cent than previously.
The key element is the creation of a permanent liquidity facility under
the aegis of the ESM. This would be available as a means of crisis reso-
lution if there is a risk to the stability of the euro area as a whole. The
crucial difference between the EFSF and ESM is that the credits of the
latter would be more senior to those of private investors. This will reduce
the risk to the budget of the creditor nations, since it is expected that by
2013 European banks should be in a better position to absorb losses. The
ESM will not come into force before 2013.17 These new measures reduce
the cost of bailing out countries in trouble but increase it for those who
have been, or potentially could be, in need of bailout. They do not
address the issue of high sovereign debt, which had appeared to have
been the focus of the whole exercise. Still, the exercise has been turned
into a political game, one of what should have been an exercise to sort
out the economic crisis. In this sense, it would not be surprising if the
European leg of the great recession is not contained any sooner.
It should be stressed that all these arrangements had not been envis-
aged by the creators of the EMU. For it is case that one of the pillars of
the EMU and the euro was the no bailout, no exit and no default clause.
The sovereign debt crisis simply changed significantly that principle
26 The Euro Crisis
at least in terms of the bailout part of the clause. Still the agreed funds
mentioned above should not be used to purchase government debt in
the open market. They should be used to buy the debt from struggling
governments. But there is a condition attached. This is that the strug-
gling governments should agree to implement significant austerity
measures. Yet it all amounts to increase the level of debt in the countries
concerned. This is justified on the premise that the new mechanism
helps the countries involved in that the loan conditions are much bet-
ter than the ones replaced. But the debt of the countries involved piles
up thereby creating another serious danger, the possibility of default.
This, however, entails a further danger in view of the high exposure of
a number of European banks to weak countries debt (see footnote 15).
This may very well explain that despite the alleged seriousness of the
European debt crisis, default has not been seriously considered yet.
Indeed, it might not happen to the extent that support continues to be
forthcoming. The weak country debt would continue to grow so long as
support is forthcoming until the debt is all accumulated in, and held, by
the official sector. Under these conditions the official sector will be the
last holder of the assets that take the full loss. The taxpayer will carry
the burden yet again, not the original bondholder. The ECB is trying
very hard to avoid this problem. While helping the troubled countries,
at the same time it attempts to sell debt to avoid excess liquidity in the
market the ECB does not undertake quantitative easing. This is not
always possible, though. It is not infrequent to find that since May 2010
when this operation started that the ECB failed in its attempt to neutral-
ize fully the effect on liquidity of purchasing government bonds.
Further relevant developments that will come into effect in 2013
include common fiscal and economic policies. One dimension of these
policies may very well be dubbed as a reformed Stability and Growth
Pact. This includes close monitoring on government spending, pension
schemes, and limits on wage increases in the public sector. There is also
a further commitment for country-members to close the gap between
their current debt levels and the EUs debt limit of 60 per cent of GDP.
This is of course in addition to the financial penalties of countries that
do not conform with the budget deficit of 3 per cent. The debt to GDP
limit should be achieved by member countries initiating a 5 per cent per
year reduction until the 60 per cent target is met. If a member country
fails to close the gap between its debt level and the 60 per cent limit
of GDP, by 5 percentage points per year, it will be subject to a fine of
0.2 per cent of its GDP. The fine would be automatic, unless a majority of
the Council opposed it. The agreement does also allow pension reforms
to be offset in national accounts and private indebtedness taken into

consideration before a country is fined. Furthermore, governments must
not spend more each year than their medium-term economic growth
rate. All these measures, however, amount to deficit- and debt-tightening
until the same rules as before the great recession are achieved. But those
rules failed since they lacked credible enforcement. So that for the same
reasons its predecessors failed in the past (see, for example, Arestis 2010;
also Arestis and Sawyer 2006a, 2006b), the current proposals are bound
to fail again. This is actually the third attempt at a revised SGP. It clearly
follows that what is needed is a plan for reform, not a pact that has
shown to have been so unsuccessful in the past. Such a plan should be
based on effective economic governance, with firm roots on economic
convergence. Coordination of economic policies is vital. Consequently
the current, similar to previous, proposals are bound to fail again with-
out such different and more secured foundations. An important missing
dimension of the grand bargain in relation to the great recession is
the lack of pan-European policies to let banks fail safely thereby forcing
losses on creditors rather than on taxpayers.
There is also the competitiveness pact; what has been labelled the pact
for the euro, or euro-plus pact. This is concerned with boosting the
growth potential along with a common corporate tax base in the region.
It covers a number of areas: improving competitiveness through higher
productivity and better alignment of wages and productivity; boost-
ing employment through flexibility and tax reforms; improving public
finances; reinforcing financial stability through legislation on banking
and regular bank stress tests; and introducing a financial transaction tax.
The pact for the euro is in principle a framework for economic policy
coordination in a number of macroeconomic policies. But it is far from it
in that no indication of such an objective is evident in the pact for the
euro. It should be noted that these arrangements are not merely for the
EMU members. They would equally apply for the non-EMU members of
the EU, if they chose to participate in the pact for the euro.
On 23 July 2010, the results of the Committee of European Banking
Supervisors (CEBS) bank stress tests were published.18 These tests sub-
jected banks in Europe to unlikely but plausible scenarios, and were
designed to ascertain whether banks had enough capital to avoid default
in crisis; also from the setting of reasonable capital targets a better lend-
ing environment would follow. Like the 2009 US similar bank stress
tests, the European results revealed a clean bill of health and a resilient
banking system.19 However, in view of the results, interesting questions
arise. The most important is perhaps the question of no provision for the
28 The Euro Crisis
possibility of sovereign default. A further question is the extent to which

the safety margin of capital (core capital to asset ratio with a threshold
of 6 per cent) that banks were required to hold should have been higher.
Consequently, was the threshold ratio sufficiently stressful? Indeed, a
number of banks perceived as weak, managed to pass the test including
five of the six Greek banks tested. There is also the argument that the
core capital, defined as equity, retained earnings and various types of
hybrid debt instruments (which have the characteristics of equity but
also of bonds), is not suitable. The relevant argument is that if core
capital had been defined as equity and retained earnings, the real risk-
absorbing elements, a number of banks would not have passed the test.
Still there is the question of whether the institutions left out were unim-
portant enough. Indeed, there are institutions whose financial health is
not entirely clear and yet left out of the test. In any case, these tests com-
plement the establishment of the EFSF and the recent financial supervi-
sory framework within Europe. We may note in passing that CEBS is due
to become the European Banking Authority (EBA).20
These recent changes, which are far stricter than previously, do not
in any way form a step forward towards a de facto political integration.
One implication is that the agreement to strengthen the euro area,
the reformed Stability and Growth Pact together with the euro-plus
pact, focusing on broader macroeconomic reforms imply that future
economic decisions will be taken collectively by the 17 euro-area
states not separately, as in the past. Still they rely on the supply-side
of the EMU economy, neglecting the role and importance of aggregate
demand. They also need to be applied to all member countries in a
consistent way. For example, in the case of imbalances within the euro
area countries, both deficit and surplus members should be involved
in the rebalancing, not merely deficit countries as it is in the current
versions. This type of policy failed in the past and they will fail again
in the future. There is nothing in the revised proposals to suggest that
they will not fail. When it comes to conflicts between national govern-
ments and the European Commission, the latter loses. This reinforces
our main point. For it is clear that all these developments lack the
important dimension of integration. It clearly follows that future steps
to closer integration are absolutely necessary. For otherwise there is a
serious risk of gradual unravelling of what little has been achieved. It
is true of course that some integration is in place within the EU/EMU,
which is difficult to break. It is, nonetheless, too weak to function satis-
factorily as we have demonstrated in this contribution. Clearly further
integration is vital.
An interesting proposal comes from the president of the ECB in a

speech (Trichet 2011a) in which he argues for an EU Finance Ministry.
The suggestion is that In this Union of tomorrow, or of the day after
tomorrow, would it be too bold, in the economic field, with a single
market, a single currency and a single central bank, to envisage a min-
istry of finance of the Union? Not necessarily a ministry of finance that
administers a large federal budget. But a ministry of finance that would
exert direct responsibilities in at least three domains: first, the surveil-
lance of both fiscal policies and competitiveness policies, as well as the
direct responsibilities mentioned earlier as regards countries in a second
stage inside the euro area; second, all the typical responsibilities of the
executive branches as regards the unions integrated financial sector,
so as to accompany the full integration of financial services; and third,
the representation of the union confederation in international financial
institutions (p. 7). The president concludes by clarifying to suggest that
I think that [eventually] a confederation of sovereign states of a new
type, with new institutions to manage the interdependence of today and
tomorrow, would be fully in line with such a heroism of reason (Trichet
2011a, p. 8; see also Trichet 2011b). This proposal may be seen as a step
towards a closer integration of national budgetary policies and enforce-
ment of controls over spending and borrowing within the EU. Such a sug-
gestion, though, is by far short of providing a true and closer integration
that would provide policies to be able to tackle the kinds of problems the
EU/EMU area has faced at the time of the great recession.
12 Concluding comments
We would argue that the policy framework within which the euro is
placed is not fit for purpose. Three aspects of this argument stand out.
First, the independence of the ECB precludes the ECB from devoting
its attention to financial stability and to coordinating and cooperating
with other macroeconomic institutions in pursuit of other objectives,
such as high levels of economic activity. Second, it does not have ways
of developing fiscal policy, which would be supportive of high levels
of economic activity, recognizing that budget deficits are generally
required. Third, there are no mechanisms for resolving the pattern of
current account deficits and surpluses, which we argue are unsustainable
in their present form. Without the ability to vary the exchange rate,
countries with current account deficits will be thrown back into defla-
tion. For it is the case that the EMU completely lacks any mechanisms
by which countries can resolve their deficit problems.
30 The Euro Crisis
A further problem, which has emerged and is highlighted by the great

recession, is the dual economic reality in the EMU. This is the northern
part of the EMU, where the economies are reviving, with Germany and
France at the forefront, especially Germany; and the periphery, mostly
southern (Greece and Portugal) but including Ireland, heavily involved
in the sovereign-debt crisis. Given the onerous austerity packages
imposed on the latter countries, the really interesting question is how
long they will be able to withstand the pressures for even more austerity
and the undesirable consequences. Fallout is seriously and eminently
possible. At the same time, though, no serious attempt is initiated at
seriously resolving the dual economic reality. The choice faced by many
EMU countries then is the stark one of remaining with the euro and
suffering an indefinite future of deflation and high unemployment or,
in effect, leaving the euro.
The economic problems within the euro area have been building since
its inception, and have become acute with the great recession. The
faults lie in the neo-liberal design of the euro project, now embedded in
the Treaty of Lisbon, and where there is little prospect of serious changes
because of the unanimity requirements for change. But without basic
and fundamental changes, many (perhaps all) euro-area countries face
a bleak economic future. Under these circumstances the future of the
euro is surely not bright to say the least. This contagious financial crisis
is the biggest threat not merely to Europe but globally. Changes within
the euro area are therefore desperately needed: most important of which
is fiscal integration. Indeed, the history of monetary unions around the
world is very telling. In the absence of economic integration, a monetary
union without a political integration simply cannot survive (Arestis et al.
2003; Arestis and Sawyer 2006a, 2006b, 2006c). Whether the latter or
any other fundamental change is forthcoming, it is unfortunately a very
sad expectation. It should also be clear that cosmetic measures as cur-
rently proposed will not save the euro. It is undoubtedly the case that
the euro experiment is going through a severe test.21
Notes
1. The split referred to in the text relates to a sharp division of views between
the ECB and the EMU political leaders. This dispute is over how to solve the
Greek sovereign debt crisis, which is a very serious one and as such it threat-
ens the euro existence seriously.
2. The situation in Greece since mid-May 2010, when the Greek rescue was
launched, is even worse. The austerity measures introduced at the time have
resulted so far and according to the 2010 figures to a debt to GDP ratio of
142.80 per cent and to a deficit to GDP ratio of 10.5 per cent. Both figures
are above the equivalent ratio of 2009, when the Greek Tragedy emerged.
In the case of debt to GDP it is clearly higher (it was 127 per cent in 2009).
In the case of the deficit to GDP although it was admittedly 15.4 per cent in
2009, it was nonetheless targeted to achieve an 8.1 per cent by 2010. Figures
are available at: http://en.wikipedia.org/wiki/Economy_of_Greece.
3. The convergence criteria applied to each country for membership of the
EMU under the Maastricht Treaty are: (1) average exchange rate not to devi-
ate by more than 2.25 per cent from its central rate for the two years prior
to membership; (2) inflation rate should not exceed the average rate of infla-
tion of the three community nations with the lowest inflation rate by 1.5 per
cent; (3) long-term interest rates not to exceed the average interest rate by 2
per cent of the three countries with the lowest inflation rate; (4) government
budget deficit not to exceed 3 per cent of its GDP; (5) overall government
debt not to exceed 60 per cent of its GDP.
4. For extensive discussion on fiscal and monetary policy in the EMU see
Arestis and Sawyer (2006a, 2006b, 2006c).
d B 1 dB B dY 1 B 1 dY
5. The change in the debt ratio is given by = = D
dt Y Y dt Y 2 dt Y Y Y dt
where Y is the level of income since the change in debt is equal to the deficit
(including interest payments) and the debt ratio is stable when the change
in this ratio is zero. This would imply d bgg = 0 and hence b = d/g
/ .
6. It should be noted that a current account deficit can interact with a budget
deficit in the following sense. A current account deficit and a budget deficit
will be related for a given net savings position. Other things being equal
(that is, net savings) then a larger current account deficit would be associated
with a larger budget deficit (there is no causal link implied).
7. The percentages mentioned in the text are from the OECD Economic Outlook
data (various issues).
8. According to IMF (2011) estimates, Germanys banking sector exposure to
EMU distressed periphery (Greece, Ireland, Portugal, Spain) debt is over 150
per cent of their equity capital; Frances banking sector exposure is just under
100 per cent, and the rest of the EMU is about 50 per cent. Interestingly
enough, and following the bailout of Greece in May 2010, the ECB exposure
to the Greek state and Greek banks is 190bn euros. Clearly, the ECB exposure
to Greek debt is very high so that restructuring of this debt would produce
huge losses to it. It clearly follows that restructuring of the Greek sovereign
debt would produce huge losses to the ECB. It is for this reason that the
Governor of the ECB is so much against restructuring of the Greek debt (see,
for example, Trichet 2011a).
9. The OCA literature starts from Mundell (1961), McKinnon (1963) and Kenen
(1969): for reviews see, for example, Baldwin and Wyplosz (2009, chapter 11).
10. D-G ECFIN stands for The Directorate-General for Economic and Financial
Affairs, which reports to the EU Commissioner for Economic and Monetary
Affairs. The D-G ECFIN strives to improve the economic wellbeing of
the citizens of the EU through policies designed to promote sustainable
economic growth, a high level of employment, stable public finances and
financial stability. At the present juncture, this means working to ensure that
the European economy emerges quickly and strongly from the present deep
32 The Euro Crisis
economic and financial crisis. This quote is available from: http://ec.europa.

eu/dgs/economy_finance/index_en.htm
11. Similar statements are made by the Governor of the ECB at the press confer-
ence after the monthly meetings of the Governing Council of the ECB. See,
for example, Trichet (2011b).
12. We elaborate on the importance of financial stability in Arestis and Sawyer
(2011).
13. The ECOFIN is a configurations of the Council of the European Union
and is composed of the Economics and Finance Ministers of the 27 European
Union member states, as well as Budget Ministers when budgetary issues
are discussed. The tasks of the ECOFIN are: economic policy coordination,
economic surveillance, monitoring of Member States budgetary policy
and public finances, the euro (legal, practical and international aspects),
financial markets and capital movements and economic relations with
third countries. It also prepares and adopts every year, together with the
European Parliament, the budget of the European Union which is about
a100 bn (both quotes are from: http://en.wikipedia.org/wiki/Economic_
and_Financial_Affairs_Council).
14. It is interesting to note that As of 31 December 2009, banks headquartered
in the euro zone accounted for almost two thirds (62%) of all internation-
ally active banks exposures to the residents of the euro area countries facing
market pressures (Greece, Ireland, Portugal and Spain). French and German
banks were particularly exposed to the residents of Greece, Ireland, Portugal
and Spain. Together, they had $727 billion of exposures to Spain, $402
billion to Ireland, $244 billion to Portugal and $206 billion to Greece. At the
end of 2009, they had $958 billion of combined exposures ($493 billion and
$465 billion, respectively) to the residents of these countries. This amounted
to 61% of all reported euro area banks exposures to those economies (BIS
2010a, pp. 1819). It clearly is the case that France and Germany have a
strong interest in rescuing the weak countries to avoid possible bankruptcies
and/or dramatic fall in the value of these countries sovereign debt.
15. It should be noted that the 700 bn-euro fund is not really substantial in that
the callable capital entails the real danger of some countries not being able
to honour their commitments.
16. The EFSF/ESM will comprise all the seventeen EMU-member states, plus a
number of EU, but not EMU, members. The latter include Denmark, Poland,
Latvia, Lithuania, Bulgaria and Rumania, which have pledged to join the
EFSF/ESM arrangements.
17. In the meantime, the EFSF is in the process of issuing the eurobond, a sov-
ereign responsibility of the EMU. This is an important development in that
it is the first time that a bond issue is undertaken by an institution on behalf
of the EMU as one entity. There is, however, great controversy over this issue
(see, for example, Arestis and Sawyer 2011).
18. It is worth noting that the exercise was repeated in July 2011 with similar
results.
19. In the European case 91 banks, with 7 of them failing the stress test, were
included in the sample. In the US 19 banks were included and 10 failed the
stress test. Apparently the more stringent and earlier US stress test has not
helped in terms of its objective to boost bank lending, which continues to
contract under tight conditions.
20. An important international development that affects the EU/EMU members

and their banking sectors is the Basel III standards (BIS 2010b). The main
purpose of Basel III is to enhance banks capital requirements to make them
safer and avoid the problems of the great recession. The EU intends to
modify Basel III standards in an attempt to allow banks to count for more
in their total capital. This would relax Basel III regulations and relax EMUs
grip on banks when the opposite should be forthcoming.
21. It is worth pointing out that the EU/EMU summit on 21 July 2011 may have
taken a very small step towards a fiscal union. This by itself, however, could
not possibly be viewed as the beginning of a political union or indeed a fiscal
union.
References
Angeriz, A. and Arestis, P. (2007), Monetary Policy in the UK, Cambridge Journal
of Economics, Vol. 31, No. 6, pp. 86384.
Angeriz, A. and Arestis, P. (2008), Assessing Inflation Targeting through
Intervention Analysis, Oxford Economic Papers, Vol. 60, No. 2, pp. 293317.
Arestis, P. (2010), Interview with Philip Arestis, Intervention. European Journal of
Economics and Economic Policies, Vol. 7, No. 2, 2316.
Arestis, P. and Pal, J. (2009), Dficits en cuenta Corriente en la Unin
Econmica y Monetaria europea y crisis Financiera Internacional, Ola
Financiera, SeptemberOctober.
Arestis, P. and Sawyer, M. (2004), Can Monetary Policy Affect the
Real Economy?, European Review of Economics and Finance, Vol. 3, No. 3,
pp. 932.
Arestis, P. and Sawyer, M. (2006a), Alternatives for the Policy Framework of the
Euro, in W. Mitchell, J. Muysken and T.V. Veen (eds), Growth and Cohesion in
the European Union: The Impact of Macroeconomic Policy, Cheltenham: Edward
Elgar Publishing Ltd.
Arestis, P. and Sawyer, M. (2006b), Reflections on the Experience of the Euro:
Lessons for the Americas in M. Vernengo (ed.), Monetary Integration and
Dollarization: No Panacea, Cheltenham: Edward Elgar Publishing Ltd.
Arestis, P. and Sawyer, M. (2006c), Macroeconomic Policy and the European
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Economic Policies in the European Union, Basingstoke: Palgrave Macmillan.
Arestis, P. and Sawyer, M. (2008), A Critical Reconsideration of the Foundations
of Monetary Policy in the New Consensus Macroeconomics Framework,
Cambridge Journal of Economics, Vol. 32, No. 5, pp. 76179.
Arestis, P. and Sawyer, M. (2011), Eurobonds Will Need a Form of Political
Union: Letter to the Editor, Financial Times, 18 August.
Arestis, P. and Sawyer, M. (2012), Economic Policies of New Economics,
International Review of Applied Economics, Vol. 26, forthcoming.
Arestis, P., Brown, A. and Sawyer, M. (2001), The Euro: Evolution and Prospects,
Cheltenham: Edward Elgar Publishing Limited.
Arestis, P., Ferrari, F. Fernando de Paula, L.F. and Sawyer, M. (2003), The Euro and
the EMU: Lessons for Mercusor, in P. Arestis and L. Fernando de Paula (eds),
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34 The Euro Crisis
Baldwin, R. and Wyplosz, C. (2009), The Economics of European Integration, 3rd

edition, London: McGraw Hill.
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Financial Market Developments, Quarterly Review, June, Basel: Switzerland.
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Heads of Supervision Reach Agreement on Basel Committee Capital and Liquidity
Reform Packages. Available at: http://www.bis.org/press/p100726/annex.pdf
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on the Role of Public Finances in European Integration, chaired by Sir Donald
MacDougall, Economic and Financial Series No. A13, Brussels: Belgium.
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originally by the Economist Intelligence Unit, January 1997).
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European Central Bank.
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European Central Bank.
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Brussels, Belgium.
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the Task Force to the European Council, Brussels, 21 October.
Goodhart, C.A.E. and Smith, S. (1993), Stabilization, The Economics of Community
Public Finance, European Economy: Reports and Studies No.5/1993, Brussels:
Belgium.
Huffschmid, J. (ed.) (2005), Economic Policy for a Social Europe A Critique of Neo-
Liberalism and Proposals for Alternatives, Basingstoke: Palgrave Macmillan.
IMF (2011), Regional Economic Outlook for Europe: Strengthening the Recovery,
Washington D.C.: International Monetary Fund.
Kenen, P. (1969), The Theory of Optimum Currency Areas, in R. Mundell and
A. Swoboda (eds), Monetary Problems of the International Economy, Chicago:
Chicago University Press.
Lerner, A. (1943), Functional Finance and the Federal Debt, Social Research,
February, pp. 3851.
Lucarelli, B. (2004), European Monetary Union: A Neo-Liberal Trojan Horse?,
Contributions to Political Economy, Vol. 23, pp. 8191.
McKinnon, R. (1963), Optimal Currency Areas, American Economic Review,
Vol. 53, pp. 71725.
Mundell, R. (1961), A Theory of Optimum Currency Areas, American Economic
Review, Vol. 51, pp. 65765.
Sawyer, M. (2010), Phillips Curve, Independence of Central Banks and Inflation
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Finance and Money, Essays in Honour of Philip Arestis, Basingstoke: Palgrave
Macmillan.
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receiving the Karlspreis, 2011 in Aachen, 2 June 2011. Available at: http://
www.ecb.int/press/key/date/2011/html/sp110602.en.html
Trichet, J.-C. (2011b), Introductory Statement to the Press Conference (with
Q&A), Frankfurt am Main, 9 June. Available at: http://www.ecb.int/press/
pressconf/2011/html/is110609.en.html
2
The European Financial and
Economic Crisis: Alternative
Solutions from a (Post-)Keynesian
Perspective
Eckhard Hein
Berlin School of Economics and Law
Achim Truger
Macroeconomic Policy Institute (IMK) at the Hans Bckler Foundation
Till van Treeck
Macroeconomic Policy Institute (IMK) at the Hans Bckler Foundation
Abstract: The financial and economic crisis in the euro area has revealed
a number of important flaws in the economic policy framework in
Europe. On the one hand, the imbalances, which have dominated
European development since the introduction of the euro, are not sus-
tainable; and this is more serious in a period of crisis in particular. On the
other hand, it has become clear that the euro area suffers from a serious
lack of institutions and policy concepts, which will not allow coping
with deep financial and economic crises unless a deep restructuring takes
place. The policy reactions of European governments, the European
Commission and the European Central Bank in cooperation with the
IMF will, therefore, hardly be able to initiate recovery. On the one hand,
some important steps towards financial stabilization have been made.
On the other hand, however, these are combined with restrictive fiscal
and wage policies, which will impose deflationary pressure on major
parts of the euro area and thus prevent stabilization (or reduction) of
public debtGDP ratios. In the paper we will first analyse the imbalances,
which have been built up in the euro area, before we briefly review the
policy responses towards the crisis. Since the prescribed fiscal and wage
policies are still dominated by the New Consensus Macroeconomics
theoretical framework, we will then develop an alternative macroeco-
nomic policy model based on Keynesian and Post-Keynesian principles.
It will be shown that stabilizing wage and active fiscal policies will have
35
36 The Euro Crisis
major roles to play in order to cope with the imbalances and to initiate
recovery for the EU as a whole. Furthermore, current account targets will
have to be included into intra-euro area policy coordination.
Keywords: European financial and economic crisis, current account

imbalances, Post-Keynesian economic policies
JEL Classification: E20, E61, E63, E64, E65, E66
1 Introduction1
The European Union and the euro area are presently facing the most
serious crisis since the introduction of the euro in 1999. As a conse-
quence of the world-wide financial and economic crisis, which started
in 2007 in the US and rapidly spread over major parts of the world
economy, Greece in early 2010, Ireland in late 2010 and Portugal in early
2011 were the first three euro area economies with serious public debt
problems. These problems triggered massive increases in interest rates on
public debt of these economies and finally public debt crises with rescue
measures introduced by the European Union member countries together
with the IMF. The financial and economic crisis in the euro area has
revealed a number of important flaws in the economic policy framework
in Europe. It has become clear that the European Union and the euro
area suffer from a serious lack of appropriate institutions and policy con-
cepts. In particular, there are no efficient mechanisms designed to pre-
vent the building up of external macroeconomic imbalances across the
euro area countries. The current debate over a reform of the Stability and
Growth Pact, and the economic policy framework more broadly, is still
dominated by the paradigm that has led to the crisis. Despite the rec-
ognition that current account imbalances contributed to the crisis, the
policy reactions of European governments, the European Commission
and the European Central Bank are still characterized by a narrow focus
on budget deficits and public debt. At the same time, there is a contin-
ued call for intensified deregulation of labour and product markets, in an
attempt to raise the competitiveness of the euro area as a whole. These
measures are conceptually flawed and will, therefore, hardly be able to
initiate recovery. Some important urgency measures have been taken to
stabilize financial markets and prevent government defaults, in particu-
lar the introduction of the European Financial Stability Facility (EFSF)
as well as the European Financial Stabilization Mechanism (EFSM), the
Eckhard Hein, Achim Truger and Till van Treeck 37
European Stability Mechanism (ESM), which will assume the role of

providing external financial assistance to euro area member states in
trouble after June 2013, and the extensions of the stabilization tools for
the EFSM and ESM agreed at the meeting of the heads of state or govern-
ment of the euro area and EU institutions in July 2011 (Council of the
EU 2011b). However, these measures are combined with restrictive fiscal
and wage policies associated with the access to the EFSF and the ESM, a
tighter Stability and Growth Pact (SGP) and a new Euro Plus Pact, which
will impose deflationary pressures on major parts of the euro area and
will thus prevent stabilization (or reduction) of public debtGDP ratios.2
Unless the structural causes for the public debt and euro crises, i.e., the
causes for the external imbalances, are overcome, and a stable financing
mechanism for remaining acceptable imbalances is introduced, the euro
area will continue to face serious threats of deflationary stagnation and
a collapse of the euro as a common currency.
In the paper we will first analyse in Section 2 the imbalances that
have built up in the euro area and which are at the roots of the present
crisis, given the institutional configuration of the euro area which,
in principle, precludes fiscal transfers among member countries and
monetizing of member country debt by the European Central Bank
(ECB). Then we will briefly review the economic policy framework in
the European Monetary Union (EMU) in Section 3, and analyse in how
far its underlying theoretical concepts have contributed to the build-
ing up of the causes of the crisis. Since the prescribed macroeconomic
policies are still dominated by the New Consensus Macroeconomics
theoretical framework, we will then develop an alternative macroeco-
nomic policy model based on Keynesian and Post-Keynesian principles
in Section 4. Having outlined the basic principles of a Post-Keynesian
macroeconomic policy approach, we will apply this approach to the
euro area. It will be shown that stabilizing wage and active fiscal poli-
cies will have major roles to play in order to cope with the imbalances
and to initiate recovery in the euro area as a whole. Furthermore, it will
be argued that current account targets will have to play a major role in
intra-euro area policy coordination.
2 Imbalances in the euro area at the root of

the euro crisis
The current euro crisis is considered by many observers above all by

the dominating economic policy makers and advisers in Germany and
also in the European Commission as a crisis of government deficits
38 The Euro Crisis
and debt.3 And a first casual look at the developments might even seem
to confirm this view. Since the start of the global financial crisis in 2007
the up to that point in time almost negligible spreads of government
bonds of euro area member states relative to the benchmark German
bonds materialized, most notably for Greece, Ireland, Portugal, and Spain
(GIPS) (see Figure 2.1). The situation continued, especially for Ireland
and Greece and especially so in mid-2009. However, in spring 2010 the
development escalated dramatically again in the Greek case. Dramatic
emergency measures had to be taken in order to prevent a Greek govern-
ment default and possibly government defaults in the aforementioned
other member states as well, and therefore to prevent an end to the euro
as a currency. The relief provided by the Greek rescue package and the
euro rescue fund set up to prevent further problems for other govern-
ments proved to be very short-lived. In October 2010 spreads for Irish
government bonds increased dramatically again so that, in November of
the same year, finally the Irish government decided to request assistance
Austria Belgium Finland

France Germany Greece
Ireland Italy Luxembourg
Netherlands Portugal Spain
16
14
12
10
0
20 Jan
20 pr
07 l
20 Oct
20 Jan
20 pr
08 l
20 Oct
20 Jan
20 pr
09 l
20 Oct
20 Jan
20 pr
10 l
20 Oct
20 Jan
r
20 Ju
20 Ju
20 Ju
20 Ju
Ap
A
A
07
08
09
10
07
08
09
10
11
07
08
09
10
11
20
Figure 2.1 10-year government bond yields, selected countries, January 2007
May 2011
Source: ECB long term interest rate statistics, June 2011 (http://www.ecb.int/stats/money/
long/html/index.en.html); authors representation.
by the EFSM, the EFSF and the IMF. In spring 2011, the Portuguese gov-
ernment had to do the same and many expect that its much larger neigh-
bour Spain could soon become the next victim of the euro debt crisis.
Mainstream economics and economic policy debates see the high and
rising government debts, and the failure of the Stability and Growth
Pact (SGP) to contain government deficits and debt, as the main rea-
son for the crisis and therefore the most important problem to be
tackled in the euro area. From that point of view the main threat for
the euro is caused by governments, which have run irresponsibly high
deficits leading public finances to the brink of default. However, even a
casual look at the data raises many doubts regarding that point of view
(see Figures 2.2 and 2.3). For Greece, of course, the picture seems clear,
as the budget deficit was outstandingly large over the whole period
since the mid-1990s. For Portugal, however, the picture is less clear, as
the budget deficit was not larger than in Germany for a long period of
time. And most strikingly, both Ireland and Spain looked perfectly well
Austria Belgium Finland France

Greece Germany Ireland Italy
Netherlands Portugal Spain EU-12
8
6
4
2
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Figure 2.2 General government financial balance relative to GDP, selected

countries, 19952010
Source: AMECO Database of European Commission, May 2011 (http://ec.europa.eu/
economy_finance/db_indicators/ameco/index_en.htm); authors calculations.
40 The Euro Crisis
Austria Belgium Finland France

Greece Germany Ireland Italy
Netherlands Portugal Spain EU-12
160
140
120
100
80
60
40
20
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
General government gross consolidated debt relative to GDP, selected

countries, 19952010
before the crisis as they seemed to follow the SGP in an almost ideal
manner. Ireland ran a budget surplus of 3 per cent of GDP in 2006 and
Spain had a surplus of 1.9 per cent in 2007. Turning to gross govern-
ment debt in relation to GDP, which many regard as a better indicator
for the sustainability of public finances, the evidence for the purely
fiscal view of the crisis becomes even weaker: Portugal used to have
a considerably smaller debt burden than Germany. And in 2007 gross
government debt in relation to GDP was only 25 per cent in Ireland and
36 per cent in Spain, far below the 60 per cent threshold of the SGP.
From this perspective, nobody would have suspected any risk of govern-
ment default in Portugal, let alone in Ireland or Spain.
The fact that the aforementioned countries nevertheless ran into
trouble must thus be due to other imbalances: And, of course, for both
Spain and Ireland it is well known that it was the private sector that
had gone deeply into debt before the crisis unfolded, partly as a con-
sequence of a housing price bubble and construction boom. Once the
crisis struck it was the government that had to step in and go into debt.
The interconnection of public, private and foreign debt can be more
systematically explored if one recalls that the following accounting
identity holds for any economy:
Public sector financial balance Private sector financial balance

Foreign sector financial balance 0
This simply means that any particular sector in the economy cannot
run a surplus, without the remaining two sectors of the economy run-
ning a joint deficit of exactly the same magnitude. If one country runs
a current account surplus, then at least in one other country the govern-
ment or the private sector has to run a financing deficit, and so on.
Figures 2.4 and 2.5 show the financial balances of the private sector,
the public sector and the external sector for Spain and Ireland respec-
tively. Although the figures are more striking for Spain, in both coun-
tries huge deficits of the private sector (more than 5 per cent of GDP in
Ireland for some years and more than 10 per cent of GDP in Spain) were
associated with (relatively small) surpluses in the government balance
and to a much larger extent with current account deficits against the
rest of the world. When the bubble growth models came to a sudden
Private sector Public sector External sector
15
10
5
10
15
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
Figure 2.4 Sectoral financial balances relative to GDP, Spain, 19952010

42 The Euro Crisis
40
30
20
10
10
20
30
40
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
Figure 2.5 Sectoral financial balances relative to GDP, Ireland, 19952010
end as the result of the crisis, the private sector balance quickly turned
into surplus and governments stabilizing the economy had to accept a
dramatic rise in government deficits. Therefore, the unsustainable gov-
ernment deficit turns out to be a consequence of unsustainable private
and external sector balances in the first place.
In fact, if one takes a look at two other economies currently in trou-
ble with their public debt, it turns out that the picture is very similar
for them. In Greece (Figure 2.6), as well as in Portugal, both the private
sector and the government sector continuously ran deficits after the
inauguration of the euro. Those deficits had to be financed by capital
inflows and hence current account deficits of about 12 per cent of
GDP in the case of Greece, and about 10 per cent of GDP in the case
of Portugal, before the crisis. After the crisis, in both countries the gov-
ernment stepped in to prevent the economy from collapsing when the
private sector reduced deficits or turned into surplus again, leading to
rising public deficits and the problems of government debt currently
in the focus of public attention.
Therefore, it seems that the current euro crisis can better be interpreted
as the consequence of earlier private debt and current account imbal-
ances and not as a result of excessive public deficits. In the four countries
20
15
10
5
10
15
20
95
06
07
96
97
98
99
00
01
02
03
04
05
08
09
10
19
19
19
19
20
20
19
20
20
20
20
20
20
20
20
20
Figure 2.6 Sectoral financial balances relative to GDP, Greece, 19952010
outlined above, the private sector obviously tended to spend more than
its income. This was associated with government surpluses (Ireland,
Spain) or amplified by government deficits (Portugal, Greece), which led
to very high and rising current account deficits in the four countries.
For Italy, which is sometimes considered part of the GI(I)PS coun-
tries, the picture is less clear. In this country the private sector balance
was consistently positive. Therefore the government deficit could be
financed partly by the private sector surplus and partly by the capital
inflows associated with the moderate, but continuously rising, current
account deficit. When the crisis hit, the improvement in the private
sector balance was compensated mostly by a rather modest increase in
the government deficit.
Obviously, there must be a counterpart to the rising current account
deficits of the GIPS countries. Since the current account of the euro area
as a whole has been roughly balanced, there must have been other coun-
tries in which the private sector has consistently spent much less than
it earns. If in such cases the government is not willing (or is prevented
by the SGP) to run a correspondingly high deficit, then this will imply
a deficit of the foreign sector, i.e., a current account surplus taking
GDP as given. Within the euro area there are at least four countries for
44 The Euro Crisis
which such characteristics hold: Germany, the Netherlands, Austria,

and Belgium, with Germany as the largest euro area country being the
most important one (see Figure 2.7).
The economic imbalances in the euro area as expressed by the current
account developments can be summarized with the help of Figure 2.8.
As can be seen, the imbalances have increased almost continuously
since the start of the euro in 1999 peaking in the year 2007, before the
crisis. For most of the countries (with the notable exception of Ireland)
the current account is dominated by the balance of goods and services,
i.e., net exports of goods and services.
As can be seen from Table 2.1, with the exception of Ireland, the
current account deficit countries in trouble have had negative growth
contributions from their net exports, whereas the surplus countries on
average from 1999 to 2007 had positive growth contributions. Since the
development of the balance of goods and services (in real terms) mainly
depends on two factors, the growth of domestic demand (relative to
foreign demand) and on international price competitiveness (relative to
trading partners), we take a look at indicators of these factors next.
As a proxy for the first factor we look at the growth contributions of
real domestic demand on average over the period from 1999 to 2007
and compare it to the average for the old euro area (EU-12) (Table 2.1).
10
8
6
4
2
0
2
4
6
8
10
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
Figure 2.7 Sectoral financial balances relative to GDP, Germany, 19952010

Figure 2.8 Current account in billions ECU/euro, selected Euro area countries,
19952010
Concerning the current account surplus countries, in Germany the GDP

growth contribution of domestic demand was considerably weaker than
the EU-12 average. Also Austria had a well below EU-12 average growth
contribution of domestic demand, and in Belgium and the Netherlands
it was slightly below EU-12 average, too. As for the second group, the
troubled deficit countries, the case is very clear for Ireland, Spain and
Greece, where the growth contribution of domestic demand by far
exceeded the EU-12 average. Portugal and Italy, however, were slightly
below EU-12 average and over the whole period even a little bit below
Belgium and the Netherlands.
As for the second indicator, the international competitiveness, we
use the development of nominal unit labour costs since the start of
the euro in 1999 until 2007 (Table 2.1). Obviously, within the group of
surplus countries Germany is the country with the slowest unit labour
cost growth; between 1999 and 2007 unit labour costs almost stagnated.
Austria used to follow the German example until 2004, since then its
unit labour cost growth has accelerated a little, but it is still way below
EU-12 average. Belgian unit labour costs grew almost perfectly in line
with the EU-12 average, whereas in the Netherlands it was visibly faster,
Table 2.1 Key macroeconomic indicators for imbalances, selected Euro area countries, 19992007, average values
46
Consumption boom Slow growth Surplus economies
deficit economies deficit economies
Greece Ireland Spain Italy Portugal EU 12 France Austria Belgium Germany Netherlands
Financial balances of 11.5 1.4 5.7 0.6 9.5 0.4 0.1 1.5 4.5 2.9 6.8
external sector as a
share of nominal
GDP, %
Financial balances 5.3 1.6 0.1 2.8 3.6 1.8 2.6 1.8 0.5 2.1 0.5
of public sector as
share of nominal
GDP, %
Financial balance 6.2 3.0 5.8 2.2 5.8 2.2 2.6 3.3 4.9 5.0 7.3
of private sector as a share
of nominal
GDP, %
Financial balance of 9.3 1.0 4.3 0.3 4.0 4.4 4.3 5.1 0.1
private household
sector as a share of
nominal GDP, %**
Financial balance of 3.1 4.8 2.1 6.1 1.5 1.3 0.5 0.1 7.0
the corporate sector
as a share of nominal
GDP, %
Annual real GDP 4.2 6.5 3.8 1.5 1.8 2.2 2.2 2.5 2.3 1.6 2.0
growth, %*
Annual growth 4.7 5.7 4.8 0.8 1.9 2.1 2.7 1.6 1.9 0.7 2.0
contribution of
domestic demand
including stocks,
percentage points
of which private 2.7 2.9 2.3 0.7 1.5 1.1 1.5 0.9 0.8 0.5 0.8
consumption,
percentage points
of which public 0.8 0.9 0.9 0.4 0.4 0.4 0.4 0.3 0.4 0.2 0.8
consumption,
percentage points
of which gross 1.3 1.4 1.6 0.2 0.0 0.6 0.8 0.3 0.6 0.2 0.4
fixed capital
formation,
percentage points
Annual growth 0.6 1.4 1.0 0.2 0.1 0.1 0.4 0.8 0.4 0.9 0.5
contribution of the
balance of goods and
services, percentage points
Net exports of goods and 11.3 13.5 3.8 0.6 9.0 1.6 0.3 3.6 4.3 3.9 6.7
services as a share
of nominal GDP, %
Annual growth rate of 3.1 3.1 3.0 2.5 2.7 1.6 1.7 0.6 1.6 0.0 2.2
nominal unit labour
costs, %
Annual inflation 3.2 3.7 3.2 2.3 3.0 2.1 1.7 1.9 2.0 1.5 2.3
(HCPI growth rate), %
Annual growth rate of 0.8 0.9 0.7 0.9 0.4 0.7 0.6 0.6 0.9 0.5
nominal effective
exchange rates (relative to
23 countries), %
Annual growth rate of 1.5 2.2 1.6 1.5 1.2 0.6 0.4 0.5 1.2 1.1
real effective exchange
rates (relative to 23
countries), %
Notes: * Growth contributions for some countries may not add up to GDP growth rates even for individual years in the AMECO data,
47
** Balance adjusted such that the sum of household and corporation sub-sectors equals the private sector balance as a whole.
Source: AMECO Database of European Commission, May 2011 (http://ec.europa.eu/economy_finance/db_indicators/ameco/index_en.htm); authors
calculations.
48 The Euro Crisis
although this is almost entirely due to a rather steep increase in the first
years of the euro; since 2003 there has been a remarkable deceleration.
Taking a look at the current account deficit countries, the picture is
very clear for all of them: their unit labour cost growth has been much
faster than that of the EU-12 average. In particular, it has exceeded the
2 per cent rate consistent with the ECB inflation target (2.5 per cent in
the case of Italy, 2.7 per cent for Portugal and 3 per cent in the case of
Spain), whereas the EU-12 average rate (1.6 per cent) is below this target
rate. The relative inflation rates mostly reflect the differences in unit
labour cost growth: the current account surplus countries mostly have
inflation rates below EU-12 average, whereas in the current account
deficit countries inflation exceeds EU-12 average.
So far we have argued that instead of the financial balance of the gov-
ernment the financial balances of all three sectors should be taken into
account and that this will automatically lead to focus on the imbalances
in the current accounts of euro area member states as the major object
of concern. In the analysis we have shown that international competi-
tiveness and differences in domestic demand growth are the main fac-
tors driving the development of the balance of goods and services and
correspondingly the current account. What we have not done is to pro-
vide an analysis on whether the current account deficits/surpluses are
sustainable, or how sustainable let alone optimal levels could be deter-
mined. We also did not provide causal reasons for the development of
the factors driving the current account. Both these tasks are well beyond
the scope of this paper. However, in Section 3 we shall show that the
existing economic policy framework, and the theoretical paradigm on
which it relies, have either largely ignored the threat posed by the exter-
nal imbalances or proposed completely inadequate remedies.
From a descriptive perspective, with respect to the question of sus-
tainability, we simply note that the net foreign asset position of the
four economies currently under pressure from the financial markets has
deteriorated tremendously over the past five years (see Figure 2.9). It is
highly improbable that such a development could go on for a longer
period of time without a major debt crisis be it a crisis of government
or private debt.
With respect to the economic reasons for the current account deficits/
surpluses we refer to our analysis of the neo-mercantilist strategy of
Germany (Hein and Truger 2009) for the most important surplus case.
As is well known, Germany combined a strategy of wage restraint
and welfare state reforms, which led to a dramatic increase in income
inequality and a stagnation of private consumer demand, with a
Austria Belgium France Germany Italy

Ireland Greece Netherlands Portugal Spain
100
50
50
100
150
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Figure 2.9 Net foreign asset position relative to GDP, selected Euro countries,
19952010
Source: Ecowin-Reuters (IMF World Economic Outlook, April 2011 and IMF International
Financial Statistics, June 2011); authors calculations.
retrenchment of the state and highly restrictive fiscal policies (see also
Horn et al. 2010). For the deficit economies the following distinction
has to be made. On the one hand, there are the economies with very
high pre-crisis growth rates, Greece, Ireland and Spain. Although part
of their current account deficits may well be explained by catching up
to the higher GDP levels of the other EU economies, there is much evi-
dence for a debt driven consumption boom that was doomed to fail (see
Hein 2011a, 2011b, for a more detailed analysis): Growth contributions
from private consumption were very high and the private (household)
sector was driven into substantial deficits (see Table 2.1). Furthermore,
except for Greece, a substantial part of the observed investment dynam-
ics must be attributed to a construction boom, much of it in residential
investment, which is evidence for a housing boom.
3 The flawed theoretical underpinnings of the economic

policy framework in the EU
The economic policy framework in the EU is succinctly described by

the ECB (2008) as follows: The Treaty foresees three different modes for
policy-making in the various fields of EMU: i) full transfer of competence
50 The Euro Crisis
to the Community level for monetary policy; ii) rules-based coordina-

tion for fiscal policy; iii) soft coordination for other economic policies
(p. 22). In other words, while the individual European nations have
completely lost their currency sovereignty in favour of an independent
central bank that focuses primarily on an average inflation target for
the euro area as a whole, no federal sovereign institution has been cre-
ated that coordinates the remaining fields of economic policy. Instead,
national fiscal policies are subject to one size fits all quantitative criteria
for public deficits and debt (the SGP). And the soft coordination of
other economic policies refers primarily to structural policies aiming at
highly flexible and competitive markets that are considered necessary
for the smooth functioning of EMU, as the countries can no longer
resort to some of the pre-EMU adjustment mechanisms to restore their
competitiveness (ECB 2008, p. 26). Hence, this coordination approach
relies on peer pressure and support (ECB 2008, p. 26) and allows for
some degree of policy competition aimed at improving policy efficiency
and emulating best practices (ECB 2008, p. 21). It was enshrined in the
Lisbon Strategy adopted in March 2000 and promotes the deregulation
of labour, product and financial markets in all member states.
Put in a nutshell, the intended interaction of the three different
modes for policy-making in the EU and the euro area can be summa-
rized as follows: monetary policy follows an interest rate rule, whereby
the policy rate is changed in response to deviations of (expected) infla-
tion from target and of (expected) output from its supply-determined
potential. The sole objective of the ECB is to maintain inflation at the
target of below, but close to, 2 per cent. It is argued that this is the best
contribution that monetary policy can make to economic growth at
the euro area level. The role of fiscal policy is to balance the budget
over the medium term and to never run excessive deficits, i.e., above
3 per cent of GDP. Moreover, the government debt-to-GDP ratio must
not exceed 60 per cent. Hence, while there is some room for manoeu-
vre for automatic stabilizers and discretionary fiscal policy to react to
country-specific shocks, fiscal policy nevertheless is confined to playing
a rather passive role, with an emphasis on solid public finances. As
a consequence, as individual member countries have lost interest rate
and exchange rate policies as macroeconomic stabilization tools, and
with fiscal policy subject to the constraints of the SGP, flexible wages
and prices and, more generally, flexible and deregulated labour, prod-
uct and financial markets are expected to provide efficient adjustment
mechanisms in the presence of macroeconomic shocks and to ensure
full employment and macroeconomic stability.
In this section, we shall briefly review the three pillars of the eco-
nomic policy framework in the euro area in turn. We shall explain
why we see their theoretical underpinnings as theoretically flawed and
empirically inappropriate in view of the macroeconomic developments
during the first decade after the introduction of the single currency, as
sketched in the previous section. We will conclude that the current crisis
of the euro area, far from indicating that individual member states have
lacked discipline in terms of fiscal consolidation and structural reforms,
clearly reveals the conceptual limits of the so-called New Consensus
Macroeconomics (NCM), on which much of the existing economic
policy framework in the euro area is based.4
3.1 Monetary policy: Inflation targeting through short-term

interest rate policies and financial market deregulation
As is well known, the European Central Bank follows a strategy of
inflation targeting. In the evaluation of its monetary policy strategy in
2003, the Governing Council of the ECB clarified that it aims to keep
the Harmonized Index of Consumer Prices (HICP) below, but close
to 2 per cent per annum in the medium run. Furthermore, monetary
policy follows the principle of one instrument, one objective, with the
short-term interest rate being the instrument, and the objective being
the medium-run stabilization of the euro area-wide inflation rate. There
is no explicit exchange rate policy, and the monetization of public debt
is precluded (of course, this principle had to be partially abandoned dur-
ing the crisis). Also, there is no attempt to directly intervene in financial
markets, for instance, to prevent excessive credit expansions or asset
price bubbles in particular sectors of the economy. In the words of the
ECB (2008):
(P)rice stability is the best and, ultimately, the only contribution

that a credible monetary policy can make to economic growth, job
creation and social cohesion. This reflects the fact that a policy-
maker who controls only one instrument cannot meet, and be held
accountable for the fulfilment of, more than one objective. The
pursuit of additional objectives would risk overburdening monetary
policy, and would ultimately result in higher inflation and higher
unemployment. Over the longer term, monetary policy can only
influence the price level in the economy; it cannot exert a lasting
impact on economic activity. This general principle is referred to
as the long-run neutrality of money. It is against this background
that the Treaty provides for a clear and efficient allocation of
52 The Euro Crisis
responsibilities, with monetary policy being assigned the primary

objective of maintaining price stability. (p. 34)
The theoretical justification for this approach is the notion that, as

long as inflation is on target, the output gap will also be closed, and
hence the economy will be at its structurally determined rate of unem-
ployment, or NAIRU (the divine coincidence property, see Blanchard
and Gal 2007, for a critique). When inflation deviates from target, it
is expected that changes in the short-term interest rate will bring out-
put, employment and inflation back to their potential or target levels.
Financial market deregulation and integration is seen as a key contribut-
ing factor to the efficient transition of the ECB interest rate policy to the
real economy; in the words of the ECB (2008):
In line with its position that the financial integration process should
be market-led, the Eurosystem considers that the role of public policy
in fostering financial integration should be limited. In particular,
policy measures should not promote a specific level or type of cross-
border activity, as only market participants themselves are in a posi-
tion to develop the underlying business strategies, take the respective
investment decisions and assume responsibility for the economic
consequences. (p. 101)
Asset price and credit bubbles are of concern to the central bank only
insofar as they pose a risk to price stability. As Woodford (2003), one
of the most prominent advocates of inflation targeting and financial
deregulation, puts it:
Not only expectations about policy matter, but, at least under cur-
rent conditions, very little else matters. Few central banks of major
industrial nations still make much use of credit controls or other
attempts to directly regulate the flow of funds through financial mar-
kets and institutions. Increases in the sophistication of the financial
system have made it more difficult for such controls to be effective,
and in any event the goal of improvement of the efficiency of the
sectoral allocation of resources stressed previously would hardly be
served by such controls, which (if successful) would inevitably create
inefficient distortions in the relative cost of funds to different parts
of the economy. Instead, banks restrict themselves to interventions
that seek to control the overnight interest rate in an interbank mar-
ket for central-bank balances. (p. 15, italics in the original)
In light of the present crisis, the emphasis on inflation targeting via

short-term interest rate policy and financial market deregulation, which
was actively pursued by the European Union and justified theoretically
by the NCM, appears very much flawed. Firstly, the belief in the ration-
ality and therefore the inherently stabilizing properties of deregulated
financial markets has been thoroughly undermined by the bursting
bubbles and the near collapse of the financial system. Therefore, sec-
ondly, the central banks sole preoccupation with price stability as
opposed to regulating and supervising the financial markets as well as
exercising the lender of last resort function becomes dubious. Thirdly,
due to the zero lower bound for nominal interest rates, the central bank
cannot stabilize the real economy and prevent deflation in times of
deep crises. Fourthly, even if central banks are able to reduce inflation to
the target level whenever the economy is facing accelerating inflation in
the short run, in a conflicting claims framework of inflation generation
it has to be taken into account that higher interest rates mean higher
costs for firms which will again push inflation in the medium run (Hein
and Stockhammer 2010).
A further cause for concern is posed by the country-specific dif-
ferences in the patterns of inflation, financial asset price and credit
developments and macroeconomic trends more broadly. Clearly, as the
ECBs only objective is the euro area-wide inflation target (which has
been roughly met since 1999), it can neither be held accountable for
inflation differentials between countries (see Table 2.1), nor for reacting
to country-specific shocks to output and employment.
3.2 Fiscal policy: One-size fits all recommendation of

stability-oriented fiscal policies
As individual member states have given up monetary sovereignty,
they can no longer use monetary policy for macroeconomic stabiliza-
tion. However, the use of fiscal policy as a means to react to country-
specific aggregate demand problems is strongly limited as well by
the public deficit and debt criteria of the SGP. As emphasized by the
ECB (2008):
In addition to structural reforms, stability-oriented fiscal policies are

a pre-condition for the smooth functioning of EMU. () High defi-
cits can give rise to demand and inflationary pressures, potentially
forcing the monetary authority to keep short-term interest rates at
a higher level than would otherwise be necessary. Fiscal policy may
also undermine confidence in a stability-oriented monetary policy if
54 The Euro Crisis
private agents come to expect that excessive government borrowing

will ultimately be accommodated by the central bank. Sound and
sustainable fiscal policies are therefore a pre-condition for sustain-
able economic growth and a smooth functioning of monetary union,
including the avoidance of imbalances across countries. (pp. 712)
All member states adopting the euro are obliged by the Treaty on
the European Union to avoid excessive government deficits above
3 per cent of GDP and they must keep the public debt-to-GDP ratio
below 60 per cent of GDP. The SGP, adopted in 1997 and revised in
2005, furthermore obliges EU member states, as a medium-term objec-
tive (MTO), to keep the government budget close to balance or in
surplus. While the need to react to adverse country-specific shocks is
recognized, all member states should aim at fiscal positions that leave
enough room to allow the operation of automatic fiscal stabilizers
without violating the deficit and debt criteria.
Clearly, one peculiar ingredient of the economic policy framework in
the EU is that one-size fits all recommendations for fiscal discipline are
expected to contribute to the avoidance of imbalances across countries.
As shown in the previous section, external imbalances in terms of trade
and current accounts emerged soon after the introduction of the euro
and intensified around 2004/5. However, the link between the fiscal pol-
icy stance and those imbalances was hardly recognized by the European
authorities. In its opinionon the Stability Programme of Spain, 2005
2008, ECOFIN (Council of the EU 2006a) was of the opinion that, over-
all, the budgetary position is sound and the budgetary strategy provides
a good example of fiscal policies in compliance with the Stability and
Growth Pact (p. 3). In the spring of 2007, just before the outbreak of the
financial crisis, while recognizing that (m)aintaining a strong budgetary
position, thus avoiding an expansionary fiscal stance, is important in the
light of large and rising external imbalances and the existing inflation dif-
ferential with the euro area, the ECOFIN (Council of the EU 2007a) still
considered that the medium term budgetary position is sound and the
budgetary strategy provides a good example of fiscal policies conducted
in compliance with the Stability and Growth Pact (p. 3). Moreover, it
was judged that it provides a sufficient safety margin against breaching
the 3 per cent of GDP deficit threshold with normal macroeconomic
fluctuations in every year (ibid., p. 2). Similarly, in its assessment of the
Stability Programme of Ireland, 20062009, the ECOFIN considered that
the medium-term budgetary position is sound and, the budgetary strat-
egy provides a good example of fiscal policies conducted in compliance
with the Stability and Growth Pact. Nonetheless, it would be prudent to

maintain room for manoeuvre against any reversal of the current growth
pattern which has been led by strong housing sector developments
(Council of the EU 2007b, p. 3). At the same time, Germany, by then run-
ning very large current account surpluses, was struggling with reducing
the government deficit below the 3 per cent threshold of the SGP:
(T)he budgetary stance in the programme seems consistent with a

correction of the excessive deficit by 2007. However, it does not seem
to provide a sufficient safety margin against breaching the 3 per cent
of GDP deficit threshold with normal macroeconomic fluctuations
until the penultimate year of the programme period. In view of
the above assessment, the Council welcomes the priority attributed
by the government to budgetary consolidation as laid out in the
programme, but notes that there are risks linked to the achievement
of the budgetary targets and to long-term sustainability of public
finances. (Council of the EU 2006b, p. 3)
As the above mentioned examples show, within the economic policy

framework of the EU, fiscal policy hardly plays a role in addressing exter-
nal imbalances. If this had been the case, then the recommendation for
the fiscal policy stance would have been to be much more contractionary
in Spain and Ireland, but much more expansionary in Germany. Rather,
the overall very passive roles attributed to both monetary and fiscal poli-
cies reflect a strong belief in the efficient working of flexible labour, prod-
uct and financial markets and their ability to contain imbalances across
countries over the medium term (see next section). Clearly, the present
crisis of the euro area suddenly revealed that Spain and Ireland may not
have been such good example of fiscal policies and that long-term sus-
tainability of public finances was much less a problem in Germany than
in those two countries (as private saving was large enough to finance
both the government debt and build up a strong net external creditor
position). Yet, it is not surprising that the defenders of the NCM policy
framework, including the ECB, parts of the European Commission and
the German government, now call for more structural reforms, especially
on the labour markets, and a competitiveness pact rather than acknowl-
edging the conceptual flaws in the design of monetary and fiscal policy.
Therefore it also comes with no surprise that the European Council in
March 2011 endorsed the priorities for fiscal consolidation and struc-
tural reform. It underscored the need to give priority to restoring sound
budgets and fiscal sustainability, reducing unemployment through
56 The Euro Crisis
labour market reforms and making new efforts to enhance growth

(European Council 2011, p. 2). In particular, the European Council
requires reductions of the structural budget deficits of well above 0.5
per cent of GDP (ibid. p. 2) for 2012 in most countries, in order to
restore confidence.5
The Euro Plus Pact agreed at the European Council in March 2011 is
mainly targeted at improving competitiveness by means of monitoring
wage setting, in particular in the public sector, at labour mar-
ket reforms increasing flexicurity, life-long learning and reducing
taxes on low-paid labour, and at improving sustainability of public
finances by means of extending effective retirement ages, reducing
early retirement and implementing fiscal rules (i.e., debt brakes)
into national legislation.6 These commitments in the Euro Plus Pact
will be reflected in the annual National Reform and the Stability
Programmes, which are assessed by the Commission, the Council, and
the Eurogroup in the context of the so-called European Semester, and
will thus have a major impact on European economic policies in the
years to come.
3.3 Structural reforms: reliance on wage and price

flexibility and capital mobility as adjustment
mechanisms to macroeconomic imbalances
In its assessment of the economic policy framework in the euro area,
conducted ten years after the introduction of the single currency and
in the midst of the global financial crisis, the ECB still considered the
deregulation of labour, product and financial markets as the key pre-
requisite of a well-functioning monetary union that is characterized
by an essentially abstinent monetary and fiscal policy strategy. As ECB
(2008) puts it:
Economic reforms in the goods, capital and labour markets, as well

as the completion of the Single Market, aim to remove barriers to
competition, increase market flexibility and allow more intense
national and cross-border competition. In general, such structural
reforms are very relevant to monetary policy, as they are important
for mitigating inflationary pressures and inflation persistence in
response to adverse shocks. More specifically, rigidities in the wage
and price-setting mechanisms or ongoing excessive wage deve-
lopments may delay the necessary adjustments of relative prices
to economic shocks and thereby give rise to inflation persistence.
Flexible and competitive markets, which would adjust smoothly
to economic changes and absorb economic shocks also across

national borders are of particular importance in a monetary union
such as the Euro area, in which adjustments to national monetary
and exchange rate policies are no longer available to respond to
economic changes. (p. 66)
The call for wage and price flexibility and deregulated financial mar-
kets can be traced back to the so-called theories of optimum currency
area (OCA). However, the array of competing and largely contradictory
OCA theories is very confusing, and hence (t)here is no robust, widely
accepted theory of optimum currency areas which can be used as a com-
pass for policy-makers (Priewe 2007, p. 47).7 The current stage of the
debate is that the optimality of a currency area can be assessed against
a catalogue of various properties, including the mobility of labour and
other factors of production, price and wage flexibility, economic open-
ness, and diversification in production and consumption, similarity in
inflation rates, fiscal integration and political integration (see Mongelli
2002). However, there is no consensus whatsoever as to how far the
lack of one ingredient of the aforementioned list could be compensated
by the existence of others, or which degree of, say, price and wage flex-
ibility would be required for a currency area to be optimal, given the
various other factors. While in some OCA theories, a high degree of
wage and price flexibility is an indispensable prerequisite for an optimal
currency union, in others labour mobility may, to some degree, be a
substitute for wage and price flexibility.8 While a thorough assessment
of OCA theories would be beyond the scope of this paper, it suffices
here to note that within the framework of economic policy in the euro
area the main focus has been on the deregulation of labour, product and
financial markets, while the importance of fiscal federalism and politi-
cal union have been downplayed.
As a consequence, in practice, the presence of large current account
balances has been interpreted as reflecting in part equilibrium phenom-
ena linked to catching-up processes,9 demographic differences, national
consumption preferences, etc. For the other part, they were seen as the
result of wage and price rigidities; and as ECB (2007) puts it:
Divergent price and cost competitiveness developments might reflect

normal and even desirable responses to catching-up processes and
country specific shocks. However, they may also be an indication
of labour cost developments that are not economically justified
and which in turn may reflect a lack of price and wage flexibility or
58 The Euro Crisis
overly optimistic expectations regarding future income growth in

some countries. For this reason the interpretation of divergent deve-
lopments in cost and price competitiveness indicators is difficult and
developments need to be monitored carefully. As national monetary
and exchange rate policies are no longer options within the Euro
area, it is important to make sure that the remaining mechanisms
of adjustment to shocks function properly. The efficient and smooth
functioning of economic adjustments within the Euro area requires
the removal of institutional barriers to flexible wage and price-setting
mechanisms as well as the completion of the Single Market and thus
greater cross-border competition. (pp. 4850)
The reliance on wage and price flexibility as a macroeconomic adjust-

ment mechanism is grounded in the New Keynesian or NCM view
that business cycle fluctuations result from nominal aggregate demand
shocks and that these shocks have real effects because nominal wages
and prices are rigid (e.g. Gal 2008). Of course, this view is in sharp
contradiction to the conviction expressed by Keynes (1936), accord-
ing to which highly flexible nominal wages and prices are likely to be
destabilizing rather than stabilizing. In fact, it is not at all clear why
falling (rising) (expected rates of change of) nominal wages and prices
should have expansionary (contractionary) effects following an adverse
(positive) output shock. Rather, by increasing (reducing) the real value
of private debts and by increasing (lowering) real interest rates, they are
likely to destabilize the economy further (see Tobin 1993, for an excel-
lent summary of the arguments). This is all the more true in a monetary
union, where a lower (higher) than average rate of inflation is associated
with a lower (higher) than average real rate of interest, given the com-
mon monetary policy. While the ECB (2005) has recognized this fact,
it has continued to believe in the correction of current account imbal-
ances via the price mechanism:
Finally, in a monetary union, where exchange rates among countries

are by definition fixed, there are strong market-based forces that work
in a stabilizing manner. In particular, if a country has lower than
average inflation on account of weak demand, it will become more
competitive in relation to other countries. This tends to increase
demand in that country (and reduce demand in others) over time. As
has been shown in a number of recent studies, the competitiveness
(real exchange rate) channel, although slow to build up, eventually
becomes the dominating adjustment factor. (p. 70)
Hence, even after the outbreak of the current crisis, the ECB (2008)
recommends further deregulation of labour and product markets and
moreover relies on capital mobility as an adjustment mechanism to
external imbalances, arguing that a deepening of financial integration
in the years to come will allow investors to diversify their portfolios
more efficiently and thereby provide a cushion against localised macro-
economic risks (p. 71). Clearly, until the sudden panic of the financial
crisis, the financial markets seemed to consider current account imbal-
ances as equilibrium phenomena not giving rise to any particular con-
cerns about the sustainability of private and public indebtedness in the
deficit countries. This was reflected in very low risk premia for private
and public debt in the deficit countries (see Figure 2.1).
The global financial and economic crisis and the crisis of the euro area
have shown that the policy package combining monetary and fiscal pol-
icy abstinence and the deregulation of labour and financial markets has
failed. While recent official proposals for reform of the economic policy
framework in EMU recognize the importance of addressing excessive
macroeconomic imbalances, including current account imbalances
(European Commission 2010; van Rompuy 2010), the monetary policy
strategy is not called into question. The flawed emphasis on the pub-
lic deficit and debt criteria of the Stability and Growth Pact is even to
be strengthened (Council of the European Union 2011a, 2011b). And
the emphasis on structural reforms and deregulation is maintained,
as the conclusions from the March meeting of the European Council
(2011) mentioned above underline. In the next section, we present the
main principles of an alternative macroeconomic policy framework
for the euro area which should be more appropriate when it comes to
tackling the present crisis.
4 Post-Keynesian policy-mix for the euro area
The outline of a Post-Keynesian policy mix for the euro area targeted
at overcoming the present crisis takes place in three steps.10 In the first
step we will recall the Post-Keynesian macroeconomic policy assign-
ment as compared to the still dominating mainstream NCM approach
outlined in the previous section. In the second step we will apply this
approach to the euro area assuming that in the long run each country
should grow at a rate consistent with a balanced current account. In
the third step we will then lift this restriction and consider that long-
run growth dynamics may persistently tend to violate balanced current
accounts, in particular due to productivity catch-up processes.
60 The Euro Crisis
4.1 The basic principles of a Post-Keynesian macroeconomic

policy mix
In Hein and Stockhammer (2010) a blueprint for a Post-Keynesian
macroeconomic policy mix as opposed to the NCM focusing on
labour market deregulation in order to reduce the NAIRU and on mon-
etary policy for short-run real and long-run nominal stabilization has
been developed, which can be used as a theoretical foundation for our
suggestions here. Macroeconomic policies should be co-ordinated along
the following lines:
First, central banks interest rate policies should abstain from attempt-
ing to fine tune unemployment in the short run and inflation in the
long run, as suggested by the NCM. Varying interest rates have cost and
distribution effects on the business sector, which may be effective in
achieving inflation targets in the short run, in particular if the economy
is facing accelerating inflation. With accelerating inflation increasing
the base rate of interest under the control of the central bank will finally
also make credit and financial market rates increase and will be able
to choke off an investment boom. But if accelerating disinflation and
finally deflation prevail, monetary interest rate policies will be ineffec-
tive due to the zero lower bound of the nominal interest rate, due to
rising mark ups in the setting of interest rates in credit and financial
markets by banks and financial intermediaries, because of increasing
risk and uncertainty premia, and due to interest rate inelasticities of
real investment of firms in a disinflationary or deflationary climate.
Further on, in the long run, rising interest rates, applied successfully in
order to stop accelerating inflation in the short run, will feed conflicting
claims inflation again, because price setting of surviving firms will have
to cover higher interest costs. Therefore, central banks should focus on
targeting low real interest rates in credit and financial markets in order
to avoid unfavourable cost and distribution effects on firms and work-
ers, while favouring rentiers.11 A slightly positive long-term real rate
of interest, below the long-run rate of productivity growth, seems to
be a reasonable target. Rentiers real financial wealth will be protected
against inflation, but redistribution of income in favour of the produc-
tive sector and at the expense of the rentiers will take place, which
should be favourable for real investment, employment and growth.
Furthermore, central banks have to act as a lender of last resort in
periods of liquidity crisis, and central banks should be involved in the
regulation and the supervision of financial markets. This includes the
definition of credit standards for refinance operations with commercial
banks, and the implementation of compulsory reserve requirements for
different types of assets to be held with the central bank, in order to

channel credit into desirable areas and to avoid credit-financed bubbles
in certain markets.
Second, incomes and wage policies should take responsibility for
nominal stabilization, i.e., stable inflation rates. In the end, accelerat-
ing inflation is always the result of unresolved distribution conflicts.
If distribution claims of firms, rentiers, government and the external
sector are constant, nominal wages should rise according to the sum of
long-run economy-wide growth of labour productivity plus the infla-
tion target. A reduction of claims of the other actors, however, would
allow for an increase of nominal wages exceeding this benchmark. In
order to achieve the nominal wage growth targets, a high degree of
wage bargaining coordination at the macroeconomic level, and organ-
ized labour markets with strong labour unions and employer associa-
tions seem to be a necessary condition.12 Government involvement in
wage bargaining may be required, too. In particular, minimum wage
legislation, especially in countries with highly deregulated labour mar-
kets and increasing dispersion of wages, will be helpful for nominal
stabilization at the macroeconomic level, apart from its usefulness in
terms of containing wage inequality. Further deregulation of the labour
market, weakening labour unions, and reductions in the reservation
wage rate by means of cutting unemployment benefits, however, will be
detrimental to nominal stabilization and will rather impose deflation-
ary pressure on the economy.
Third, fiscal policies should take responsibility for real stabilization,
full employment and also a more equal distribution of disposable
income. This has several aspects. By definition the excess of private
saving (S) over private investment (I) at a given level of economic
activity and employment has to be absorbed by the excess of exports
(X) over imports (M) (including the balance of primary income and
the balance of income transfers, thus the current account balance)
plus the excess of government spending (G) over tax revenues (T):
S I = X M + G T. Therefore, with balanced current accounts gov-
ernment deficits (D = G T) have to permanently take up the excess of
private saving over private investment in order to assure a high desired
level of employment.13 As is well known from Domar (1944), a constant
government deficitGDP ratio (D/Y) with a constant long-run GDP
growth rate (g) will make the government debtGDP ratio (B/Y) con-
verge towards a definite value [B/Y = (D/Y)/g].14 Therefore, there will
be no problem of accelerating public debtGDP ratios. Furthermore,
low real interest rates falling short of GDP growth and hence of tax
62 The Euro Crisis
revenue growth will prevent that government debt services redis-

tribute income in favour of rentiers. Permanent government deficits
should be directed towards public investment in a wider sense (includ-
ing increasing public employment), providing the economy with public
infrastructure, and public education at all levels (Kindergartens, schools,
high schools, universities) in order to promote structural change towards
an environmentally sustainable long-run growth path. Apart from this
permanent role of government debt, which also supplies a safe haven
for private saving and thus stabilizes financial markets, counter-cyclical
fiscal policies together with automatic stabilizers should stabilize
the economy in the face of aggregate demand shocks. At the same time,
progressive income taxes, relevant wealth, property and inheritance
taxes, as well as social transfers, should aim at redistribution of income
and wealth in favour of low income and low wealth households. On the
one hand, this will reduce excess saving at full employment and thus
stabilize aggregate demand without generating problems of unsustain-
able indebtedness for private households. Progressive income taxation
and relevant taxes on wealth, property and inheritance thus also reduce
the requirements for government deficits. On the other hand, redis-
tributive taxes and social policies will improve automatic stabilizers and
thus reduce fluctuations in economic activity.
4.2 The Post-Keynesian macroeconomic policy mix applied

to the euro area
Applying the Post-Keynesian macroeconomic policy mix to the euro
area takes place in two steps. In the first step we assume that in the
medium to long run each of the member countries will be able to grow
at a rate consistent with a balanced national current account. Starting
from Thirlwalls (1979; 2002, chapter 5) derivation of the balance of
payments constrained growth rate,15 this growth rate for the single
economy in the euro area is given by:16
b = (1 ) ( pd pf ) + Yf , , < 0, , > 0,
+ +
Yd (1)

where Ybd is the balance of payments constrained growth rate of GDP

for the domestic economy, Y Yf is the foreign GDP growth rate, i.e., the
growth rate of the rest of the euro area since its current account with the
rest of the world is roughly balanced and should remain in balance in
the future, pd is domestic inflation, pf is foreign inflation, i.e., inflation
in the rest of the euro area, is the price elasticity of the demand for
exports, is the price elasticity of demand for imports, is the income

elasticity of the demand for exports and is the income elasticity of the
demand for imports. Disparities in and among countries are consid-
ered to reflect differences in non-price competitiveness. With given for-
eign GDP growth and given foreign inflation, the balance of payments
constrained growth rate of a single economy can be improved by lower
domestic inflation, provided that 1 + + < 0, i.e., the Marshall-Lerner
condition holds, a higher income elasticity of domestic exports, or a
lower income elasticity of domestic imports.
Applying the model to the member countries of the euro area means
that each of the member countries should grow at its balance of pay-
ments constrained growth rate, i.e., avoid current account surpluses and
current account deficits. Each of the countries should also target the
same rate of inflation and thus equalise domestic and foreign inflation.
This is so because a rate of inflation below the foreign rate will mean
a higher balance of payments constrained growth rate of the country
under consideration; it implies, however, a lower balance of payments
constrained growth rate of the other countries of the euro area, because
its current account with the rest of the world is assumed to (and should)
be roughly balanced. Following this rule therefore implies that the
balance of payments constrained growth rate for each of the member
countries becomes:

b = Yf = X .
Y (2)
d

Note that with balanced current accounts within the currency area, and
with equal rates of inflation, GDP growth rates of member countries
may nonetheless differ, depending on the relative income elasticities of
demand for exports and imports. Also note that the improvement of the
balance of payments constrained growth rate of a single country within
a currency area, by means of increasing the income elasticity of exports
or by reducing the income elasticity of imports, has the adverse effect
on the balance of payments constrained growth rate of the rest of the
currency area, because it will mean increasing its income elasticity of
imports and decreasing the income elasticity for its exports assuming
a roughly balanced current account of the currency area with the rest of
the world. One might, therefore, wish to argue that in an ideal currency
union, income elasticities of intra-union exports and imports should be
equal, and the balance of payments constrained growth rate for each
member country should therefore be given by the growth rate for the
64 The Euro Crisis
currency union as a whole, as in equation (3). However, as will be seen

below, we do not apply this requirement for the present euro area.
b = Y
Y . (3)
d f
In order to improve the growth rate of the euro area as a whole, and
thus the balance of payments constrained growth rate for each mem-
ber country, and to provide the conditions and incentives for each
country to grow at a rate consistent with balanced current accounts,
major institutional reforms in the European Union and the euro area
are required.
First, the institutional setting of the ECB and its monetary policy
strategy have to be modified such that the ECB is forced to take into
account the long-run distribution, employment and growth effects of
its policies, and to pursue a monetary policy targeting low real interest
rates. In a first step, an adjustment towards the objectives of the US
Federal Reserve might be helpful, which include stable prices, maxi-
mum employment and moderate long-term interest rates on an equal
footing (Meyer 2001). In its monetary policy strategy the ECB should
refrain from fine tuning the economy in real or nominal terms and
should target low interest rates, such that long-term real interest rates
remain below euro area average productivity growth in the medium
run. This should be conducive to real investment and growth in the
euro area. The ECB should focus on financial market stability. Instead
of the blunt instrument of the interest rate it should introduce those
instruments, which are appropriate to contain bubbles in specific asset
markets in specific countries or regions, i.e., credit controls or asset-
based reserve requirements (Palley 2004, 2010).
Second, the orientation of labour market and social policies towards
deregulation and flexibilization still prevalent in the European Union
and the euro area will have to be abandoned in favour of re-organizing
labour markets, stabilizing labour unions and employer associations, and
euro area-wide minimum wage legislation. This could provide the insti-
tutional requirements for the effective implementation of nominal stabi-
lizing wage policies. Nominal wages should rise according to the sum of
long-run average growth of labour productivity in the national economy
plus the target rate of inflation for the euro area as a whole.17 This would
contribute to equal inflation rates across the euro area, it would prevent
improving the balance of payments constrained growth rate of a single
country at the expense of the rest of the euro area, and it would prevent
mercantilist strategies based on nominal wage moderation in general.
Third, the SGP at the European level has to be abandoned and needs
to be replaced by a means of coordination of national fiscal policies at
the euro area level which allows for the short- and long-run stabiliz-
ing role of fiscal policies. Hein and Truger (2007) have suggested the
coordination of long-run expenditure paths for non-cyclical govern-
ment spending, i.e., those components of spending, which are under
control of the government. Such expenditure paths could be geared
towards stabilizing aggregate demand in the euro area at full employ-
ment levels, and automatic stabilizers plus discretionary counter-cyclical
fiscal policies could be applied to fight demand shocks. In order to avoid
the current account imbalances within the euro area, which have con-
tributed to the present euro crisis, these expenditure paths would have
to make sure of the following: On average over the cycle and the aver-
age tax rate in each member country given, as a first approximation, the
government deficits in each of the countries would have to be roughly
equal to the excess of private saving over private investment in the
respective country; such that the current accounts are roughly balanced
at a high level of aggregate demand and employment (S I = G T), and
GDP growth is close to the balance of payments constrained growth rate
of the individual country. All government debt issued in line with this
principle should be guaranteed by all member states (either in the form
of Eurobonds or by guarantees provided by a European Monetary Fund)
and it should be monetized by the ECB in its refinancing procedures:
The avoidance of external balances is beneficial to the euro area as a
whole; and as long as euro area governments are not indebted in foreign
currency, there is no solvency issue for sovereign debt.
Fourth, attempts at effective macroeconomic ex ante policy coordi-
nation among monetary, fiscal and wage policies at the euro area level
will have to be made in order to contribute to an improvement of euro
area average growth rate with positive feedbacks on the balance of
payments constrained growth rates for each of the member countries.
For this the Macroeconomic Dialogue (Cologne-Process) provides an
institutional basis.18
Fifth, on the global level, the European Union should push for a
return to a world financial order with fixed but adjustable exchange
rates, symmetric adjustment obligations for current account deficit and
surplus countries, and regulated international capital markets in order
to avoid the imbalances that have contributed to the severity of the
present crisis. Keyness (1942) proposal for an International Clearing
Union can be seen as a blueprint for this. As is well known, Keynes
suggested an International Clearing Union in a fixed but adjustable
66 The Euro Crisis
exchange rate system, with the bancor as international money for

clearing operations between central banks, the Clearing Union as an
international central bank financing temporary current account defi-
cits, and selective controls of speculative capital movements between
currency areas. What is most important for the present situation is that,
according to Keynes (ibid.), whereas permanent current account deficit
countries would be penalised in order to contract domestic demand (or
to depreciate their currencies), also permanent current account surplus
countries should be induced to expand domestic demand and thus to
increase imports (or to appreciate their currencies), so that the whole
burden of adjustment does not have to be carried by the deficit coun-
tries. This should give an overall impetus to world aggregate demand
and would therefore increase the balance of payments constrained
growth rates for each of the individual countries, and thus also for the
euro area and its member countries.19
4.3 How to deal with existing (and persisting?) current account

imbalances
As we have shown in Section 2, the basic problem underlying the
present euro crisis are the massive current account imbalances which
have developed within the euro area. Whereas on average over the
period from 19992007, GDP growth in Greece, Ireland, Spain and
Portugal has exceeded their respective balance of payments constrained
growth rates, GDP growth in Austria, Belgium, Germany and the
Netherlands has fallen short of the respective balance of payments
constrained growth rates. From this it follows, that the immediate task
for the member countries is to adjust actual growth to the balance of
payments constrained growth rate.
For the current account surplus countries this means that they should
use expansionary fiscal policies to increase domestic demand and adjust
actual growth to the balance of payments constrained growth rate. This
would lift foreign growth for all the current account deficit countries
and raise their balance of payments constrained growth rate, and would
thus allow the current account deficit countries to reduce their deficits.
For a transitional period, the current account surplus countries should
also increase their rates of inflation relative to the rates of inflation in
the current account deficit countries (equation 1), lowering the bal-
ance of payments constrained growth rate in the surplus countries and
increasing it in the deficit countries. Unit labour cost growth should
therefore exceed the sum of national productivity growth plus the euro
area inflation target during the adjustment process.
The major task for the current account deficit countries, with the
exception of Ireland,20 will be to improve their balance of payments
constrained growth rates. This means, on the one hand, to contribute
to a reduction of the inflation differentials with respect to the surplus
countries, by means of unit labour cost growth below the sum of
national productivity growth plus the inflation target. In order to pre-
vent the risk of deflation in these countries during the process of adjust-
ment, the euro area inflation target should be increased above the rather
ambitious present target of below, but close to 2 per cent for the HICP.
On the other hand, current account deficit countries have to increase
the income elasticity of demand for their exports and to reduce the
income elasticity of demand for imports by means of industrial, struc-
tural and regional policies; this means they have to improve their non-
price competitiveness.21 In fact, export growth in Greece (6.1 per cent
average annual growth in 19992007) and Spain (5.3 per cent) has been
rather dynamic, but imports have grown even more. These countries
would therefore have to reduce their income elasticities of demand
for imports. Italy and also France have had the weakest export growth
(2.8 per cent and 3.8 per cent respectively) among the countries consid-
ered in our study, with import growth exceeding export growth. These
countries would have to focus on increasing the income elasticity of
demand for their export goods. Due to the still considerable negative
balance of goods and services, Portugal should aim at both increasing
the income elasticity of demand for its exports and reducing the income
elasticity of its imports, although export growth has already exceeded
import growth in the past.
Even if these adjustment processes of actual and balance of payments
constrained growth rates in each of the euro area member countries
takes place, we would not expect complete adjustment in the short
or medium run. Growth rates of member countries will differ due to
productivity catch-up processes and it is hard to imagine that these
differences in growth rates will be matched by reverse differentials
in inflation rates or by inverse relative income elasticities of demand
for exports and imports. In other words, it is not very likely that the
more rapidly-growing catching-up countries will have lower inflation,
higher income elasticities of demand for their exports, and lower
income elasticities of demand for imports than the slowly growing
more advanced economies, so that actual growth differentials will be
matched exactly by balance of payments constrained growth differen-
tials. Therefore, current account surpluses and deficits will arise due to
these differentials.
68 The Euro Crisis
Coordinating fiscal policies and government deficits should therefore

take tolerable current account deficits associated with catch-up processes
into account in the short and medium run. With a constant current
account deficitGDP ratio (D Ld /Yd) and constant nominal GDP growth
(Y d), the foreign liabilities-GDP-ratio (Ld /Yd) of a current account deficit
country will be constant, too, i.e., the growth rates of foreign liabilities
and nominal GDP will be equal (Y d =Ld) (see Appendix B):
L d L d
= L = L Y Ld Y
Yd d
d
= d = d . (4)
Ld Ld Yd
Y d
Yd
Provided that nominal GDP growth exceeds the nominal interest rate,
also the foreign debt service-GDP-ratio will not rise. Furthermore, the
higher the (sustainable!) growth trend of the catching up economy, the
higher will be the tolerable current account deficitGDP ratio for a given
maximum foreign-liabilitiesGDP ratio.22 As derived in Appendix B, in
a currency union with a balanced current account with the rest of the
world and therefore with a zero net foreign assets/liabilities position, a
constant net foreign liabilitiesGDP ratio of the current account deficit
member countries will be associated with a rising net foreign assetsGDP
ratio of the current account surplus member countries, provided that
GDP growth in the deficit countries exceeds growth in the surplus coun-
tries. Alternatively, a constant net foreign assetsGDP ratio of the surplus
countries will be accompanied by falling net foreign liabilitiesGDP
ratios of the deficit countries, or net foreign assetsGDP ratios of surplus
countries will be rising and net foreign liabilitiesGDP ratios of deficit
countries will be falling. In other words, provided that current account
deficit countries have a higher growth rate than the surplus countries, it
is impossible for their net foreign liabilitiesGDP ratio to rise.
Sustainably higher growth than the surplus countries on euro area
average should therefore be the ultimate criterion for tolerable current
account deficits in the coordination process of fiscal policies within the
euro area. Current account deficits of countries with a below surplus
country average GDP growth rate, and the related current account sur-
pluses, should not be tolerated and should be tackled symmetrically, i.e.,
by deficit and surplus countries, with the measures discussed above.
Current account deficits will have to be financed by capital imports.
Appropriate financial regulations, avoiding excessive asset price infla-
tion and credit bubbles, are a key prerequisite for sustainable growth,
and for the stability of productivity growth catch-up processes and

the related current account deficits and net foreign liabilities position.
Long-term capital flows as a means of finance of acceptable current
account deficits are therefore most important. Long-term direct invest-
ment may be the most stable and beneficial, but structural effects (and
also the outflow of profits) have to be taken into account (see Ireland!).
If capital inflows are financed by credit, the focus should be on long-
term credit. Therefore, the European Union and the euro area will have
to develop institutions, which take care of the transfer of the current
account surpluses of the more slowly growing mature member countries
to the catching up less developed economies. On the one hand, for this
a European Monetary Fund which guarantees the public debt of the
current account deficit countries meeting the conditions for tolerable
current account deficits (sustainable above euro area average real GDP
growth), and of course also of the current account surplus countries,
and a European Central Bank ready to monetize these liabilities, seem
to be most important. On the other hand, the European Investment
Bank, together with the European regional and structural funds and the
government institutions of the recipient countries, should be involved
in directing the private capital flows into appropriate sectors and areas
which facilitate real catching-up processes and avoid bubbles in certain
sectors (i.e., in housing or financial sectors).
5 Summary and conclusions
In this paper we have analysed the imbalances, which have been built
up in the euro area and which are at the roots of the present crisis,
i.e., the Greek, the Irish and the Portuguese public debt crises and
the related euro crisis which started in 2010. Since the current reform
debate in Europe and the macroeconomic policy measures applied are
still grounded in the theoretical framework of the NCM, the reforms
are likely to fail and create either further deflationary pressure and/
or a resurgence of macroeconomic imbalances. We have, therefore,
described some key ingredients of an alternative macroeconomic policy
model based on Keynesian and Post-Keynesian principles. Having out-
lined the basic principles of a Post-Keynesian macroeconomic policy
approach, we have applied this approach to the euro area. We have
derived that stabilizing wage and expansionary fiscal policies will have
major roles to play in order to cope with the imbalances and to initiate
recovery for the euro area as a whole. Furthermore we have argued that
current account targets will have to play a major role in intra-euro area
70 The Euro Crisis
policy coordination. We have derived a criterion for acceptable current

account deficits, and we have shown that if the criterion is met there
is no reason to assume exploding foreign debtGDP ratios of the deficit
countries. Finally, we have argued that the European Union and the
euro area will have to develop institutions that guarantee the stable
financing of these acceptable foreign deficits and thus a stable transfer
of current account surpluses of the mature, more slowly growing, coun-
tries to the more rapidly growing and catching-up member countries.
Notes
1. For most helpful research assistance we would like to thank Nina Dodig and
Gregor Semieniuk. Earlier versions of the paper were presented at a work-
shop at the University of the Basque Country, Bilbao, in December 2010, and
at the 8th International Conference Developments in Economic Theory and
Policy at the University of the Basque Country, Bilbao, in July 2011. We are
most grateful for the comments by the participants. Remaining errors are,
however, exclusively ours.
2. See the agreements of the meeting of the Economic and Financial Affairs
Council (ECOFIN) on 15 March 2011 (Council of the EU 2011a), the conclu-
sions of the meeting of the European Council (2011) on 24/25 March 2011,
and the statement by the heads of state or government of the euro area and
EU institutions on 21 July 2011 (Council of the EU 2011b).
3. See for example the argument of the German Federal Ministry of Finance
(2011) in the German Stability Programme submitted to the European
Commission and the European Council (2011) in its proposal for the Euro
Plus Pact (see also section 3.2. of this article).
4. For NCM see Goodfriend and King (1997) and Clarida et al. (1999), and for
detailed critiques of the NCM, see Arestis (2009), Arestis and Sawyer (2004a),
and Hein and Stockhammer (2010).
5. See also the agreement of the ECOFIN regarding the reform of the SGP and
the surveillances of economic policies (Council of the European Union,
2011a).
6. The euro Plus Pact also briefly mentions the reinforcement of financial
stability and tax policy coordination.
7. As Priewe (2007) summarises his survey of OCA theories, there are numer-
ous approaches with strong contrasts and contradictions, both among the
early theorists (Mundell, McKinnon, Kenen) and the second generation
theories summarised in the criteria-approach put forward by Tavlas and oth-
ers. The latter is a hybrid approach, paving the way for large and heterogene-
ous unions, albeit with strong shortcomings (pp. 478).
8. For instance, it seems that in the United States, generally considered an
optimal currency union, wage and price flexibility is not much higher than
in Europe, but labour mobility is much higher. Hence, when a particular
region is affected by an adverse shock to output and employment, work-
ers migrate to more dynamic regions with higher growth and employment
(see Blanchard and Katz, 1992; Goodhart, 2007). Another scenario is that
capital mobility may take the place of labour mobility (which for obvious
reasons is limited in the euro area), hence avoiding prolonged external
imbalances across countries: There is no question that a single currency
enhances capital mobility. The hope is that a rise in labour availability
(i.e., unemployment) and constrained wages may make capital flow into
such, previously uncompetitive, regions and thereby restore their pro-
ductivity and growth (ibid., pp. 923); Goodhart (ibid.) also adds: This
prospect seems (to me) unconvincing as the deflationary pressure is likely
to raise political and exchange rate risks, while the unemployed are quite
likely to be less skilled and demotivated (p. 93).
9. We will address the catching-up issue in our Post-Keynesian alternative
policy framework in Section 4 of this paper.
10. For the integration of the macroeconomic policy mix for the euro area
outlined here into a broader Keynesian New Deal in order to tackle and
overcome the world-wide financial and economic crisis see Hein and Truger
(2011). Such a Keynesian New Deal at the European and the Global Level
should include the following pillars: the re-regulation of the financial sec-
tor, the re-orientation of macroeconomic policies and the re-construction
of international macroeconomic policy co-ordination, in particular at the
European level, as well as the introduction of a new world financial order.
11. See Rochon and Setterfield (2007) for a review of Post-Keynesian suggestions
regarding the parking it approach towards interest rate policies of central
banks and the rate of interest central banks should target.
12. See Hein (2002) for a review of the related theoretical and empirical literature.
13. This is, of course, the functional finance view, pioneered by Lerner (1943).
See also Arestis and Sawyer (2004b).
14. A constant government debtGDP ratio (B/Y) requires that government debt
and GDP grow at the same rate g = B/B = Y/Y. Since the government deficit
D = G T = B, if follows that B/Y = (D/Y)/g.
15. See Appendix A for the derivation of the balance of payments constrained
growth rate.
16. McCombie (2002) nicely summarizes the balance of payments constrained
growth model as follow: The central tenet of the balance-of-payments-
constrained growth model is that a country cannot run a balance-of-
payments deficit for any length of time that has to be financed by short-term
capital flows and which results in an increasing net foreign-debt-to-GDP
ratio. If a country attempts to do this, the operation of the international
financial markets will lead to increasing downward pressure on the currency,
with the danger of a collapse in the exchange rate and the risk of a resulting
depreciation/inflation spiral. There is also the possibility that the countrys
international credit rating will be downgraded. Consequently, in the long
run, the basic balance (current account plus long-term capital flows) has to
be in equilibrium. An implication of this approach is that there is nothing
that guarantees that this rate will be the one consistent with the full employ-
ment of resources or the growth of productive potential (p. 15).
17. Quite remarkably, the president of the ECB recently acknowledged the
importance of this wage rule: Thus a medium-term inflation rate of some-
what below 2 per cent over the medium term is the appropriate benchmark
also at the national level. Unit labour costs, and therefore developments in
72 The Euro Crisis
compensation, after having taken due account of the labour productivity

increases, need to be consistent with this in order to avoid a rise in unem-
ployment (Trichet 2011).
18. See Hein and Niechoj (2007), Hein and Truger (2005) and the papers in Hein
et al. (2005) for the deficiencies of macroeconomic policies and macroeco-
nomic policy coordination in the euro area and for an outline of required
institutional reforms.
19. See Davidson (2009, pp. 13442), Guttmann (2009) and Kregel (2009) for a
more detailed discussion of the needs for a reform of the international mon-
etary system, and UNCTAD (2009) for a concrete proposal which, however,
is still incomplete because it does not include capital controls.
20. In the case of Ireland, the current account deficit was not due to a deficit in
external trade but rather a deficit in the flows of primary incomes. Ireland
shows huge surpluses in the balance of goods and services which, however,
fell short of the net payment commitments associated with the negative bal-
ance of primary incomes.
21. Following Thirlwall (2002, p. 78), The only sure and long-term solution to
raising a countrys growth rate consistent with balance of payments equi-
librium on current account is structural change to raise and to reduce .
Remember that is the income elasticity of the demand for exports and is
the income elasticity of the demand for imports.
22. Dullien (2010) and Dullien and Schwarzer (2009) have proposed an External
Economic Stability Pact for the euro area countries allowing for external
deficits or surpluses of 3 per cent of GDP. For deficit countries this would
stabilize foreign debt at 60 per cent of GDP, for surplus countries the foreign
assetsGDP ratio would also become 60 per cent, assuming that trend nomi-
nal GDP growth amounts to 5 per cent. The advantage of this suggestion
is that it includes symmetric adjustment obligations for deficit and surplus
countries. However, the proposed target or threshold ratios would have to
be differentiated for individual countries because tolerable current account
deficits should be based on different growth dynamics. In Appendix B we
also show that with different growth dynamics foreign liabilitiesGDP ratios
of current account deficit countries and foreign assetsGDP ratios of current
account surplus countries cannot be stabilized simultaneously.
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76 The Euro Crisis
Appendix A: Balance of payments constrained growth in a

currency union
Following Thirlwall (2002, chapter 5), we can derive the balance of payments
constrained growth rate in the following way. We start with a current account
equilibrium:
pdXpfeM, (A1)
where pd is domestic prices, pf is foreign prices in foreign currency, e is the

exchange rate, X is the yields from exports, and M is payments for imports (this
ignores primary incomes coming from and going abroad and income transfers).
Equation (A1) in growth rates gives:
p dXpfeM. (A2)
Exports are determined in the following way:
p
X = Q d Yf , < 0, > 0, (A3)
pf e
with denoting price elasticity of demand for exports, income elasticity of

demand for exports, and Yf foreign income. From equation (A3) we get for the
growth rate of exports:
X(p dp fe) Y

Yf (A4)
Imports are given as:
p e
M = R f Yd , < 0, > 0, (A5)
pd
with denoting price elasticity of demand for imports, income elasticity of

demand for imports, and Yd domestic income. From equation (A5) we get for the
growth rate of imports:
M(p fep d)Y

Yd. (A6)
Substituting equations (A6) and (A4) into equation (A2) yields the domestic rate
of growth which is consistent with a current account equilibrium.
b = (1 + + ) ( pd pf e ) + Yf .

Yd
(A7)

Since in a currency union the exchange rate among member countries is fixed,
they all use the same currency, the balance of payments constrained growth rate
for the individual member country becomes:
b = (1 + + ) ( pd pf ) + Yf .

Yd (A8)

Appendix B: Current account imbalances and net foreign

assets/liabilities
In a two-country model net foreign liabilities of the domestic economy (Ld) are
equal to net foreign assets of the foreign economy (Af):
LdAf. (B1)
Current account deficits (surpluses) mean a change in net foreign liabilities

(assets) and hence:
LdAf. (B2)
Dividing equation (B2) by equation (B1), it follows that the growth rate of net
foreign liabilities of the domestic economy has to be equal to the growth rate of
net foreign assets of the foreign economy:
L d A f .
L d = = Af = (B3)
Ld Af
A constant net foreign liabilitiesGDP ratio, or a net foreign-assetsGDP ratio,

requires that net foreign liabilities, or net foreign assets, and nominal GDP of the
respective economy grow at the same rate:
Ld
constant, if LdY
Yd, (B4.a)
Yd
Af
constant, if AfY
Yf. (B4.b)
Yf
Taking into account equation (B3) this means that the constancy of both, the
net foreign liabilitiesGDP ratio of the domestic economy and the net foreign
assetsGDP ratio of the foreign economy requires that the two economies have
to grow at the same rate:
Ld L
and d constant, if LdY
YdAfY
Yf. (B5)
Yd Yd
By definition in a two-country model net foreign liabilities have to grow at the

same rate as net foreign assets. GDP growth rates of the domestic economy and
the foreign economy, however, will not necessarily be equal. If this is the case,
only one country can see a constant net foreign liabilities/net foreign assets
GDP ratio, whereas the other will witness continuously falling or rising net
foreign liabilities/net foreign-assetsGDP ratios. If we assume that the current
account deficit country, the domestic economy, grows at a higher speed than the
current account surplus country, the foreign economy, Y Yd > Y
Yf , either a constant
foreign liabilitiesGDP ratio of the domestic economy will be accompanied by
a rising foreign-assetsGDP ratio of the foreign economy; or a constant foreign-
assetsGDP ratio of the foreign economy will be accompanied by a falling foreign
78 The Euro Crisis
liabilitiesGDP ratio of the domestic economy. Of course, one may also obtain
both, falling foreign liabilitiesGDP ratios of the domestic economy and rising
foreign-assetsGDP ratios of the foreign economy.
From equations (B3), and (B4.a) and (B4.b) we obtain that the net foreign
liabilitiesGDP ratio for the domestic country and the net foreign assetsGDP
ratio of the foreign economy are given as:
L d L d
L d Y Ld Y
Ld = = d = d , (B6.a)
Ld Ld Yd
Y d
Yd
A f A f
= A Y Af Y
A f
f
= f = f . (B6.b)
Af Af Yf
Y f
Yf
With constant current account deficitGDP ratios, or current account sur-

plusGDP ratios, and constant nominal GDP growth rates, the net foreign
liabilitiesGDP ratio, or the net foreign assetsGDP ratio, will converge towards
definite values. As should be clear from the arguments put forward above, this
can only hold for both economies simultaneously if their GDP growth rates are
the same.
3
Debt Sustainability Revisited
Yannis A. Monogios
Centre of Planning and Economic Research, Athens, Greece
Panagiotis G. Korliras
Athens University of Economics and Business and Centre of Planning and Economic
Research, Athens, Greece*
Abstract: After a decades experience for the EMU and based on ongoing
fiscal consolidation plans, a comparative evaluation exercise was con-
ducted for the sustainability of public debt dynamics and that of fiscal
policies pursued in Germany, the Netherlands and Finland (fiscally prudent
economies), against those in Greece, Ireland and Portugal (economies in fiscal
distress). Standard debt sustainability analysis (based on the governments
inter-temporal solvency condition) was complemented with a range of
short and medium term sustainability indicators. In addition, a synthetic-
recursive fiscal sustainability indicator, utilized to assess the sustainability
of past fiscal policies, provided corroborative evidence for the fact that
the policies pursued so far, generated unsustainable and divergent fiscal
outcomes for the economies in the second group, in contrast to the econ-
omies in the first group. Overall, the findings suggest that current fiscal
policies are on an unsustainable trajectory for the economies in fiscal dis-
tress. Although all economies considered in this study need to embark on
a course of fiscal adjustment to some extent, this adjustment seems like a
daunting fiscal exercise for the economies which face severe budget imbal-
ances. Furthermore, based on a number of macro-fiscal and indebtedness
indicators, the analysis also reveals pronounced asymmetries in perform-
ance between the two groups. In terms of convergence, the results indicate
that progress in achieving the Maastricht objectives has been slow, partial
and fragmented and observed only in a small number of EMU economies,
which unlike the rest of the economies examined in the study, were not
characterized by asymmetric macroeconomic disequilibria.
Keywords: Fiscal policy, debt dynamics, debt sustainability, EMU
JEL Classification: H30, H6, H63, H87
79
80 The Euro Crisis
1 Introduction
Over the last decade, explosive debt dynamics in many economies the
world over have become one of the principal sources of policy con-
cern. Many countries with high public debt ratios, mainly as a result of
unsustainable or undisciplined fiscal policies pursued in the past, are
now faced with formidable challenges and need to take decisive and
prompt actions including, but not confined to, sweeping adjustment
policies, stern fiscal austerity measures and deep structural reforms, in
order to regain control of the state budget. Large budget deficits and ris-
ing levels of accumulated public debt constitute direct threats and can
deal a serious blow to short-term macroeconomic stability and longer-
term fiscal sustainability. In the post-2008 era, a gradual shift back to
fiscal prudence, to effectively address downside risks and to rein in
the evolution of state liabilities, is now on the reform agenda of many
economies, especially so in the economies of the Eurozone but also in
the United States.
The effects of high debt and deficits have been explored extensively
in the economics literature and in a growing mass of empirical works
to date. Economic analysis offers many useful insights and advances in
methods are continuously employed to sharpen our understanding of
a changing economic reality. In this respect, frequent re-examination
and reassessment of analyses is warranted, as new developments need to
be taken into account and evaluated accordingly. Moreover, a universe
of satellite issues, such as the institutional framework within which
fiscal policy is conducted, the economys initial conditions, binding
constraints as a result of a participation in a monetary union, etc., have
now been widely recognized as having serious implications for fiscal
performance. These factors offer invaluable insights and thus cannot be
ignored in the overall evaluation of a countrys fiscal performance.
In this connection and in view of the growing debt concerns and
appropriate policies to tackle rising debts and deficits in the EMU, the
objective of the present work is to explore the key issues involved in the
debt sustainability assessment. Specifically, the aim is to conduct a sus-
tainability analysis for a group of selected EMU countries in an effort to
assess whether in the light of recent developments, debt dynamics are on
a sustainable trajectory. Past macro-fiscal performance, indebtedness and
convergence indicators shed additional light in our understanding of the
evolution of key budget variables and thus observed fiscal outcomes.
To this end, we critically review the main approaches developed in the
literature, focusing on the traditional fiscal approach to sustainability
Yannis A. Monogios and Panagiotis G. Korliras 81
which utilizes specific fiscal sustainability indicators.1 The gist here is to

show that using alternative sustainability measures, such as the inter-
temporal budget constraint, the primary gap and the tax gap criteria,
and a synthetic-recursive fiscal sustainability indicator (IFS), the results
obtained cast considerable doubt on ongoing policies in some EMU
countries to yield sustainable fiscal outcomes. As such our results echo
louder calls for fiscal prudence.
This contribution is structured as follows: at the outset, we present
and discuss some theoretical considerations surrounding the issues of
sustainability and solvency. Then, we take stock of the fiscal situation
in selected groups of EMU economies summarizing the evolution of
some key macro-fiscal variables. Next, we provide a critical review of the
standard or traditional analysis of fiscal sustainability and go a step fur-
ther in applying a battery of alternative criteria, in order to assess debt
sustainability in the groups of EMU economies under scrutiny. The final
section briefly summarizes the results and offers concluding remarks.
2 Debt sustainability approaches. Some theoretical

considerations
Public debt sustainability is a controversial issue and for many econo-

mists it remains an uncomfortably vague concept (Wyplosz 2007). It
may, in general, refer to the policies pursued or to the evolution of par-
ticular policy variables, such as various measures of the fiscal deficit or
the public debt or their ratios in relation to output. In public finance the
concept of sustainability is, in essence, rather simple: under current and
projected conditions fiscal policy is sustainable if it can be conducted
ad infinitum, whereas an unsustainable fiscal policy will, sooner or later,
require some adjustment to the budget in terms of (non-interest) expen-
ditures and tax revenues. In this connection, sustainability is a criterion
indicating the possibility of a government to remain solvent in the
present and in the future without the need to resort to abrupt adjust-
ments in the course of fiscal policy. Against this background, the sustain-
ability of public finances is often understood as the situation in which
an economy is able to service its public debt without having to resort to
large, frequent or sudden changes in the revenues and/or expenditures
and without resorting to a perpetual increase in public debt.
The European Commission has adopted a measurable version of
the sustainability of public finances (European Commission 2009). In
that context, sustainability is defined as a situation in which, given
implementation of current economic policy and projected trends, the
82 The Euro Crisis
expenditures and revenues of any member state of the Monetary Union,

should comply with the criteria set out in the Treaty of Maastricht, so
that the resulting (accumulated) debt is lower than 60 per cent of a
countrys GDP. This is the reference value of debt to GDP ratio, so that
the fiscal variables of each member state shall be regarded as sustain-
able in the long term, as defined in this context.2
However, and according to the OECD (2009), fiscal sustainability is a
multidimensional concept that incorporates an assessment of solvency,
stable economic growth, stable taxes and intergenerational fairness
(p. 1). This is a wider set of parameters necessary for the sustainability
of the debt dynamics in the medium-term. In the long term, however,
sustainability should be also assessed against fiscal pressures and risks
associated with demographic changes, global climate change (which
may have non-negligible consequences on the state budget) and con-
tingent government liabilities.
According to the World Bank (Burnside 2005), a parallel concept
of fiscal sustainability relates to a governments ability to indefinitely
maintain the same set of policies while remaining solvent. If a particular
combination of fiscal and/or monetary policies would, if indefinitely
maintained, lead to insolvency, these policies would be referred to as
unsustainable. Thus, one role of fiscal sustainability analysis is to pro-
vide some indication as to whether or not a particular policy mix is sus-
tainable. Debt sustainability, accordingly, is understood as the ability to
manage debts, so they do not grow and impede economic stability and
growth. This has been identified as a perquisite especially for countries
trying to attain the Millennium Development Goals.3 In this framework
debt sustainability serves as an indication of a countrys ability to service
its borrowing, external and domestic, public and publicly-guaranteed,
and private non-guaranteed, including both short-term and long-term
debts, without compromising its long-term development goals and
objectives and without resorting to debt rescheduling or continuous
accumulation of arrears.
The International Monetary Fund (IMF 2002), on the other hand,
has formalized the concept of sustainability in relation to solvency.4
The concepts of sustainability and solvency are closely intertwined.
Solvency is the basis upon which sustainability is structured. In this
framework, the IMFs working definition utilizes the debt criterion as
the main indicator of sustainability. The IMF states that: an entitys
liability position (i.e. the debt) is sustainable if it satisfies the present
value budget constraint (i.e. the solvency condition) without a major
correction in the balance of income and expenditure given the costs
of financing it faces in the market (ibid. p. 5). Nonetheless, the IMF

offers no guidance as to what constitutes a major correction and makes
no value judgment as to the cost of financing. In the IMFs context an
entity is solvent if the present discounted value (PDV) of its current and
future primary expenditure is no greater than the PDV of its current and
future path of income, net of any initial indebtedness (ibid. p. 5).5
Based on the above, sustainability is incompatible with situations of
imminent debt restructuring, such as in situations where the borrowing
government is engaged in Ponzi financing schemes (i.e. the debt keeps
accumulating indefinitely and faster than the borrowing governments
capacity to service it, so that it has to be rolled over through sequential
refinancing), or with situations in which the borrowing government
continues to accumulate debts and to live beyond its means, knowing
however, that major adjustments will be needed at some point in the
future, in order to service its maturing liabilities.
A useful distinction between solvency and illiquidity needs to be
made at this point. According to the IMF an entity is illiquid if, regard-
less of whether it satisfies the solvency condition, its liquid assets and
available financing are insufficient to meet or roll-over its maturing
liabilities (ibid. p. 5). Illiquidity, however, is a quite different condi-
tion, as it relates to the inability, not unwillingness, of a government to
repay its debt obligations due to difficulties in securing available financ-
ing (usually in situations like these, high interest rates prohibit access
of the government to the private capital markets). Liquidity risks may
arise even in the presence of solvency and under certain circumstances
can lead to insolvency. For instance, a government may face a maturity
bunching of loans at a time when there is not enough liquidity (or
access to capital markets is restricted) to meet creditors demands.
Concerns of fiscal sustainability may also arise from circumstances or
events beyond a countrys direct control, such as global incidents (e.g.
financial panics) or external shocks to the economy (unfavorable move-
ments in terms of trade, energy prices hikes, unexpected and sharp vola-
tility in the financial markets due to shifts in investors risk appetites, etc.)
which may affect the budget in unpredictable ways, possibly weakening
the governments capacity to service its debt. Insolvency does not have
to be the underlying factor here but liquidity can be. Under conditions
of this type, high levels of public (or external) debt can be perceived by
the markets as risky and, as a result, a high probability of default may
be attached to the country. This drives sovereign credit spreads and risk
premia on government debt to higher levels, forcing thus rapid debt
accumulation and increased debt interest service. Since maturing debt
84 The Euro Crisis
refinancing may be temporarily impossible in such a case, this may

force a debt default even though the debt is sustainable. Economists refer
to this situation as a self-fulfilling solvency trap (Roubini 2001, p. 2),
where a liquidity crisis may turn into a solvency one.
In economic policy debates sustainability is often treated as a distinct
objective. Regarding fiscal sustainability, the present value budget con-
straint is the starting point and the benchmark against which solvency
is determined. Fiscal sustainability is, in turn, defined in reference to
both static and inter-temporal budget constraints. The static budget
constraint is satisfied if the public sector is able to finance current
expenditures with current revenues plus new borrowing, and thus it
is able to meet (or rollover) maturing obligations; in other words, the
public sector would not be liquidity-constrained. The inter-temporal
budget constraint, on the other hand, is often formulated with respect
to conditions for solvency and imposes a limit on the governments
ability to borrow indefinitely. In this connection, a standard applicable
definition of sustainability which stems directly from the governments
inter-temporal budget constraint is that fiscal policy is deemed sustain-
able if the present discounted value of future primary budget balances
is at least equal to the value of the outstanding stock of debt.6 In other
words, the stream of all future primary surpluses should be sufficient
for the repayment of the sum of the principal debt and accumulated
interest. In more precise technical terms: the current value of debt plus
the present discounted value of expenditures should not exceed the
present discounted value of revenues. It follows that the existence of
debt at present requires that the primary balance should become posi-
tive at some date in the future, in order for the present-value budget
constraint to hold.7
In general, any definition of fiscal sustainability, if it is to be of any
practical usefulness, apart from being theoretically sound, must enable
policy makers to determine concrete fiscal targets. It has been argued
however that in practice the above concepts are rather problematic to
be of practical value for, in effect, they hinge on the assumption of a
credible government pursuing any necessary fiscal adjustment in the
future. The necessity to produce fiscal primary surpluses in the future
implies however that a government may have to follow a highly dis-
tortionary tax policy where high marginal tax rates in the future come
as a consequence of low marginal tax rates in the short run, or may be
that a government has to adopt severe spending reduction measures
in response to excessive spending in the present or most probably, a
combination of both most often accompanied by additional measures
(such as privatizations of state-owned enterprises and/or sale of liquid

state assets). In such a situation, the state budget comes under tremen-
dous stress to generate fiscal outcomes consistent with sustainability.
An analysis of this case goes far beyond mere budget considerations, as
huge budget adjustments call into question the political willingness to
carry out unpopular policies.
Making the sustainability definition operational requires the formu-
lation of certain methodology, analysis and testing. The IMF (2008)
and the World Bank (Bandiera et al. 2007; Ley 2010) have formalized
standard debt sustainability assessment procedures as part of their sur-
veillance and lending operations. The European Commission (2009) fol-
lows suit. Nevertheless, and despite their high degree of sophistication,
sustainability analyses have not managed to escape serious criticism
(Akyz 2007; Wyplosz 2007; Vallee and Vallee 2005).
Debt sustainability analysis (DSA) is now part of the standard fiscal
policy evaluation toolkit. It is often used as an operational instrument
in the assessment of a countrys borrowing path but it also serves as an
(implicit) indicator of the quality of policies pursued and institutions
involved in sovereign debt management. Through standardized for-
ward-looking analysis of debt and debt service dynamics, DSAs facilitate
inferences and comparisons relevant to fiscal performance, most impor-
tantly for countries in risk of debt distress.
Any fiscal or debt sustainability assessment is fundamentally a for-
ward-looking exercise and as such it necessitates the formulation of ad
hoc or subjective views about future economic and fiscal developments.
Since the analyses draw heavily on the course of the future evolution of
policy variables, such as the tax rates or expenditures, as well as on vari-
ables such as growth and interest rates, they are subject to a considerable
degree of uncertainty. The future path of these variables is inherently
unknown so that passing judgments are required on their course of
development over long but finite horizons. Without pretense, uncer-
tainty about the future renders any DSA analysis quasi-probabilistic and
thus the results obtained at best tentative. In this regard, attempts to
trace the implications of a particular set of policies based on forecast
exercises bear considerable risk. On the other hand, stylized assumptions
in modeling the future evolution of key variables (such as constant inter-
est or growth rates) in the sustainability analyses are often a source of
concern for they may offer poor policy insights.
Any sustainability exercise is time and conditions specificc and the results
obtained should be considered with extreme caution for they are as valid
as the underlying assumptions employed in the relevant calculations.
86 The Euro Crisis
Thus, sustainability exercises are constrained by their own nature and

design. This observation forms the basis of the impossibility principle
according to which, debt sustainability is a purely forward-looking
concept; thus, it cannot be assessed with certainty. In that sense, debt
sustainability analysis (DSA) is impossible (Wyplosz 2007, section 2.2,
pp. 67). Attaching probabilities to the range of outcomes from a sus-
tainability analysis seems a possible way out of the impasse, although
extreme caution should be exercised if any sustainability analysis serves
as a tool for policy prescriptions.
The traditional approaches to sustainability suffer from ambiguity or
they have clear limitations (Chalk and Hemming 2000). There are cases
where a particular fiscal policy may be deemed unsustainable although it
may satisfy the present value budget constraint and vice versa. Conversely,
a sustainable policy at present may turn unsustainable in the future.
Evidence, of past sustainability or lack thereof, does not provide any
guarantees about future sustainability. Hence, no definitive statements
can be made regarding sustainability outside the bounds of the analysis
and foreseeable horizon. Attempts however have been made to bridge
the gap between theoretical requirements and practical assessments of
fiscal sustainability. For this reason, a variety of sustainability indicators
with considerable intuitive appeal have been complements to the tradi-
tional sustainability assessments. Over the years, sustainability analyses
have, arguably, become increasingly demanding. Yet adding complexity
and a higher degree of technical sophistication, often at the expense of
transparency, does not seem to have improved the observed gap between
predictions and outcomes (Wyplosz 2007). Simplicity on the other hand,
comes at a cost as well, for it often compromises accuracy.
Based on the above observations, the position adopted in this work is
that a prudent perspective should be maintained in any assessment, in the
sense that any analysis adopted, apart from being realistic, should be
more sensitive to the downside risks rather than the upside ones. This
view is quite justifiable and can be rationalized with reference to the
fiscal implications exacerbated by cyclical asymmetries in the conduct
of fiscal policies under diverse underlying conditions, be it weak initial
fiscal positions, limited fiscal space or chronic deficit-bias (Korliras
and Monogios 2010). This starting point goes well beyond simple
budget concerns and extends to a set of qualitative factors affecting fis-
cal outcomes, mainly the existence of well-designed fiscal frameworks
containing all crucial elements for improved fiscal performance such as
institutions, numerical fiscal rules, budgetary processes and medium-
term budgetary frameworks.
Nonetheless non-negligible considerations of this type should more

appropriately be addressed within a separate framework for assessing
all possible aspects of existing fiscal vulnerabilities (Hemming and
Petrie 2002) before assessing a countrys fiscal or debt sustainability.8
In this connection, a realistic assessment of the initial fiscal position
for instance, should accompany any assessment of the short-term
risks to medium or long run fiscal (or debt) sustainability. Hence, a
country-specific analysis along with a set of different indicators and
their dynamics is of particular importance in identifying key vulner-
abilities to which the country may be exposed in the future. Any single
indicator, as a sole source of sustainability analysis, may prove elusive
or misleading and possibly will not capture the whole spectrum of the
complex relationships underlying the subject of analysis.
In this contribution, and taking into account the host of sustainabil-
ity related issues discussed above, we take stock of the fiscal situation
in two distinct groups of EMU economies; namely a group of fiscally
prudentt versus a group of economies currently under fiscal distress and
conduct a debt sustainability analysis in an attempt to assess whether
in the light of recent developments, debt dynamics are on a sustainable
trajectory. In this context, and in view of the growing debt concerns
and appropriate policies to tackle explosive debt dynamics, the sustain-
ability investigation was based on an analysis which compounds both
the standard technique and a comprehensive set of fiscal sustainability
indicators. This sustainability assessment follows the examination of
some key macro-fiscal, indebtedness and convergence indicators for the
EMU economies under consideration.
3 A decade of fiscal experience in the Eurozone:

A stock-taking exercise
This section provides a brief overview of ten years of fiscal experience

in the Eurozone for a selected group of Eurozone economies. In order to
assess economic developments and progress we resort to a useful set of
macro-fiscal indicators. As we will see below, although all EMU econo-
mies ought to operate in a fiscal manner consistent with the ultimate
aim of convergence to the norms of the Maastricht Treaty, ten years into
the EMU experiment reveal that this goal remains largely unattained.
Based on a taxonomy adopted in a previous work by Korliras and
Monogios (2010), we have chosen to examine a subset of six EMU coun-
tries, which share some common characteristics purely on the grounds
of macroeconomic and fiscal achievements. The aim here is not to
88 The Euro Crisis
provide a compelling justification for the way the numbers evolved the
way they did, but rather merely to depict the main economic develop-
ments by resorting to purely statistical information. For each country
in this study, the effects of the recent economic and financial crisis are
distinctly pronounced in the statistical series from 2008 onwards.
Our taxonomy divides the countries to be examined into two distinct
groups. The first group consists of three fiscally prudent
t EMU econo-
mies, namely Germany (DE), the Netherlands (NL) and Finland (FI). The
second group contains Greece (GR), Ireland (IE) and Portugal (PT) as the
three EMU economies in fiscal distress. The latter economies, currently
under economic surveillance, have recently sought financial support
from the International Monetary Fund, the European Commission and
the European Central Bank due to the insurmountable fiscal challenges
they have accumulated.
Output growth during the last decade has been uneven in the
Eurozone and among the groups under examination, judging from
their relative performance against each other but also against the 16
EMU economies output performance.9 The growth in real GDP has been
smoother albeit lower (on average) in the decade in the first group of
countries than in the second group (with the exception of Portugal).
Both groups experienced a pronounced dip in output growth due to the
impact of the recent financial and economic downturn (2008 onwards).
However, growth has shown signs of rebound in the post-crisis era in
the first group of countries, in contrast to the second group, where the
effects of the crisis have been more pronounced, and thus more difficult
to overcome. Inflation, as depicted by movements in the Harmonized
Index of Consumer Prices (HICP), has been higher (on average) in the
decade in the second group, than in the first and also higher than the
EMU16 average annual rate in the corresponding period.10
Apart from the observed growth imbalances, fiscal progress has been
asymmetric as well, judging from the evolution of the main budget
fundamentals but ultimately from the budget outcomes. Specifically,
regarding total revenues as a per cent of GDP, the average perform-
ance in the decade for the second group of countries has been notably
lower in comparison to that for the first group and against the EMU16
average revenues/GDP of 45 per cent. Revenues underperformance in
the second group of EMU states was matched by lower expenditures/
GDP ratios against the EMU16 average of 47.7 per cent of GDP in the
decade. Government expenditures ratios in the first group of the EMU
countries in our sample, although consistently higher than those in the
second group, were also lower than the EMU16 average expenditure to
GDP ratio as well. In overall budget terms the group of the economies
in fiscal distress recorded a deficit to GDP ratio much higher than the
EMU 16 average of 2.7 per cent.
During the period 2000 to 2010, the group of fiscally prudentt econo-
mies on the other hand recorded, on average, a much lower budget
deficit (which in the case of Finland was actually a surplus which
averaged around 2.9 per cent of GDP) than that in the second group.
However, looking at the primary balance as a ratio to GDP instead (i.e.
the overall balance excluding interest payments as per cent of GDP), the
differences among the groups in the sample are more pronounced. All
countries belonging to the first group have produced primary surpluses
well in excess of the EMU16 average record of 0.5 per cent during the
period 20002010. The second group however exhibited primary defi-
cits throughout the corresponding period.11
Developments in indebtedness are an additional testimony of the
diverging paths followed during the last decade in the selected groups
of EMU economies under scrutiny. There is an apparent recession-
fuelled debt/GDP growth due to the global crisis (notably from 2008
onwards), but this is difficult to ascertain by judging the debt dynamics
in the countries belonging to the second group, where the debt/GDP
was already in an upward trajectory since the early years of the mon-
etary union. This trend is more pronounced however, in the group of
the fiscally prudentt economies. In this group, the debt/GDP ratio was
(and still is) well contained to safe (e.g. Finland) or comfortable levels
(e.g. the Netherlands). In Germany although the debt/GDP fluctu-
ated around the 60 per cent Maastricht benchmark until 2002, it then
started to drift apart, reaching levels around 83 per cent of GDP in the
post-crisis period. From the countries in the second EMU group, Greece
has consistently been an outlier having a high debt/GDP ratio (108.8
per cent on average in the decade),12 well above the EMU16 average of
71.2 per cent. In 2010 Greeces debt stood at 142.8 per cent of the coun-
trys output. Portugal and Ireland had both been good performers half
way through the decade. Nonetheless, these countries breached the 60
per cent Maastricht threshold in 2005 and 2009 respectively, and their
debt/GDP ratios continued on a rising path thereafter. All three econo-
mies in the second group are projected to incur debt ratios in excess of
100 per cent of their output from 2011 onwards.
A class of useful criteria against which fiscal performance can be
evaluated, are various measures of interest payments relative to the
economys output, and to the states revenues and expenditures.
The interest payments/GDP is one measure of the claims of the state
90 The Euro Crisis
budget on national income. Average interest payments/GDP for all the

countries examined here have been well below the 20002010 EMU16
average of 3.2 per cent. A notable exception is Greece where interest
payments/GDP stood on average at 5.3 per cent during that period.
Similarly, the ratio of interest payments/revenues gauges the interest
burden as a proportion of the governments income. The EMU 16 aver-
age during 20002010 has been 7.1 per cent. Again, all economies in
our groups, except Greece, have been below the EMU16 average. The
interest payments/revenues ratio in Greece has been 15.3 per cent on
average in that period.13 Finally, interest payments over expenditures
summarize the cumulative burden from past and current borrowing as a
portion of the general governments total expenditures bill. Against the
EMU16 20002010 average benchmark of 6.7 per cent, all countries per-
formed better (i.e. had lower ratios) with the exception of Greece which
has a record of an average 11.5 per cent interest/expenditures ratio in
the corresponding period. All the above criteria attest to the dispropor-
tional burden of interest expenditures on national income and the state
budget in the economies examined in our sample.
In relation to the above indebtedness criteria, an additional criterion
of convergence according to the Treaty of Maastricht is the evolution of
the long-term interest rates.14 This criterion which tracks developments
in the long-term government bond yields (i.e. the yield on government
bonds with a maturity of ten years), is often used as a benchmark for
the cost of long-term borrowing, and as such it is a useful element to
be taken into account when evaluating the burden on government
liabilities but also progress in terms of convergence within the EMU.
The average cost of long-term borrowing during 20002010 in the EMU
16 has been 4.3 per cent. All economies in the first group enjoyed lower
interest rates relevant to the EMU16 average in this period, as opposed
to the countries in the second group, where the average cost of borrow-
ing had been considerably higher. Greece has been a front-runner in the
group with an average cost of borrowing of 5.21 per cent (that amounts
to 91 basis points higher than the average) in the previous decade.
Ireland and Portugal faced average borrowing costs of 4.61 per cent and
4.56 per cent respectively.
4 Sustainability indicators
The starting point in any sustainability exercise is to define the meth-

odology and the criteria against which sustainability is evaluated.15 As
discussed previously, any fiscal or debt sustainability assessment is time
and conditions specific. The underlying assumptions employed in sus-

tainability testing reflect the quasi-probabilistic nature of the analysis
and determine the outcomes produced.
In this part of the study, and apart from employing standard debt-
sustainability analysis, the sustainability of public finances is also
assessed through a number of sustainability-specific indicators. More
precisely, since fiscal policy is considered sustainable if it satisfies the
inter-temporal budget constraint, or in other words, as long as the
present value of future primary surpluses equals the current level of debt,
we have estimated the magnitude of the primary balance required to sta-
bilize the debt/GDP in its current (2010) levels for both groups of EMU
countries in our sample. Having calculated the debt-stabilizing primary
balance, we then perform a debt target analysis and provide estimates
of the primary balance required to reduce the debt/GDP ratio to a) the
pre-crisis 2007 debt level (within a period of ten years), and b) to the
Maastricht benchmark level of 60 per cent (within the next 20 years).
Several sustainability indicators are introduced and discussed next.
We first calculate the so-called primary gap indicator for sustainability,
which is a measure of the distance between the debt-stabilizing primary
balance or simply, the sustainable balance from the current period
primary balance. This indicator provides useful information as to the
magnitude of the adjustment needed for fiscal stabilization. However,
despite its attractiveness, this indicator does not provide any insights as
to how the required adjustment should come about (i.e. what mix of
revenues/GDP or expenditure/GDP needs to be adjusted in the future).
A set of complementary indicators are thereby introduced in an
attempt to partially address the above concern. We provide estimates for
the class of the tax gap short- and medium-term sustainability indicators.
Given the projected course of expenditure/GDP, the tax gap expresses the
difference between the sustainable i.e. the debt-stabilizing revenues/
GDP ratio from its current level. The notion of the sustainable tax ratio
is analogous to that of the sustainable (i.e. debt-stabilizing) primary
balance. Since the sustainable tax ratio can ensure financing of future
spending, we first estimate the sustainable tax ratio for the year 2011 as
the basis for the calculation of the short-term tax gap (i.e. the difference
between the sustainable tax ratio in 2011 minus the actual tax ratio in
2010). This indicator shows the magnitude of the adjustment needed in
terms of revenues/GDP to achieve debt sustainability.16 Based on certain
assumptions for the evolution of growth and the interest rates and given
the future course of expenditures/GDP, we then provide estimates for
the sustainable tax ratios up to 2016, which allows calculations of the
92 The Euro Crisis
medium-term tax gap indicators, along the same line of reasoning. The
medium tax gap indicator is considered a more appropriate criterion for
signaling the magnitude of the required fiscal corrections further in the
future and thus it is more relevant to policy planning.
Sustainability indicators are, as a rule, forward looking, in the sense
that they have been applied in a forward-looking manner. However,
an innovation of this paper is that, instead of focusing exclusively on
the necessary budget adjustments dictated by the evolution of the key
variables in the future, it attempts to also evaluate sustainability of past
policies by applying a synthetic-recursive indicator of sustainabilityy (IFS)
proposed by Croce and Juan Ramon (2003). This ex-post indicator of
fiscal sustainability,
y which is based on the standard law of motion of
the debt/GDP (see Ley 2010), where applicable, conveys useful informa-
tion on whether past policies have been conducted in a manner consist-
ent with fiscal policy sustainability objectives. The attractive feature of
this indicator is that it is based on an algorithm that does not require
estimation of future output growth or interest rates. It generates results
based on past, current and target values of the variables involved in its
calculation. However, the IFS is more of a monitoring device rather than
a pure criterion for fiscal sustainability.17
All sustainability indicators signify the need for fiscal policy
readjustment. Their usefulness however, is summarized in their ability
to convey reliable signals of future fiscal imbalances and their impor-
tance rests on the necessity to take corrective policy actions to pre-
vent deterioration of the budget. In practical terms, they indicate the
magnitude of the fiscal correction required to achieving the set policy
targets, but their mechanistic use as a policy prescription tool should be
avoided. Although highly relevant to policy making, these indicators do
not always provide adequate answers as to what kind of adjustments are
fiscally feasible and/or politically or socially desirable. In other words,
they indicate what needs to be done, but not how.
However, any sustainability analysis must adopt some kind of estima-
tion or forecasting regarding the evolution of growth and the interest
rates, or it can rest on plausible assumptions about the course of devel-
opments of the variables employed in the analysis.
5 Assessing sustainability
In this section we follow the standard methodology to test for the sus-
tainability of public finances in the groups of EMU economies discussed
in the previous part. Within the inter-temporal budget constraint
framework we test for sustainability by first estimating the primary bal-

ance required to stabilize the debt/GDP ratio in its current, pre-crisis
and the Maastricht 60 per cent level, under three alternative scenarios,
where different pair-wise values for various interest rate/growth rate
combinations are employed in each scenario.
In the first scenario, termed the base case scenario, we have calibrated the
baseline path of exogenous variables in line with current projections and
past averages modified by standard statistical assumptions. Specifically,
the growth rate of GDP used in the calculations and presented in this
scenario, follows the IMFs official projections for 20102016.18 In this
case, we have calculated the projected average GDP growth rate over
the corresponding period and have used it in our baseline analysis. In
the absence of relevant forecasts, the interest rate variable has been con-
structed as the 10-year historical average (20002010) plus one standard
deviation from the mean.
The second scenario is a favorable one and it is termed the optimistic
scenario. Here the growth rate of GDP is calibrated as before but, in addi-
tion, it has been positively shocked by half a standard deviation over
the projected average value for 20102016. Interest rate in this scenario
follows the same path as explained in the base case scenario, amplified
however, by half a standard deviation.
Finally in the third case, labeled the conservative scenario, the average
projected value for 20102016 of real GDP growth is shocked negatively
by one-fifth of its standard deviation, whereas the corresponding inter-
est rate is higher than its historical average by one and a half standard
deviation points.
Table 3.1 summarizes the assumptions made in the corresponding
scenarios.
History is, in general, an inadequate/inappropriate guide to the
future, and the assessment of the realism of projections may need to
Table 3.1 Assumptions adopted in the analysis
Base case Scenario Optimistic Scenario Conservative Scenario

Growth Average over Average over Average over
rate ((gg) 20102016 IMF 20102016 IMF 20102016 IMF
projections projections + projections 15
standard deviation standard deviation
Interest Average of historical Average of historical Average of historical
Rate (r)
r path over 20002010 + path over 20002010 + path over 20002010 +
1 standard deviation standard deviation 1 standard deviation
94 The Euro Crisis
take into account other factors such as the impact of regime changes19
and/or the interdependence between fiscal variables, growth and inter-
est rates.20 However, in this kind of budget accounting exercises, it is
important always to keep in mind that future values of key variables
determining debt/GDP sustainability are fundamentally uncertain, thus
implying many sources risk for the validity of outcomes.21
The results of the standard sustainability analysis along with the
results for the corresponding primary gap indicators (Tables 3.2, 3.3
and 3.4) are summarized next (under the heading debt-target analysis).
Table 3.5 presents the results as calculated for the sustainable tax ratios
from 2011 to 2016 and Tables 3.6 and 3.7 document the short and
medium tax gap indicators respectively. Finally, Table 3.8 reports the IFS
indicator for the past five years (20062010).
Turning to Table 3.2, under the base case scenario, the primary surplus
required to sustain the debt/GDP at the 2010 level in the countries in
our sample, ranges from 0.64 to 4.71 percentage points of GDP. This is
a first indication of the varying degrees of fiscal effort required in dif-
ferent EMU economies. The effort is a function of the current debt/GDP
level among other things. The higher the debt/GDP, the higher the fis-
cal effort, i.e. the higher the primary surpluses required to stabilize the
debt/GDP ratio. Countries such as Greece and Ireland have to put in
place ambitious fiscal consolidation plans, in order to maintain a debt/
GDP ratio at current levels.
Comparing the results of the base case scenario with the correspond-
ing ones in the optimistic scenario (Table 3.3), one can observe that the
fiscal effort required for debt sustainability at the 2010 level, is con-
siderably lower (almost one-third in most cases, compared to the base
case scenario), mainly due to the positive impact of higher growth.
However, the situation becomes worrisome, if the conservative scenario
materializes (Table 3.4). In this instance, where growth is lower and
the interest rates are higher, the fiscal effort required almost doubles
in intensity. In this scenario, the second group of economies, needs to
embark in deep and profound consolidation programmes, in order to
control their debt/GDP at the 2010 level, otherwise the debt/GDP ratio
will continue to increase at explosive rates. However, it is evident in all
calculations of this sort (Tables 3.2, 3.3 and 3.4) that all the countries
in our sample need to generate primary surpluses in order to contain
rising debt dynamics.
The primary gap indicator estimated for each scenario provides a more
accurate picture of the fiscal distance needed to be covered when tak-
ing into account the budget outcome of the current year. In all three
Debt target analysis
Table 3.2 Base-case scenario
Base Case Scenario T
Debt as % of Growth/interest pb* = Primary pb** = Primary
GDP rate scenarios Surplus Surplus required
based on required for for the reduction of
projections the Debt/GDP to Target-
for 20102016 stabilization levels
of Debt/GDP
to 2010 levels
Country 2007 2010 Growth Real Int. pre-crisis Maastricht Primary gap
rate, g Rate, r 2007 debt level, indicator
debt b* = 60% as % of
level T=20 GDP
T=10
Germany 0.649 0.832 0.0208 0.042 1.722 3.729 2.130 Germany 2.612
Netherlands 0.453 0.627 0.0165 0.029 0.784 2.685 0.935 Netherlands 4.206
Finland 0.352 0.484 0.0247 0.038 0.645 2.083 in target Finland 2.025
Greece 1.054 1.428 0.0048 0.038 4.718 8.677 7.736 Greece 9.654
Ireland 0.250 0.962 0.0193 0.065 4.274 10.98 5.375 Ireland 33.43
Portugal 0.683 0.930 0.0053 0.032 2.428 5.649 3.757 Portugal 8.564
Notes: T real gdp growth projections are based on the average of the 20102016 available IMF projections. Interest rate projections are based
on calculations of historical data plus one st.dev. of historical average.
Source: Authors calculations.
95
96
Debt target analysis (cont.)
Table 3.3 Optimistic scenario
Optimistic Scenario T
Debt as % Growth/interest pb* = Primary pb** = Primary
of GDP rate scenarios Surplus Surplus required
based on required for for the reduction of
projections for the Debt/GDP to
20102016 stabilization Target-levels
of Debt/GDP
to 2010 levels
Country 2007 2010 Growth Real Int. pre-crisis Maastricht Primary gap
rate, g Rate, r 2007 debt debt level, indicator
level b*= 60% as % of
T=10 T=20 GDP
Germany 0.649 0.832 0.025 0.036 0.966 2.920 2.074 Germany 1.855
Greece 1.054 1.428 0.020 0.029 1.333 5.434 5.310 Greece 6.268
Ireland 0.250 0.962 0.028 0.046 1.775 9.165 3.370 Ireland 30.93
Notes: T real gdp growth projections are based on the average of the 20102016 available IMF projections plus 1/2 st. dev. Interest rate
projections are based on calculations of historical data plus 0.5 st.dev. of historical average.
Debt target analysis (cont.)
Table 3.4 Conservative scenario
Conservative Scenario T
Debt as % Growth/interest pb* = pb** = Primary
of GDP rate scenarios Primary Surplus required
based on Surplus for the reduction of
projections for required Debt/GDP to
20102016 for the Target-levels
stabilization
of Debt/GDP
to 2010 level
Country 2007 2010 Growth Real Int. pre-crisis Maastricht Primary

rate, g Rate, r 2007 debt debt level, gap indicator
level b*= 60% as % of
T=10 T=20 GDP
Germany 0.649 0.832 0.019 0.047 2.296 4.290 3.220 Germany 3.186
Greece 1.054 1.428 0.001 0.047 6.844 10.72 9.260 Greece 11.78
Ireland 0.250 0.962 0.016 0.083 6.314 12.52 6.970 Ireland 35.47
Notes: T real gdp growth projections are based on the average of the 20102016 available IMF projections minus 1/5 st. dev. Interest rate
projections are based on calculations of historical data plus 1.5 st.dev. of historical average.
97
98 The Euro Crisis
scenarios, the estimated primary gap indicators have a positive sign,

signaling that fiscal policy needs to be readjusted in order to generate
sustainable outcomes. In the base case scenario (Table 3.2) for exam-
ple, Greece and Portugal have quite a long way to go in the direction
of fiscal consolidation (Ireland is different in this respect, due to an
unexpectedly sharp increase in the budget deficit, experienced between
2007 and 2010, following the economic and banking crisis). In the first
group of countries however, the adjustment in terms of primary surplus
is considerably lower, since the distance between the debt-stabilizing
primary surplus and the current value of the actual primary surplus
in 2010 is much lower.22 The primary gap indicators in the optimistic
and the conservative scenarios (Tables 3.3 and 3.4 respectively) sug-
gest proportional, although quite sizeable adjustments in the primary
budget respectively. However, the primary gap is a rather short-sighted
indicator of sustainability, since it measures the distance between the
current years primary balance from its sustainable level. The current
years budget outcome however, may not be indicative of past budget
performance.
Based on the assumptions adopted for GDP growth and the interest
rate, calculations for the debt-reducing primary surplus (Tables 3.2, 3.3
and 3.4) provide an additional indication of the fiscal distance needed
to be covered, in ten and 20 years, in case where the debt target is set
to the pre-crisis 2007 debt level and to the Maastricht debt level respec-
tively, in all three scenarios.
In the optimistic scenario (Table 3.3) for instance, and assuming that
the debt/GDP target is fixed at the pre-crisis level in each country,
the primary surpluses necessary to achieve this target range from
1.7 percentage points of GDP in the first group of countries to 9.1
percentage points in the second group. However, the suggested primary
surpluses need to cover the whole period of ten years.
Similarly, if the debt target to be achieved in a time span of 20 years
is set to the level required by the Treaty of Maastricht (i.e. 60 per cent
of GDP), then fiscal policy in the economies examined will have to
endure very long and substantial adjustments, especially so in the
economies already under fiscal distress. In this group, the initial debt/
GDP level is very distant from the debt target, thus making an effort
of this sort quite an excruciating fiscal exercise. Greece, Ireland and
Portugal all have debt/GDP ratios close to or well in excess of 100 per
cent, meaning that is next to impossible to reduce their debt burden
to the 60 per cent reference Maastricht benchmark in the foreseeable
future.
The crux of the above exercise was not to provide precise numerical
results, but rather to put the emphasis on the fiscal effortt necessary for
debt stabilization/reduction, as well as on the disproportional implica-
tions for budgetary policy in the EMU countries under consideration.
The sensitivity of the primary surplus to alternative growth-interest rate
combinations is a key factor determining the outcomes. In all cases,
the numbers point to one direction: that of inevitable and long-lasting
fiscal adjustments. This in turn, implies that severe fiscal retrenchment
(both tax hikes and spending cuts) and prolonged austerity programs
will eventually be needed to ensure sustainability of public finances.
Even though, economic history provides several examples of successful
fiscal consolidation episodes,23 large and long-lasting adjustments tend
to be associated with lower success rates. Apparently, any delays in the
adjustments required can only come at a higher economic and social
cost in the future.
Tables 3.5, 3.6 and 3.7 next, present the results from the calculations
of the sustainable tax ratio (necessary to sustain the debt/GDP in its
current level), the sort run tax gap, as well as the medium term tax gap
indicators.
Given the debt/GDP levels currently prevailing and the projected
trends regarding expenditures/GDP, Table 3.5 provides the estimates
for the sustainable tax ratios from 2011 to 2016 for each EMU economy
in this study. Figures 3.1 and 3.2 provide visual representation of the
results. The sustainable tax ratio depicts more accurately the magnitude
of fiscal adjustment than the sustainable primary surplus, since the
future evolution of public spending is taken into account in the relevant
calculations. A sustainable tax to output ratio offers an indication of
the changes in future tax and spending policies necessary to stabilize
Table 3.5 Sustainable tax ratios in selected EMU economies (20112016)
2010 * 2011 * 2012 * 2013 * 2014 * 2015 * 2016

Germany 43.30 44.06 45.36 45.21 44.97 45.02 44.92
Netherlands 45.91 48.85 48.95 48.69 48.45 48.28 47.96
Finland 52.33 55.17 55.65 55.71 55.62 55.56 55.53
Greece 39.07 43.45 46.59 43.99 42.27 40.13 38.81
Ireland 34.61 54.68 54.86 51.74 49.13 47.35 46.20
Portugal 41.53 44.12 46.96 45.36 45.06 44.67 44.50
Notes: * Sustainable tax ratio ( *) necessary to stabilize the debt/gdp at the 2010 level.
100 The Euro Crisis
Germany Netherlands Finland
55.0
50.0
45.0
40.0
*2011 * 2012 * 2013 * 2014 * 2015 * 2016
Figure 3.1 Sustainable tax ratios for Germany, Netherlands and Finland
Greece Ireland Portugal
60.0
50.0
40.0
30.0
*2011 * 2012 * 2013 * 2014 * 2015 * 2016
Figure 3.2 Sustainable tax ratios for Greece, Ireland and Portugal
the debt/GDP ratio at current levels. For all countries in our sample
the sustainable tax ratios up to 2016 are higher than the current ratios.
A notable exception is Greece, where the current tax ratio exceeds the
value of the corresponding sustainable ratio in 2016. Strictly speaking
this is not to be perceived as a signal that current tax policy ensures that
no adjustments will be required in the future. This indicator only tells
us, at a given point in time, how far the current tax policies are from
those required for debt sustainability.
Table 3.6 reports the calculations of the corresponding one year short-
term tax gap. Given current (and projected) spending policies, a positive
value for this indictor suggests that the current level of taxes is too
low for debt sustainability. The short term tax gap in the countries
Table 3.6 Short-term tax gap indicator in selected EMU economies

(20112010)
One-year (Short term) Tax gap indicator as % of

GDP
Germany 0.75
Netherlands 2.94
Finland 2.84
Greece 4.38
Ireland 20.06
Portugal 2.59
examined here, runs a wide gamut (from 0.75 to 20.06 percentage

points), indicating that the current tax ratios have to be tuned to higher
levels in all countries, judging from the magnitude of the sustainable
tax ratio in 2011.24
Again, owing to its very short-term nature, and similarly to the
primary-gap indicator, the one year tax gap may prove quite misleading
in signaling the magnitude of the adjustment that would reasonably
be required. Besides, one year is quite a short period of time to imple-
ment any credible consolidation plan. This prompts us to construct
forward-looking medium term tax gap indicators up to the next five
years, for they transmit more reliable signals about the magnitude of
the required change in fiscal policy over the medium term. Table 3.7
reports the medium term tax gap indicators for the economies under
scrutiny, while Figures 3.3 and 3.4 illustrate the corresponding values
of the indicators. All medium term tax gap indicators are positive con-
firming thus, the previous findings and take values that range from
almost a percentage point to double digit numbers throughout that
period. However, it is interesting to note that the magnitude of the cor-
responding tax gaps is diminishing over time. In the case of Greece we
note that the value of the medium term tax gap 20162010 is negative.
This outcome follows logically since the sustainable tax ratio in 2016 is
lower although marginally than the corresponding one in 2010 for
Greece. This conveys a signal that if expenditures to GDP continue on
their projected course, current tax policies will eventually converge to
the debt-stabilizing tax ratios.25
As in the case of the primary indicators, tax gap indicators provide
complementary insights as to how far current fiscal policies depart from
sustainability. The results from the computation of the various tax gap
102 The Euro Crisis
Table 3.7 Medium-term tax gap indicators in selected EMU economies

(2012/2010 2016/2010)
tax gap tax gap tax gap tax gap tax gap
2012 2013 2014 2015 2016
Germany 2.06 1.90 1.67 1.72 1.62
Netherlands 3.04 2.78 2.53 2.36 2.05
Finland 3.32 3.38 3.28 3.23 3.19
Greece 7.52 4.91 3.20 1.06 0.26
Ireland 20.24 17.13 14.52 12.73 11.59
Portugal 5.42 3.83 3.52 3.14 2.97
Germany Netherlands Finland
4.0
3.0
2.0
1.0
0.0
Tax gap Tax gap Tax gap Tax gap Tax gap
2012 2013 2014 2015 2016
Figure 3.3 Medium-term tax gap indicator for Germany, Netherlands and
Finland
indicators suggest, that future policy adjustments are rather demand-

ing, especially so in the economies currently under fiscal distress.
Adjustments in fiscal policy are pronounced and more imperative in
that group of countries, as opposed to those economies who have a
record of fiscal prudency.
As a last exercise, we have calculated a synthetic-recursive indicator of
fiscal sustainabilityy (IFS), proposed by Croce and Juan-Ramon (2003)
for a selected sub-sample of countries in our groups.26 Contrary to the
signals transmitted for future fiscal policy by the forward-looking indi-
cators calculated so far, this indicator is used in our framework to assess
consistency of past fiscal policies with sustainability objectives. In our
Greece Ireland Portugal
22.0
12.0
2.0
8.0
Tax gap Tax gap Tax gap Tax gap Tax gap
2012 2013 2014 2015 2016
Figure 3.4 Medium-term tax gap indicator for Greece, Ireland, Portugal
analysis, an attempt has been made to evaluate those policies for the
past five years (i.e. from 20062010).
Calculations of this indicator require, apart from the baseline assump-
tions on growth and interest rates, corresponding calculations of the
debt-stabilizing primary surplus (estimated previously) and a debt
target, which in the case of the EMU economies is the Maastricht debt
level of 60 per cent of GDP. What is of importance, however when
assessing the IFS, it is not its absolute values but values that depart from
unity, which is the threshold-test level. Values around unity signify that
future debt/GDP levels will, other things being equal, be maintained at
around their current levels. When the IFS takes values over unity, con-
sistently and for many successive periods, this signals that current (past)
policies produce fiscal outcomes that diverge from the target and thus
fiscal policy is deemed unsustainable. Convergence on the other hand,
is attained when the IFS takes negative values.
The usefulness of this indicator is that it complements the previ-
ous analysis on sustainability, while assessing progress in terms of
convergence to the debt target. Table 3.8 and Figure 3.5 report and
graphically illustrate the results from the relevant calculations. All
values of the IFS were positive for the countries examined during the
20062010 period. However, a closer inspection reveals that in the
case of Germany the IFS value has been lower than unity throughout
this period, with the exception of 2009, where the effects of the crisis
were more pronounced. The implication is that fiscal policies in the
past five years in Germany were deemed as consistent with the aims of
104 The Euro Crisis
Table 3.8 IFS synthetic-recursive indicator for selected EMU economies

(20062010)
2006 2007 2008 2009 2010

Germany 0.844 0.567 0.684 1.791 0.989
Greece 0.933 0.979 1.117 1.334 1.290
Portugal 1.442 0.862 1.302 2.013 1.376
Greece Portugal Germany
2.50
2.00
1.50
1.00
0.50
0.00
06 07 08 09 10
20 20 20 20 20
Figure 3.5 IFS synthetic-recursive indicator for Greece, Portugal and Germany
sustainability and convergence. Nevertheless, this does not seem to be

the case for Greece and Portugal were the IFS values exhibit a diverg-
ing trend, only reversing in 2010. This signals that policies pursued
in the past five years did not manage to produce sustainability and
convergence consistent outcomes, and as a result fiscal corrections
needed to be initiated.27
The results obtained from the entire sustainability analysis performed

above are summarized in Table 3.9. Overall, the results reported are
rather clear and simple and they confirm customary intuition. The need
for minor or moderate fiscal adjustment is present in the first group of
economies (Germany, Netherlands and Finland) without posing, how-
ever, any serious threat to the sustainability of their public finances.
Table 3.9 Summary of sustainability indicators for selected EMU member states
Fiscally Prudent Economies Economies in Fiscal Distress
Germany Netherlands Finland Greece Ireland Portugal
Sustainability Fiscal adjustment required for sustainability of debt/GDP at

Indicator current levels *
1. Debt Stabilizing minor minor minor major major moderate

Primary surplus
(base case scenario)
2. Debt Reducing moderate minor in target major major major
Primary surplus
(base case scenario,
Maastricht level)
3. Primary Gap moderate major minor major major major
Indicator (base case
scenario)
4. Short term Tax minor moderate moderate major major moderate
Gap Indicator
5. Medium term minor moderate moderate major major major
Tax Gap Indicator
6. IFS Indicator minor n/a n/a major n/a major
Overall minor minor minor major major major
Assessment
Notes: * minor fiscal adjustment: less than 2 per cent of GDP; moderate fiscal adjustment: between
23 per cent of GDP; major fiscal adjustment: over 3 per cent of GDP.
Enduring sustainability is a fiscal policy objective served well so far in

the countries of the first group. The fact that the debt/GDP ratios in this
group, fluctuated at low or comfortable zones throughout the past decade,
should not make room for complacency. It provides, however, some com-
fort to future fiscal policy, although other factors not examined here, such
as the governments contingent liabilities stemming from country-specific
demographic and social dynamics, are expected to uplift the challenges to
economic policy in the future in all countries studied in this work.
Under current conditions, fiscal policies in Greece, Portugal and
Ireland are deemed unsustainable.28 This is reflected in their budget
fundamentals (i.e. revenues and expenditures trends) and in the rising
trends in their debt/GDP ratios. It was also suggested by all sustainabil-
ity indicators presented in the analysis. Moreover, being constantly in
breach of the Maastricht convergence criteria, these countries have not
managed to cover the ground required for convergence to the Unions
targets. Unsustainability of budget policies in the present will inevitably
lead to huge, unpopular and possibly abrupt adjustments in the path
106 The Euro Crisis
of future fiscal policies, which will call into serious question economic
feasibility, political willingness and social tolerance.
Consequently, a return to fiscal prudence (as set in the Maastricht
Treaty) and the adoption of active budget and debt stabilization poli-
cies are urgently needed in the above economies of the currency union,
which are threatened by severe asymmetric macroeconomic disequi-
libria. It turned out that these disequilibria which stem, inter alia, from
asymmetric features of undisciplined past fiscal policies (such as fis-
cal laxity and deficit-bias in good times) have resulted in rapid debt
accumulation in the recent years. In the face of these and forthcoming
challenges the countries with serious budget imbalances, now have
an opportunity to re-consider their budgetary frameworks in terms
of taxing and spending and in terms of a more prudent and effective
debt management, with a view to maximize growth potential, reduce
macro imbalances and fiscal asymmetries and to better stir their course
towards convergence to the EMU targets (Korliras and Monogios 2010).
At the same time, an apparent need to allocate resources in a more
efficient and forward-looking manner will also contribute to improved
fiscal balances, bridging at the same time the observed gap with the best
performing economies in the monetary union.
The results presented leave little room for doubt: the countries with
a sound fiscal record need to take minor-to-moderate corrective fiscal
actions to adjust their future fiscal policy in order to ensure sustainability,
as opposed to the countries with a chronic record of budget imbalances,
which have a long way to move towards that direction. Asymmetric fiscal
performance among those two groups has resulted in a diverging path
from the Maastricht objectives of fiscal convergence in the Eurozone. At
the margin, one conclusion is that after a decade of experience in the
EMU, it becomes more evident now that the existence of time-invariant
fiscal targets (as those set out in the treaty of Maastricht and the Stability
and Growth Pact), and in the absence of operational fiscal governance
rules, seem to have failed to promote fiscal consolidation.
For one thing, persistent budget deficits and rising debt/GDP ratios in
many EMU economies, if not addressed holistically, timely and effectively
and in a well-coordinated manner, they will continue to pose a growing
challenge for the long-term sustainability of EMU public finances.
Notes
* Yannis A. Monogios is Research Fellow at the Centre of Planning and
Economic Research, Greece, and Panagiotis G. Korliras is Professor at the
Athens University of Economics and Business and Scientific Director of the

Centre of Planning and Economic Research, Athens, Greece. A preliminary
version of this work has been presented in the 8th International Conference
on Developments in Economic Theory and Policy,
y held in Bilbao (Spain), 29
June1 July 2011. The authors would like to thank Professors P. Arestis and
M. Sawyer for their valuable comments. The usual disclaimer applies.
1. The menu of alternative sustainability analyses is quite extensive. Apart from
the traditional fiscal sustainability approach based on the governments
inter-temporal budget constraint examined in this work, there is the exter-
nal sustainability analysis (IMF 2008; World Bank 2006; IMF & IDA 2004;
Ley 2010; Borensztein et al. 2010), the debt overhang analysis (Krugman
1988; Cassimon et al. 2008), the Sudden Stop Approach (Edwards 2004), the
probabilistic approach to fiscal sustainability (Celasun et al. 2006; Mendoza
and Oviedo 2003), the Human Development Approach (Sachs 2002) and
numerous econometric approaches to debt sustainability (Hamilton and
Flavin 1986; Bohn 1991, 1995, 1998; Arestis et al. 2004), etc.
2. The Treaty of Maastricht (Article 109 j (1)) provides that the Sustainability
of Public Finances is a criterion for accession to the European Monetary
Union. Article 104 c (2) and defines the criteria against which sustainability
is assessed by direct reference to the ratios of deficit and debt to GDP. The
Protocol for the Excessive Deficit Procedure sets the reference values to
3 % and 60 % for the budget deficit and the public debt respectively. These
reference values constitute the first numerical approach to the sustainability
of Public Finances. Sustainability in this context, is defined as the non-
violation of the arbitrarily defined reference values of the Treaty.
3. See the World Bank website: http://www.worldbank.org
4. The IMF conducts analyses of three distinct aspects of sustainability:
overall external sustainability, fiscal sustainability, and financial sector
sustainability. However, in this work we are concerned only with fiscal
sustainability.
5. According to the European Commission (2011): The concepts of sustain-
ability, solvency and ability to access, or return to markets are often used
interchangeably as if they were synonymous. Sustainability may be defined
as the capacity of a government (or more generally of any entity) to continue
current policies. Such a concept, however, is not the one that matters:
what is relevant is to assess whether a government is able to effectively
implement expenditure and revenue policies, and privatization, which
ensure the government debt enters a steadily declining path, under the pro-
jected growth and interest rates. If a government is able to implement the
policies that reduce the debt-to-GDP ratio, then the government is solvent.
Thus, solvency depends on the political and social conditions which allow
or not the implementation of the required policies (p. 28). In this respect,
fiscal consolidation is a precondition to solvency and sustainability, but it
alone, cannot guarantee access to markets.
6. The analytics of the inter-temporal budget constraint are essentially the
same in the cases of external and fiscal sustainability. In the former, external
debt is associated with the evolution of the primary current account balance,
whereas in the latter, public debt is associated with the evolution of the
primary budget balance.
108 The Euro Crisis
7. For a formal treatment of these and the rest of the concepts in this contribu-
tion see Appendix: An analysis of public debt dynamics.
8. According to the IMF (2002) vulnerability is the risk that the liquidity or
solvency conditions are violated and the borrower enters a crisis. However,
the IMF is lately considering integrating vulnerabilities associated with the
debt profile (debt structure and liquidity issues) into the DSA (see IMF 2011a).
Vulnerability indicators can be found in the IMFs website: http://www.imf.org
9. In 200010 the EMU 16 recorded an average in output growth of 1.38 %.
10. The EMU 16 average HICP for 200010 was 2.1 %.
11. However, this statement is not entirely correct. Ireland had an excellent
record of primary surpluses during 200007, which were reversed to primary
deficits in the advent of the crisis.
12. Greece is not the only country in the EMU with debt/GDP level higher than
100 %. In 2010 Belgium and Italy had debt/GDP ratios of 96.8 % and 119 %
respectively, all with rising trends.
13. This is almost twice as much, as the relevant ratio of the second country in
the row (Portugal at 7.0 %) and more than four times as much as the most
fiscally prudent economy in the first group (Finland at 3.5 %)
14. Long-term interest rates are one of the convergence criteria-indicators for
EMU (Article 121 of the Treaty establishing the European Community).
Article 4 of the Protocol on the convergence criteria annexed to the Treaty,
states that a Member State must have an average nominal long-term inter-
est rate that does not exceed by more than two percentage points that of,
at most, the three best performing Member States in terms of price stability
(Eurostat 2011).
15. The IMF discusses the importance of identifying criteria for fiscal sustain-
ability evaluation (IMF 2002) and conducts both scenarios-based medium
term projections and stress testing for deviations from the baseline scenario
in assessing sustainability. In addition, emphasis is placed on continuous
monitoring the evolution of key fiscal indicators as a means to complement
the formulation of reliable assessments.
16. Similarly to the case of the primary gap indicator, and by construction, this
indicator does not convey much information about the future course of
necessary policy adjustments.
17. A number of additional qualifications are required in the use of this indica-
tor. For instance, a target for debt needs to be set. Fiscal policy reaction is
triggered when the actual debt/GDP is diverging from the set target, in order
to generate the necessary primary surpluses required for convergence to the
debt target. In this perspective, IFS can be used to evaluate whether fiscal
policy in the past has been in a corrective course.
18. The projections used in the debt sustainability analysis are taken from the
IMF database: www.imf.org
19. The issue of regime changes and their implications for fiscal sustainability
opens up an interesting albeit wider discussion which however, lies beyond
the aims of this work (see for instance Makrydakis et al. 1999, Vasco and
Pataaree 2009).
20. This critique applies to any partial equilibrium analysis, since considerations
of this endogeneity can only be addressed within a general equilibrium
framework.
21. Da Costa and Juan-Ramon (2005) discuss a number of approaches that incor-
porate certain risks in the sustainability analysis.
22. The primary gap indicator turns out to be high in the case of the Netherlands
at 4.21, due to the fact that the primary deficit recorded in that year (2010)
was exceptionally high (at 3.4%).
23. For instance, successful fiscal consolidation episodes in Denmark (198386),
Ireland (198284, 198689), New Zealand (19862001), Finland (19922000),
Spain (199397), Canada (199499) and Sweden (19942000), resulted in
improvements in fiscal balances and the debt/GDP ratios in a relatively short
period of time. However, in most of those cases, deep fiscal and structural
reforms were backed by strong public support.
24. However, if the same assumptions for the evolution of growth and the inter-
est rates are maintained then the one year tax-gap indicator should be just
equal to the projected change in the debt/GDP. This is a direct consequence
of the fact that given the level of expenditures/GDP, the one year tax gap
indicator equals the primary gap indicator. However, in our analysis the
results are different due to the fact that the values of r and g used in the
calculations of the short-term tax gap are the historical/projected values of
these variables in the corresponding year, whereas the primary gap calcula-
tions utilize values of r and g specified according to the relevant scenarios.
25. The estimated medium term tax gap indicators reported here have, in most
of the cases, values less than those of the primary gap indicators. This is
because by construction these indicators utilize the projected values for
growth, interest rates and expenditures/GDP for each year up to 2016, as
explained in footnote 24.
26. The test has been conducted only for Germany, Greece and Portugal. It
would not make sense to apply it in the case of the Netherlands and Finland,
since during 200610 these countries had debt/GDP ratios less or about
the Maastricht debt/GDP target level. The same is true for Ireland up until
2009.
27. This was actually the case for both Greece and Portugal. In 2010 both coun-
tries found themselves in a state of extreme distress and sought international
financial assistance to overcome mounting economic and fiscal straits.
28. For the case of Greece, our results are in accord with those reached by the
recent IMF report (see IMF 2011b).
29. Blanchard (1990) actually proposes two indicators of sustainability the pri-
mary gap and the medium and long term tax gap indicators. Buiter (1985)
has also proposed a more appropriate indicator of sustainability based on
governments net worth. Apart from these, there is a growing number of
alternatives proposed in the literature to assess fiscal sustainability such as
the natural debt limit hypothesis (Mendoza and Oviedo 2004), the over-
borrowing hypothesis (Croce and Juan-Ramon 2003), the U-Statistic (Rudin
and Smith 1994), etc., to name only but a few.
30. For a detailed technical exposition see also Escolano (2010), Ley (2010).
31. Equation (5) is widely known as the law of motion of the governments
debt to GDP ratio (Ley 2010).
32. However, satisfying eq. (7) it implies that (1+r)/(1+g)>1 or that r>g.
33. For computational simplicity it is customarily assumed that the interest rate
and the growth rate of GDP are constant. If that is the case, then from the
110 The Euro Crisis
economic point of view, r and g should then be interpreted as long-run, or

steady-state, equilibrium values.
34. The condition (rg)/(1+g) >0 also known as the modified golden rulee (see Escolano
2010, p. 8) has both theoretical and empirical justification. On the theoretical
front, this condition derives from dynamic efficiency considerations regarding
the economys output path and the time-preference of economic agents for
current versus future consumption (Blanchard 1990, Blanchard and Weil 2001
and Blanchard and Fisher 1989, chapter 2, p. 45). On empirical grounds the
modified golden rule has been supported by empirical data for most mature
economies (see Escolano 2010, Table 1, p. 9) with the exception of Greece
(19922008), Spain (19952008) and Ireland (19912008).
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Countries, Debt Division, World Bank, Washington, DC.
Wyplosz, C. (2007), Debt Sustainability Assessment: The IMF Approach
and Alternatives, HEI Working paper, No. 03/2007, Graduate Institute of
International Studies, Geneva.
Appendix
1 An analysis of public debt dynamics

The analysis that follows focuses on fiscal sustainability and does not deal with
external sustainability. It extends the previous work by Korliras and Monogios
(2010), to include the sustainability criteria proposed by Blanchard (1990) and
by Buiter et al. (1993), namely the primary gap and the tax gap indicators.29
Moreover, since we are concerned with sustainability in a group of European
Monetary Union member states, our analysis abstains from debt monetization
issues, and thus it excludes seignorage and inflation as a means for debt/GDP
reduction. In addition, this analysis does not deal with stock-flow adjustments,
nor does it account for the governments contingent liabilities that stem from
population ageing, future health and pension entitlements expenditures.
Similarly, no adjustments have been made for the sale of government assets.
The starting point in the traditional analysis of debt dynamics is the inter-
temporal budget constraint which formalizes the conditions for fiscal sustain-
ability with respect to long-run solvency.
The basic dynamics of debt accumulation are computed as follows:30
Gt rBt1 Tt (B
( t Bt1) (1)
Bt Bt1 rBt1 (T
Tt Gt) (2)
Bt (1 r)
r Bt1 PBt (3)
where, at the end of a given period t,t

B is the countrys gross public debt stock
r is the real interest rate on debt outstanding
G is government expenditure
T is government revenues
PB is the primary balance (interest payments on debt excluded), with PB T
G > 0 denoting the primary surplus ((PB T G < 0 denoting primary defi-
cit), which equals revenues minus non-interest expenditures. As the economy
expends over time, the governments capacity to repay its liabilities increases.
Therefore, what is of importance is the evolution of the debt to GDP ratio and
not the debt in absolute terms.
Expressing the above identity in percentage of GDP terms, Yt, we obtain:
Bt B Y PB
= (1 + r ) t 1 t 1 t (4)
Yt Yt 1 Yt Yt
Yt Yt 1
Manipulating (4) and setting real GDP rate of growth: g t = , we get the
fiscal sustainability identity: 31 Yt 1
1 + rt
bt = bt 1 pbt (5)
1 + gt
where the small letters now denote the ratios of initial variables to GDP.
114 The Euro Crisis
The key determinants of the debt/GDP ratio in (5) are: the debt/GDP ratio in
the previous period, the interest rate/growth rate ratio and the primary balance/
GDP ratio. This formula can be extended to the long horizon by systematically
substituting the debt/GDP ratio up to the final T period (the starting reference
time is t 1 0). Based on the assumption of constant r and g rates, we simplify
calculations that yield:
T T
(1 + g ) (1 + g ) (1 + g )
bo = pb1 + ... + pbT + bT (6)
( 1 + r ) ( 1 + r ) (1 + r )
For an infinite time horizon eq. (6) becomes:
j T
+ (1 + g ) (1 + g )
b0 = j =1 pbj + lim T + bT (7)
(1 + r ) (1 + r )
Imposing the no-Ponzi condition (also known as the transversality condition),

the last term in (7) which implies that the discounted value of the public debt
must tend to zero, we get:
j
+ (1 + g )
b0 = j =1 pbj (8)
(1 + r )
This is the governments solvency condition which shows that the discounted
value of the sum of future primary balances must equal the current value of
public debt. It follows that the government needs to produce primary budget
surpluses in the future, in order to achieve sustainability in public finances.
Nonetheless, the assumption that the discounted value of the debt at infin-
ity converges to zero is crucial for sustainability:
T
(1 + g )
bT = 0
32
lim T + (9)
(1 + r )
The no-Ponzi condition in equation (9), can be viewed as a constraint on public

debt growing at a slower pace than the interest rate.
As long as the ratio of debt to GDP converges to its initial level (or to any other
finite level), this ensures consistency with sustainability. Nonetheless, the debt to
GDP may diverge from its initial level. In this case sustainability is ensured if the
debt to GDP rate of growth is lower than the difference between the real interest
rate and the real GDP rate of growth (rg).g The inter-temporal budget constraint
allows interpretation of fiscal sustainability in the broadest sense, because from
the one hand it defines the conditions for the debt to converge to its initial (or
any predefined level), while on the other hand, it allows for a diverging debt
ratio as long as its rate of expansion is less than the interest rate/growth rate
differential. However, the crux of the analysis is to verify the long held belief
that indebtedness cannot grow forever. It should be noted that in such a partial
equilibrium framework of analysis, the interactions between the budget variables
and the economy are not addressed.
Calculations for the finite horizon are similar and starting from eq. (6) we get:
j T
(1 + g ) (1 + g )
bo = j =1 pb
T
+ bT (10)
(1 + r ) (1 + r )
2 Primary balance required for debt stabilization

The primary balance necessary to stabilize the stock of debt/GDP at current (or
predetermined) levels can be calculated from the standard formulation of the
evolution of b.33 From equation (5), in discrete time this is summarized in:
r g
b = b pb (11)
1+ g
and if b 0 (i.e. there is no change in b), then one arrives at the required pri-
( *) necessary to stabilize the debt/GDP ratio, which depends on
mary balance (pb
the difference between (rg) g i.e. the growth-adjusted interest rate and the debt
level b0 prevailing in year t 0:
r g
pb * = b0 (12)
1+ g
If rg = 0 , i.e. r g , then from (11) we obtain bt pbt. In this case pb will be
the primary surplus equal to the change in debt Db. It is apparent that the greater
the rgg difference is, the greater the required primary surplus has to be in order
to stabilize the debt/GDP ratio. Since rg >0 is a necessary condition for dynamic
efficiency in a sense of Diamond (1965) analysis, all indicators discussed here
need to satisfy this condition.34
Nonetheless, if rg <0 then the growth rate of output exceeds the real interest
rate. In such a case the GDP grows at a faster rate than the stock of debt, which,
in other words, means that the debt/GDP ratio declines automatically. In this
instance, the government can run primary deficits which could lead to a posi-
tive but stable debt level (see Blanchard 1990). However, a situation of this sort
imposes limitations to the interpretations of the standard approach to debt sus-
tainability for it implies a declining debt/GDP ratio without the need to generate
primary surpluses in order to stabilize it. When the primary budget is in surplus,
the rate at which the debt/GDP ratio declines is given by the difference of gr.
3 Debt-target analysis
Simply stabilizing the debt/GDP ratio however, does not satisfy the governments
solvency condition (8). Producing a constant primary surplus to merely satisfy the
solvency condition cannot ensure that the debt/GDP will converge asymptoti-
cally towards zero or to some positive number. Reduction of the debt/GDP ratio
to a desired (target) level d* over a period of T years, requires a primary surplus pb**
which is calculated by first solving recursively equation (5) for b yielding
t j
1+ r t 1 1 + r
bt = b0 pbt j = 0 (13)
1+ g 1+ g
116 The Euro Crisis
and then solving equation (13) for pb, we get the primary surplus pb** required to
reduce the debt/GDP to a specific debt-target level b* in T periods:
T
1+ r
b
b0 *
1+ g
pb ** = j (14)
T 1 1 + r
j =0 1 + g

4 Primary gap and tax gap indicators of sustainability

Similarly to the case of the standard approach to debt sustainability discussed
above, the primary gap and the tax gap indicators have been extensively used in
empirical works as additional means of testing sustainability (Blanchard 1990,
Buiter 1993, Krejdl 2006). Their construction follows the same sequence. The
first step involves the calculation of the sustainable level of the fiscal variable
under consideration. Next, a gap is defined as the difference between the sus-
tainable and the current level of the primary surplus (or deficit) or the tax ratio
respectively.
Starting from equation (12) we calculate the sustainable primary balance pb*
(here surplus) required to stabilize the stock of debt (i.e. the debt/GDP ratio) at
current or pre-determined levels. Then, we subtract the actual (realized) primary
balance pb from both sides to arrive at:
r g
pb * pbt = b0 pbt
1+ g
Here prrgap pb* pbt denotes the primary gap indicator:
r g
prgap = b0 pbt
1+ g
The primary gap indicator in equation (16) shows the adjustment needed to be
carried out in terms of the primary balance in order to stabilize the outstanding
public debt ratio.
( rgap pb* pb < 0) indicates that the debt-sta-
In formula (16) a negative gap (pr
bilizing primary surplus is lower than the actual primary surplus, implying down-
ward pressure on the debt to GDP ratio and thus fiscal sustainability. A positive
value for the indicator suggests that the required primary surplus for debt stabili-
zation is higher than the actual primary surplus, which implies that government
must embark on fiscal adjustment to ensure that the debt/GDP ratio will not
increase any further. In this case, fiscal policy is on an unsustainable trajectory.
Since the budgetary balance (surplus) is usually an important objective of fiscal
policy, this is a useful indicator as it defines an appropriate fiscal target for fiscal
sustainability. The primary gap is a measure of the adjustment that is warranted in
order to bring the fiscal balance to a level consistent with debt sustainability.
A primary gap of zero in the present indicates that no fiscal policy adjustment
in the budget is necessary. This is however, not a safe conclusion, because in the
future a number of factors may exert an upward pressure in the spending ratio
(such as ageing-related or pension expenditures), thus maintaining the primary
balance pb* at a sustainable level, would inevitably call for some sort of adjust-
ment in revenues and/or expenditures. Therefore, the requirement of a sustain-
able (i.e. constant) primary balance will eventually need to be relaxed.
Since primary surplus is the difference between current revenues and current
non-interest expenditures (all expressed as ratios to GDP) we get:
pbt t t (17)
Substituting equation (17) to equation (8), applying some algebra and solving for
a constant we arrive at an expression for the sustainable (i.e. time invariant)
revenues ratio *:
r g + 1 + g j

* =
1 + g j= 1 ( j )

+

+ b0
(18)
1 r
If we subtract the current level of revenues to GDP from the sustainable rev-
enues ratio *, we get the tax gap indicator:
xgap *
tax (19)
The finite version of the above indicator can be obtained by an analogous sub-
stitution of equation (17) into equation (10). Algebraic manipulations yield the
sustainable tax ratio *:
T 1
1 + g j
T
r g 1 1 + r b b 1 + r +
* = j
T
(20)
1 + g

1 + g
0 T
1 + g
j= 1 1 + r

which in the case where the debt/GDP ratio is required to equal the initial level
of debt at period T, it becomes:
T 1
r g 1 + r 1 + g j
* = b0 + 1
T

1 + g 1 + g j=1 j 1 + r (21)

In the case of the infinite time horizon, * in equation (19) needs to be substituted
by its equivalent from equation (18), whereas in the case of the finite horizon equa-
tion (19) must be modified by incorporating the value of * from equation (21).
Different values of the tax xgap indicator have different implications for sustain-
ability, since they are largely dependent on the current tax level. In case of a
xgap * > 0), the sustainable tax ratio * is greater than
positive tax gap (i.e. tax
the current tax ratio . This is an indication of unsustainability and suggests that
fiscal adjustments need to be initiated to prevent future increases in debt. A posi-
tive tax gap implies that future expenditures cannot be financed or that the debt
cannot be serviced based on the current tax ratio. In order to satisfy the inter-tem-
poral budget constraint and to stabilize the debt ratio, fiscal adjustments in future
taxation and/or government spending will eventually need to be instigated.
In case of a negative tax gap (tax xgap * < 0) fiscal policy is on a sustainable
path. The current tax ratio is greater than the constant tax ratio required for debt
118 The Euro Crisis
sustainability and thus no immediate adjustments are necessary. In any case, the
value of the tax gap indicator determines the magnitude of the adjustment in the
tax ratio and as such it constitutes a useful policy guide.
In sum, the primary gap criterion indicates the extent of reduction in the
primary deficit or increase in primary surplus required for debt sustainability.
On the other hand, the tax gap criterion indicates the increase in tax ratio (tax
effort) required for public debt sustainability given current levels of government
spending. Both the primary gap (equation 16) and the tax gap (equation 19)
indicators suggest that the government may have to engage in some sort of fiscal
adjustment in the future in order to stabilize the debt/GDP ratio.
5 Assessing convergence and fiscal policy consistency

A useful indicator that is simple and easy to use in order to monitor the fiscal
stance or to make projections has been proposed by Croce and Juan Ramon
(2003). Their idea is rather simple: based on the premise that the current debt
ratio in many countries stands at uncomfortably high levels (as reflected e.g. in
limited access to capital markets), governments may wish to reduce it to a lower
level (a benchmark or target level b*) in a number of years. Convergence to a
specific target for the debt ratio could be achieved through decreasing, rather
than constant, primary surpluses and without reference to time.
The authors suggest that the primary surplus that needs to be created in each
period consists of two parts: the first is a constant value for pb* (obtained from
equation (12) and assigning values to r and g assumed to prevail once the bench-
mark or target debt ratio b*, has been achieved), and the second component is
a constant policy response to the gap between the observed debt ratio and the
target debt ratio (bb*).
As the gap between the observed and targeted debt ratios closes, the need to
produce constant primary surplus throughout the adjustment period decreases.
A synthetic-recursive indicator of fiscal sustainabilityy (IFS) can be derived based on
this specification, which could be calculated recursively, in order to frequently
assess progress towards the policy objective:
1 + r pbt pb *
IFSt = *
(22)
1 + g bt 1 b
Various types of shocks or policy responses are incorporated in the calibration of

this indicator which fluctuates over time around the value of one. Values of the
IFS indicator around one suggest that future debt/GDP ratios will remain about
their current levels other things being equal (i.e. if there will be no change in the
fundamentals). If the IFS lies below unity, this provides an indication that under
current conditions, the debt ratio (b) will eventually converge to the target level
(b*). A lower indicator signals faster convergence.
Similarly, values of IFS greater than unity indicate that the debt ratio is diverg-
ing (increasing) from the targeted level and thus convergence becomes a remote
possibility in the absence of policy changes. In essence, the IFS summarizes, in
a single number, fiscal policy sustainability under the assumption that current
conditions remain unaltered.
4
Greeces Sudden Faltering
Economy: From Boom to Bust
With Special Reference to the
Debt Problem1
Evangelia Desli
Aristotle University of Thessaloniki
Theodore Pelagidis
University of Piraeus
Abstract: In this paper, we deal with theoretical propositions and

empirical evidence that are needed to explain the paradox of rapid
GDP growth in the face of the dismal competitiveness of the Greek
economy during 19952008. We show how Greeces economic struc-
tural weaknesses have hit the domestic economy and we investigate
their impact on the current turmoil of the economy. We show that
the previous favourable global economic environment acted as a
locomotive to domestic growth, and now that it is gone, structural
problems of poor governance, low competitiveness and a ballooning
public deficit and debt, have come to the surface. Also, in the context
of debt sustainability we look at the recent actions to reduce debt that
are taken by the Growth and Stability Program. We construct five
scenarios regarding the level of public debt at the end of the 201115
period that is commonly accepted that Greece will return to global
financial markets to finance its debt. We find that only under a very
optimistic scenario of robust growth of the economy based on struc-
tural and institutional reforms that boost productivity, significantly
improve competitiveness, and boost the financial sector as described
in the Growth and Stability Program along with a successful privati-
zation of 50 billion euros the public debt-to-GDP ratio can reach the
60 per cent threshold that the financial markets find comfortable.
We offer a specific explanation of the current unfortunate state of
the economy and we briefly suggest avenues of necessary progressive
reforms to overcome it.
119
120 The Euro Crisis
Keywords: Macroeconomy and institutions, competitiveness, the Greek

economy
JEL Classification: D020, E020, E300, E660
1 Introduction
From the mid-1990s until the financial crisis, Greeces economy

enjoyed an average growth rate of 4 per cent (see Figure 4.1), which let
the country converge, more or less, with the eurozone standards of liv-
ing. But despite that, many structural weaknesses continued to prevail if
not deteriorate. Also, during the last 15 years or so, Greece substantially
succeeded in improving the private standard of living but it remained
behind in the organization of its society, of its economic institutions,
of the provision of public goods to the citizens. So, when the global
economic crisis hit, all the mess behind the glittering and superficial
nominal growth came to the surface and Greece entered a turbulent
period with ballooning public debt mainly expressed with the widening
of the Greek bond yield spreads relative to the German bonds.
To find a way out of this financial disarray we need first to under-
stand Greeces economy basic flaws, the distortions, the injustices, the
bad incentives in her institutions that dominate today this economy
and, then, find out the crucial link, the link of cardinal importance, the
link that could bring a domino wave of progressive structural reforms.
In this context, section 2 presents and analyses the engines of the
strong growth and macroeconomic stability that the Greek economy
experienced during 1995 to 2008. Section 3 focuses on the warning
signs that lay beneath, which were mainly facets of low competitive-
ness, institutional weakness and poor governance, and investigates the
paradox of the underlying high labour productivity in a low competi-
tiveness context. Section 4 briefly presents the main parameters of the
Greek deficit and debt. Section 5 explains the steps taken to date to deal
with the debt and studies their sustainability. Finally, section 6 summa-
rizes and concludes with some policy recommendations.
2 Growth and macroeconomic stability. A historic

evolution of key macroeconomic indicators
Greece in the 1950s was the poorest country among its EU-15 peers
in terms of per capita GDP but grew to reach the average level by
Evangelia Desli and Theodore Pelagidis 121
Greece. Real gdp % YoY Euro zone. Real gdp % YoY.AMECO.
15%
10%
5%
0%
5%
10%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Real GDP growth rate: Eurozone and Greece
Source: OECD, Economic Survey of Greece, Paris 2009, OECD.
the mid-2000s. During this period it experienced three main phases.

Figure 4.1 shows the growth rates of Greece and the eurozone coun-
tries from 1961 and in this section we discuss them along with the
engines of growth for the latter period of 19952008.
2.1 Strong growth and high productivity 19952008

From 1950 to 1973 Greece was the fastest growing economy among the
EU-15 (Maddison 1995). However, during the second half of the 1970s
Greeces growth rate decelerated, but it was still the highest among the
EU-15, and the second highest growth rate (to Japan) among OECD
countries. This long period of robust growth came to an abrupt end
in the early 1980s with not only slower growth rates but frequently
negative rates as well. At the beginning of the 1980s two main events
occurred: Greeces accession to EEC, which forced changes to the Greek
industries that operated in a heavily protected environment; and the
new socialist party government that adopted a series of increased spend-
ing policies (mainly wages and social benefits). The entire decade of the
1980s and the first half of 1990s are characterized by weak per capita
GDP but it was followed by strong growth performance up to 2008.
After 199596, Greece clearly outperformed the benchmark euro zone
economy. At the same time the employment ratio remained stable, for
reasons that are presented later, and the resulting growth of labour pro-
ductivity was one of the highest in the EU-15. However, it is absolutely
crucial to look at the factors of growth to see why, at least in the greater
part, this was superficial, fragile, not based on the improvement, the
deepening or the expansion of domestic production.
122 The Euro Crisis
2.2 Engines of growth 19952008

The liberalization of the credit markets at the beginning of the 1990s,
completed by the end of the 1990s, was coupled with entry into the
European Monetary Union. These two developments led simultane-
ously to macroeconomic stabilization and a steady increase of private
credit after 2000. It has also to be stressed that after the beginning of the
1990s the expansion of private credit replaced the government deficit
spending as the main way to finance the expansion of consumption in
Greece, although the data should be treated with caution.
As Figure 4.2 shows by measuring demand injections into GDP, the
impact of these injections was important as a percentage of GDP for
every year during a prolonged period that spans all the duration of
Greeces strong performance. The contribution of the stabilization of
the macroeconomic outlook of Greece in the wake of EMU accession
towards the expansion of private credit was significant, which reflects
also the decline in the rates offered by commercial banks to households
and businesses. (It also brought a significant fall of the inflation differ-
ential of Greece with respect to the eurozone average during the same
period.) It can be seen clearly how the expansion of credit to house-
holds fuelled the growth of private consumption during the past years
(see Figure 4.3). In fact, in only just the period preceding the comple-
tion of the infrastructure projects, which were prepared to be ready for
Change in net credit issued by the private banking sector to enterprises and households.
Change in the stock of financing over the year as a percentage of GDP.
Net inflows from the E.U. as a % of year end GDP.
Change in General Government debt as a % of GDP. Percentage points. * In 1993 all guarantees issued
by the Government that had been claimed were added to the public debt.
30%
25%
20%
15%
10%
5%
0%
5%
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 4.2 Demand injections

Source: Authors elaboration from Bank of Greece, Ministry of Finance, European Commission
Budget and Eurostat, various years.
% YoY change private consumption. Greece. ESYE. Y2000 prices.

Credit to households-housing. % YoY change. BoG.
Credit to households-consumer credit after write-offs. % YoY change. BoG.
Credit to households-consumer credit. % YoY change. BoG.
7 60
6 50
5
40
4
3 30
2 20
1 10
0
1 0
2 10
12-98/6
12-99/6
12-00/6
12-01/6
12-02/6
12-03/6
12-04/6
12-05/6
12-06/6
12-07/6
12-08/6
12-09/6
Figure 4.3 Credit expansion and private consumption, yearly change, Greece
Source: Authors elaboration, Bank of Greece, Annual Report of the Chairman,various issues,
Athens, Bank of Greece.
the 2004 Olympic Games, did private consumption keep accelerating in

spite of a lull in the explosive growth of private sector credit.
But this exception is easily explained by the peak in the investment
growth rate during that time. Besides the credit expansion, two other
factors contributed significantly to Greeces growth performance during
the 2000s. Firstly, the shipping and tourism industries. These secure
significant annual revenue inflows of about 25 per cent of GDP that
are added to the domestic demand and help to mitigate the huge trade
balance deficit. Secondly, the fiscal stimulus given by the 2004 Olympic
Games nourished through public borrowing and which led to the
improvement of certain key infrastructure facilities.
The rapid increase of new investment, both public and private, also
demonstrates the impact of the infrastructure investment that was largely
financed by the EU structural funds. Still, the rush into EU-financed infra-
structure investment did not only contribute to investments and conse-
quently to the creation of new jobs, as in the end many of these projects,
when finished, actively boosted to some extent the productivity in the
area surrounding Athens. The inflow of funds from the European Union,
within the context of the European Union structural funds and the
Common Agricultural Policy, also contributed largely to the improvement
of key productivity enhancing infrastructure facilities. Last but not least,
124 The Euro Crisis
the improvement in the regulation of certain product markets, which has

been reduced from a very high level, even though it still remains very high
compared to other OECD countries according to Conway and Nicoletti
(2006), contributed significantly to Greeces growth performance during
the 2000s. This improvement was mainly due to the liberalization of the
telecommunications market at the beginning of the 1990s and to a lesser
extent to the liberalization of the transportation and energy sectors.
2.3 Consistently low efficiency

Despite the high growth rate that Greece experienced, the efficiency
studies consistently ranked the country among the lowest countries in
terms of efficiency among the OECD or EU countries with its efficiency
level in the 1980s and 1990s to be around 6570 per cent at country
level (Arestis et al. 2006; Moomaw and Adkins 2000; Henderson and
Zelenyuk 2007); and even at specific sectors like education at best 7075
per cent (Afonso and Aubyn 2005), or public sector around 78 per cent
(Afonso et al. 2005). Country efficiency is a measure that compares the
actual gross domestic output of a country to its potential, where the
potential gross domestic output is estimated based on the best practice
of its peers using the same type of inputs in their productive process; the
sector specific efficiency shows a similar trend. When one observes such
low efficiency in one of the largest sectors of the economy like the pub-
lic sector or in one of the core sectors to future growth like education,
there are implications that the entire country suffers from endogenous
and persistent shortcomings that spread to all parts of its economy.
This may show as a result that the public sector is less inefficient than
the public sector but the reality is that the high inefficiency of public
sectors such as transportation, education, electricity, etc., doom private
sectors efficiency and make it appear worse. Based on most recent data
from Eurostat the analysis by Desli and Chatzigiannis (2011) estimated
the efficiency of EU-27 countries over the period 19952008 and the
average efficiency for Greece is 71 per cent versus 87 per cent for the
entire EU. The low level of efficiency becomes even more apparent
when it is compared to the average efficiency level of 92 per cent dis-
played by the oldest EU-15 members that include the EMU members
and should be considered as the peers for Greece. Table 4.1 shows these
statistics with Greece experiencing the lowest efficiency for this period
in 1965 with an efficiency level of 65 per cent and steadily increasing
up to 2007 reaching a maximum of 76 per cent. The low standard error
during 19952008 indicates the efficiency level was stable and further
supports the fact that the efficiency of Greece was consistently low
Table 4.1 Technical efficiency at country level, 19952008, %
Country Average Tech. E s.e. Min Max

EU-27 87 5.7 18 100
EU-15 92 5.4 48 100
EU new members 43 8.1 18 100
Greece 71 3.3 65 76
Source: Authors elaboration based on efficiency data from Desli and Chatzigiannis (2011).
GR EU15 EU27
100%
95%
90%
85%
80%
75%
70%
65%
60%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 4.4 Technical efficiency, 19952008

and hints at the persistent presence of weaknesses driving the poor

performance.
Figure 4.4 shows the annual efficiency levels over time and it can
be seen that in the late 1990s Greeces efficiency level was around
70 per cent. It is worth noting that in the 2000s the efficiency level
of Greece continued to increase while the EU-15 and EU-27 average
efficiency levels were declining. This improvement must be due to the
same factors discussed in the previous section, which improved the
GDP. However, the underlying weakness of this growth is hinted at by
the sharp reduction of the efficiency level of the Greek economy by 9
per cent versus only 6 per cent of the EU15 members at the beginning
of the financial crisis in 2008. From the more detailed presentation of
the efficiency levels of selected EU-15 member countries in Table 4.2,
it can be seen that countries that seem lately to have financial troubles
had severe deterioration of their efficiency levels after the EMU acces-
sion, while certain countries like Germany displayed a robustness in the
126
Table 4.2 Efficiency level for selected EU-15 member countries, 19952008, %
Countries 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
EU-15 91 93 95 95 95 95 95 93 91 91 91 91 91 85
DE 100 100 100 100 100 100 100 100 100 100 100 100 100 100
ES 81 86 89 88 86 82 80 78 73 71 68 67 68 60
FI 72 75 79 84 84 83 81 79 79 84 82 83 84 72
GR 65 68 70 69 69 69 72 71 73 75 74 76 76 67
IE 100 100 100 100 96 91 88 79 79 77 77 75 78 71
IT 100 100 100 100 100 100 100 92 88 85 84 83 85 73
PT 50 52 54 54 55 53 53 50 51 51 53 54 56 48
handling of the financial crisis. Portugal seems to fare worse than Greece
during the entire period 19952008, Spain experienced a deterioration of
its efficiency from 89 per cent in 1997 to 60 per cent in 2008 and a simi-
lar but not as severe corrosion is observed for Italy and Ireland with their
efficiency levels for 2008 to fare slightly above 70 per cent. Overall the
average efficiency of the EU-15 area prior to EMU accession was slightly
improved but afterwards it was stabilized at a level of 91%. Based on the
efficiency studies there may be other countries too among the EU-15
with efficiency levels consistently lower than the EU-15 average so that
their economies ought to have a closer examination, like Finland.
2.4 Warning signs in the real economy during the last decade:
Low competitiveness
A wide range of factors persisted in contributing towards the poor
performance in certain aspects of the Greek economy. The poor per-
formance regarding competitiveness, to name just the most important
one, is not only documented by numerous databases and surveys by
international organizations and researchers, but also by the persistent
deficit of the current account in double-digit numbers (as percentage of
GDP); also, the persisting positive differential with the eurozone aver-
age inflation and the unattractiveness of Greece to foreign direct invest-
ments that are practically zero (inflows minus outflows).
The interesting part about the inflation differential of Greece with the
eurozone (see Figure 4.5) is not that it is there, something that many
would explain with the Balassa-Samuelson effect because of the rapid
growth rate of the country. It is rather that it seems to emerge both
in the goods (tradable sector) and services (non-tradable) sub-indexes,
something that initially seems to refute the Balassa-Samuelson line of
argument.2 An expository comparison with Ireland, where the inflation
rate of the price of goods is much lower than the inflation rate of services,
which thus emerges as a textbook Balassa-Samuelson case, is most reveal-
ing. The high inflation of Greece therefore seems to emerge as a result
more of the demand increase, which is largely driven by the expansion of
credit and the inflows from the EU structural funds as well as from tour-
ism and shipping industry or public borrowing, which is not matched by
a similar increase in the domestic supply of goods and services. And this is
unlike the case of Ireland in which the surplus of the goods balance seems
to finance a deficit in the services balance following again a pattern that
well fits the standard predictions of the Balassa-Samuelson model.
The second piece of evidence that supports this argument is the
increasing deficit of the goods trade balance, as a percentage of GDP
128 The Euro Crisis
Inflation difference of Greece wrt EA-13

Euro zone 13
Inflation, HICP, goods. EUROSTAT.
5%
4%
3% 0.6% 1.2% 1.3% 1.2%

1.9% 1.2%
0.7% 0.6%
2%
1% 0.5%
0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
Inflation, HICP, services. EUROSTAT.
5%
4% 1.4%
1.4% 1.6% 1.2%
3% 1.3% 1.2%
2.2% 1.1%
2% 1.1%
1%
0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 4.5 Inflation differential between Greece and Euro zone-13

Source: Authors elaboration, Eurostat data base, various issues.
(see Figure 4.6). As a matter of fact the trade deficit is of a magnitude

relative to GDP that has never been seen in any country without the
subsequent emergence of serious consequences. In the case of Greece,
participation in the eurozone seems to have averted developments like
the entrance into a spiral of high inflation and currency devaluations.
As a result, the trade deficit in Greece can clearly demonstrate the exist-
ence of a serious discrepancy between the growth of domestic demand
and the increase of the domestic supply of both goods and services. It
should be stressed that in the case of non-tradable services, the infla-
tion differential is sufficient to document the discrepancy between
supply and demand, but the emergence of such a differential for goods
also suggests the peculiarity of Greeces case. Therefore, the evidence at
hand would make it more appropriate to label Greece as a unique case
of quasi Balassa-Samuelson, where exports are replaced by EU-transfers
Ireland Greece
Services balance as % of GDP. Eurostat.

10%
7% 7% 8% 8%
6% 6% 6% 6% 6%
4% 5%
5%
0%
5%
5% 4%
6% 7% 7% 7%
8% 8% 8%
10%
11% 11%
15% 13%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Goods balance as % of GDP. Eurostat.
35%
26% 26% 28%
25% 20% 20% 23% 24% 22%
18% 19% 18%
15%
15%
5%
5%
15%
11% 12% 12% 13% 14% 17% 14% 15% 15% 16% 15% 16%
25%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Figure 4.6 Goods and services balances 2006

Source: Authors elaboration, Eurostat data base, various issues.
and domestic credit expansion through external public and private

borrowing, and the price level is pushed upwards both in the goods and
in the services sector, which would actually be in line with the conclu-
sions of recent research on the topic (Gibson 2007; Pelagidis and Toay
2007). The increase of the goods deficit follows as a natural consequence
in this case as increases in demand are satisfied by competitive and avail-
able imported goods since there is no sufficient domestic supply of goods
that can compete with the imports.
The third piece of evidence is the following. This persistent deteriora-
tion of the goods balance has been financed, apart from the surplus of
the services account, through foreign inflows such as loans from foreign
banks, in both Greek government bonds as well as into the stocks of
Greek companies, at least until the present financial turmoil. However,
it should be noted, that rarely were these inflows FDIs. FDIs during the
last three years were close to zero ($0.9 billion for 2006, $2.5 billion for
2007 and $1.3 billion for 2008 (Bank of Greece 2009).
130 The Euro Crisis
FDI inward flows for Greece as a percentage of GDP are very low for
almost all years, something that is in line with the link between the
attractiveness of the business environment and FDI (as described by
authors such as Hajkova et al. 2007). The performance of the goods
balance together with the inflation differentials with the eurozone for
tradable goods suggests also that the cost of importing and distributing
these competitive imported goods is higher compared to the eurozone,
as a country, to face the sky-high current account deficit, needed to
borrow massively to cover it . Furthermore, it suggests that the imports
remain competitive in the domestic market in spite of this high cost of
importing and distributing, which seems to be really damning for the
competitiveness of the domestic supply of goods.
It has to be noted that for the two sectors that contribute to the serv-
ices account surplus, namely shipping and tourism, it should be noted
that they are less affected by the regulatory environment of the Greek
economy. This is so either because they operate almost completely
outside the Greek jurisdiction and administrative reality, in the case of
shipping, or because they draw their competitive strength largely from
the geographical attractiveness and the cultural heritage of Greece, as is
the case for tourism.
These pieces of evidence manifest themselves in the compelling
case for the low competitiveness of the Greek economy that is docu-
mented by a number of annual surveys by World Bank, Transparency
International and World Economic Forum. The impressive part to note
here is that a wide selection of different surveys, including those that
measure governance and corruption, rank Greece in a roughly similar
way even though they often use different methods based either on
the evaluation of hard evidence, the responses to questionnaires, or a
combination of both.
2.5 Facets and evidence of institutional weakness and

poor governance
The OECD Regulation Database, the World Economic Forum com-
petitiveness survey, the World Bank Doing Business and Governance
Indicators and European Commission estimates (EC 2006; EU 2002),
to name a few, all find that in Greece the administrative burden is also
exceptionally high. Namely, that regulation of markets is excessive, that
government intervention limits competition as well as resource alloca-
tion and pricing decisions in crucial network industries, that the regula-
tion of professional services and legal services in particular are high as
far as entry and price setting is concerned. At the same time, qualitative
standards are excessively lax (Paterson et al. 2003; OECD 2007) and that
the business environment, as an aggregate, is unattractive.
These findings are complemented by more general statements that
indicate weak institutions, poor governance (Kaufmann et al. 2005) and
high levels of corruption that seem to follow as a consequence of the
high administrative burden and the poor governance (Ackerman 2006).
The magnitude of the weaknesses documented by these pieces of
evidence matches the size of the competitiveness deficit documented
for Greece by the inflation differential with the eurozone, the current
account deficit and the low level of FDIs. It has to be added that, not
surprisingly, Greece is found to be the OECD country that has the most
to gain from rectifying these documented deficiencies, such as product
market regulation (Conway et al. 2006), in terms of increased productiv-
ity. This performance can be labelled dismal not because of its absolute
level, but because of the large discrepancy between the performance
of the country in all these aspects and the per capita GDP that it has
achieved in the past years. In particular, following the strong perform-
ance till the 1970s and the strong performance of the past years, per
capita GDP is relatively close to the per capita GDP of the other OECD
and EU member countries. And while Greece remains among the poorer
half of these groups, it still can distance itself clearly from most other
countries that do not participate in these two groups of privileged
countries. On the other hand all the other performance indicators
mentioned above are clearly much weaker than the performance of all
other OECD and EU member countries. Here Greece clearly is placed,
repeatedly, in the middle of the sample of all the countries in the world,
and not in the top 20 per cent of the countries, as is the case with per
capita GDP. Greece, ultimately, emerges as a country with almost first-
class per capita GDP but clearly second-class governance, institutions,
business environment and corruption.
The factors analysed previously that document why Greece grew so
fast in spite of these shortcomings can also reconcile the recent per-
formance of Greece with the now extended literature, mainly of OECD
Economic Department Working Papers,3 that directly link the perform-
ance of an economy with the quality of the regulatory framework and
the prevalence of competitive markets. In a similar way one can rec-
oncile also almost all of the other weak performances of the country,
which range from research and innovation (Bassanini et al. 2000) to the
protection of the environment, the quality of public health services and
schools and the performance of the higher education system (Bassanini
and Scarpetta 2001; Mitsopoulos and Pelagidis 2007; OECD 2007b).
132 The Euro Crisis
Even the weak performance of the judiciary can be ultimately linked to

this pattern (Mitsopoulos and Pelagidis 2007; Djankov et al. 2002).
2.6 The paradox of the underlying high labour productivity

in a low competitiveness context
The result of the strong demand growth that is not driven by an increase
in domestic supply that follows from an increase in employment (see
Figure 4.7), directly affects the reliability of productivity indexes that
measure GDP to labour input in various forms, which gives a percentage
of around 2.53 per cent for Greece during these years. This follows as
the increase in the numerator (GDP) matches a restrained increase in
the denominator, thus measuring a large increase in the productivity per
worker or per hour worked, in spite of the dismal performance of the
Greek economy as measured by the rigidity index of relevant product
markets (OECD productivity and regulation international database).
It follows from the previous exposition that the use of such indica-
tors is not correctly capturing the variety of the parameters that shape
the performance of the Greek economy during the past decade, often
depicting Greece in a position that does not favour the drawing of reli-
able conclusions. This gives also an explanation to the puzzle of having
on the one side high GDP and productivity growth rates, and on the
other side low competitiveness with twin deficits.
All kinds of structural institutional rigidities that one can easily find
in the OECD database constitute a true cost to society in the environ-
ment of a non-competitive economy like the Greek economy. It means
and leads to the exclusion of many others from the labour market,
Employment rate of population over 15 years of age. Greece. Source OECD.

Spain France United Kingdom Finland
65
60
55
50
45
40
35
30
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Figure 4.7 Employment ratio for the population over 15 years of age
Source: Authors elaboration from Eurostat database, 2011, Brussels,Eurostat.
and especially the young that seek salaried labour. Under 26 year-olds
unemployment is more than 35 per cent and 20 per cent for women and
men correspondingly today. This should be read as under-utilization of
a dynamic labour force, and should not be considered solely as a major
social or ethical issue. Also, one would be right to suppose that the riots
of December 2008 had their roots in the marginalization of huge masses
of unemployed young people.
3 The Greek public finances debt. A brief history
The main index that is used regarding the debt sustainability is the
debt-to-GDP ratio. Debt-to-GDP ratio did not increase due to high GDP
growth but alarmingly did not experience a decline. As long as GDP
experienced a strong growth the denominator in the ratio would keep
the various components in stable mode. Alongside this, a low interest
rate environment was enjoyed as a result of being part of the eurozone.
Thus, it was perceived that the debt was under control. However, this
was deceiving as after 2003 government expenses were rising and at the
end of 2009 the projected budget deficit was 12.7 per cent vs. expected
5.1 per cent of GDP (in the Annual Budget of 2009) leading in May 2010
to the a110 billion bailout package offered by the EU, the ECB, and the
IMF (troika).
3.1 Main parameters of the Greek public finances

We can observe in Figure 4.8 how the primary expenses of the central
government were reduced in the 199092 period, and after a significant
increase in 1993, which was related to the change of government fol-
lowing the elections at the end of the year (1993), essentially kept under
control, as a percentage of GDP, till 2003.
After 2003 the ratio of expenses to GDP that was kept under control
all these years with the help of the rapid growth of GDP during all this
period, started to increase as the new government that won the 2004
elections did not fulfill its promise of fiscal responsibility. In the year
2009, when GDP growth had started to falter for the first time since
the mid-1990s, the ratio of central government expenditure to GDP
increased rapidly (see Figure 4.8). This happened as a combination
of expenditures like an increase in salaries that reflected the lack of
restraint in government hiring the previous years, increasing needs of
the social security funds for unbudgeted cash infusions and increases
in the former public sector employees pension bill. The problem of
runaway expenditures, which already was of a sizeable proportion, was
134 The Euro Crisis
Net ordinary budget revenue of the central government to GDP

Primary expenditure of central government, without revenue assigned to third
parties, to GDP
Interest payments on general government debt to GDP
35%
22.9%
22.2%
21.7%
21.5%
21.6%
21.3%
21.2%
30%
20.7%
25%
17.5%
15.2%
15.6%
15.0%
20% 14.7%
19.2%
19.0%
14.8%
17.5%
17.1%
17.2%
14.4%
15.3%
14.4%
16.3%
15%
14.6%
13.9%
15.7%
15.7%
15.2%
13.7%
14.1%
14.0%
10%
5%
0%
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010E
2011B
Figure 4.8 Net revenue, primary expenditure and interest expenditure of Greek
central government budget
Notes: E estimate, B budget, including stability and Growth Program update of budget
with measures taken up to March 2011.
Source: Annual government budgets, various years.
further aggravated by the decision of the newly-elected government to

proceed in the fiscal year 2009 with a solidarity hand-out and by an
initiative to incorporate in the budget of 2009 certain expenditures that
were hitherto either kept off budget; examples are such as the procure-
ment of hospitals, or those that had not been allocated to a certain fiscal
year, such as the settlement with former Olympic Airways employees.
These developments on the expenditure side were paired with the peter-
ing out of the falling trend of the interest payment to GDP ratio that,
starting in 1994, constantly contributed positively to the improvement
of the general government budget bottom-line. To make matters worse,
the increasing trend in the central government revenue to GDP ratio
that started from 1990 and were kept on an upward trend till 2000, with
the significant assistance towards the end of this period of the opera-
tion of the tax authorities integrated information system (TAXIS), was
gradually reversed. In the 200408 period the situation was stabilized
at a lower level, but a renewed reduction in 2009 coincided with the
above-mentioned developments and resulted in the rapid deterioration
of the budgetary net position in that year. Those developments demon-
strate that the estimated deterioration for 2009 was built on the founda-
tion of a period during which the structure of the budget was gradually
weakened, as the structural gains and efforts of the early 1990s were not
followed up.
As a result of the combined effect of the weakening revenue, increas-

ing expenditure and rising interest expenditure, the primary govern-
ment budget surplus available to finance interest expenses, followed a
deteriorating trend, and in 2009 even turned negative. In 2009 the then
government shifted many tax returns from the end of 2008 to January
2009 in order to window-dress the 2008 budget, and then in December
2009 the successive government paid out many tax rebates to window-
dress the 2010 budget (Table 4.3).
The extremely high spreads between the interest of the German
and the Greek 10-year bonds documents the reflection of the concerns
of financial markets regarding the Greek government bonds, and the
ability of Greece to finance its public debt, through the rise in the yield
of the benchmark Greek government 10-year bond. The period after
the year 2000, which was a period of stable and rapid growth, was not
taken advantage of in any way with regard to the strengthening of the
structural position of the budget, and only the falling interest expense,
as a percentage of GDP, kept contributing towards the improvement
of public finances. Figure 4.9 presents this reality from another point
of view. The ratio of the central government budget revenue, net of
funds collected by the budget on the behalf of other beneficiaries and
the redistribution of these funds, to the stock of government debt,
that was increasing till 2000, started to decline, At the same time the
interest cover of the government, that is the budget surplus available
to finance interest expenses, followed a similar trend, assisted though
by the fall of the interest expenses, and in 2009 even turned negative.
Figure 4.8 also shows the projections of the 2011 budget regarding the
Table 4.3 Macroeconomic indicators, millions of euros
YEAR GDP* REVENUES EXPENDITURES DEFICIT DEBT** DEBT %

GDP
2003 153,045 37,500 40,735 3,235 179,008 117.0
2004 164,421 40,700 45,414 4,714 198,832 120.9
2005 196,609 42,206 48,685 6,479 209,723 118.9
2006 213,085 46,293 50,116 3,823 224,162 105.1
2007 228,180 49,153 55,733 6,580 237,742 104.2
2008 239,141 51,680 61,642 9,962 260,439 108.9
2009 237,494 48,491 71,810 30,866 298,524 125.7
2010 231,000 52,700 66,188 19,473 340,680 147.5
Notes: *GDP 2005 upward revised 20% by adding part of the Black economy. ** Central
Government Debt.
Source: Ministry of Finance, Annual Government Budget 2010 (p. 49 and p. 64).
136 The Euro Crisis
Revenue net of redistributed sums of ordinary budget to debt of GG

Revenue net of redistributive sums minus expenses except of interest expenses
of GG to interest expense
0.30 1.2
1.0
0.8
0.25 0.6
0.4
0.2
0.20
0.0
0.2
0.15 0.4
0.6
0.8
0.10 1.0
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009E
2010B
Figure 4.9 Interest cover of Greek general government
Source: Ministry of Finance, Annual Government Budgets, various years.
evolution of revenue and primary expenditure of the central govern-

ment, as well as the measures announced after the presentation of the
2010 budget as they had cumulated till March 2010 (2010M). If one
assumes the GDP used in the 2010 budget and that all other revenue
and expenditure items remain as foreseen in the budget, the impact as
a percentage of GDP of these measures amounts to roughly 3 per cent
of GDP. Figure 4.9 thus also documents the source of the concerns of
financial markets regarding the Greek government bonds, and also the
ability of Greece to finance its public debt. These concerns are further
substantiated by certain uncertainties that prevail over the final param-
eters of the budget for the year 2010 that will in turn affect the realities
of the budgets after 2010. One concerns the budgeted cost of borrow-
ing, which according to the 2010 budget is declining as a percentage
of the years average existing stock of debt; while so far the yield of
the government 10-year bonds remains at levels that significantly
exceed the average yield of 2009 and 2008. As a result the question
remains open about whether, gradually, the debt that has been rolled
over in 2010 implies an increase in the cost of borrowing for 2011
and the future years till the debt issued in 2011 matures. While the
25 billion, less than 10 per cent of the outstanding debt, that will be
rolled over till the summer of 2010 may not crucially affect the aver-
age cost of servicing the total debt. The related challenge will become
more pertinent during the following two years, when according to the
government budget for 2010 nearly half of the outstanding general
government debt will have been rolled over.
A second concern is the gradual increase in the expenditure from the

central government budget to finance the social security system. During
past years the pensions for the former public employees along with the
contribution of the central government budget to the social security
funds has been one of the fast-growing expenditure items of the budget.
Since the absolute magnitude of these expenditure items is also large,
amounting to 31.7 per cent of all central government expenditures in
2009, their impact on the net fiscal position of the government budget
is one of the most crucial parameters that will determine the net posi-
tion of the general government budget in the coming years. As a result
a reform of the social security system that will reduce these significant
and increasingly mounting pressures on the fiscal position of the gen-
eral government is the other important, and still unresolved, parameter
of the fiscal prospects of Greece.
Finally, a third risk remains for the projected fiscal prospects of the
country. A deep and prolonged recession in the economy will not only
undermine the prospects of the economy in general but government
revenues as well. And at the same time the denominator in the debt-
to-GDP ratio will face an unfavourable development in that case. This
can threaten the gains of any efforts that will relate to the previously
mentioned concerns. The latter risk, which is not insignificant at all,
can of course be reduced and possibly even eliminated with the promo-
tion of aggressive product market reforms, as previously outlined, and
with an aggressive program to reduce the administrative burden that is
today posed on the economy. The importance of this risk is highlighted
by the fact that according to the updated Stability and Growth Program,
submitted at the beginning of 2010 by the Greek government, the
return of satisfactory growth from the last quarters of 2012 will gradu-
ally dilute the ratio of general government expenditures to GDP; and
this will happen without necessitating their decline in absolute size or
even permitting their increase after 2010. At the same time the increase
of taxable incomes and profits, along with the growth of GDP, will
permit an increase in the revenue of the general government not only
as a percentage of GDP but, most significantly, by a sizeable absolute
number. The success of this strategy evidently depends crucially on the
ability of the economy to return to the projected (in the Stability and
Growth Program) positive growth rates after 2011.
Even though the Greek government announced a new series of
measures in March 2010, when added to the measures announced
since December 2009, it emerges that most of these measures amount
to extraordinary tax increases, which most probably will become
138 The Euro Crisis
permanent once the new tax law is finalized and adopted by the end
of September 2011. Only a smaller part of these measures, less than
one third,4 comprises expenditure cuts or the freezing of expenditure
increases. In addition, these additional measures will probably simply
cancel out revenue shortfalls. This could easily happen if the recession
of the Greek economy gathers pace until determined efforts to reform
the issues analysed in this chapter are undertaken.
The significance and size of these risks, as well as the potential sug-
gested from the experience of other countries regarding these reforms
in combination with the currently adverse ranking of Greece on these
aspects, strongly suggests the appropriate way to move forward, swiftly
and decisively. At the same time it has to be stressed that in such a
virtuous development it will be much easier to implement a program
to reduce the shadow economy and to extract tax revenue from it.
Of course even if these three issues are tackled, with a determined
product reform program, a satisfactory reform of the social security sys-
tem and a continuation of other efforts that would lead to a rapid decline
in the cost of borrowing for the Greek government, a number of realities
will still prevail in the short term for the Greek public finances. So, it
will remain as a reality that the Greek public sector not only has more
employees than it needs, but that they are paid on average very gener-
ously when compared to private sector salaries. It will remain, above
these realities, that the human resources management and the organiza-
tional chart of the public sector does not permit its efficient operation
and the supply of quality services at low cost to society. Unfortunately
this problem has no easy and fast solution. Given that a reduction in
the size of public sector employees not only will adversely affect the job
market, but also will probably involve the risk of expelling the better
working but less well connected, in clientelistic terms, part of the staff.
Thereby cuts in the average pay of public sector employees should be
preferred over lay-offs. The argument for pay cuts, over lay-offs, is also
substantiated by the high average wage bill per public employee that was
revealed by the data presented in Mitsopoulos and Pelagidis (2011). At
the same time the better management of wage bills will become possible
through the operation of a centralized payment system. This system to
be introduced should be able to identify potential cuts in a way that
will not hurt too much those who receive relatively low pay and mainly
seek out those cases in which numerous hand-outs and wage related
payments lead to very high annual incomes that are not justified by the
quality and quantity of the services provided. Tackling the issue of public
sector pay is of significant importance, as after the payments for public
sector pensioners and social security funds and interests on debt the
wage bill is the third big expenditure of the budget amounting to 28.4
per cent of all central government expenditure in 2009, with all other
expenditure items such as wage bills, being less significant.
The reform of the social security system and the reduction of the wage
bill are pressing priorities since projections to increase taxes are subject to
the developments of the economy and the resilience of economic activ-
ity, while expenditure cuts will yield the budgeted savings with certainty,
regardless of the developments of the economic situation and despite the
fact that some reductions in tax revenues should be expected as a result
of. As a result the measures implemented since December 2009 and till
May 2010, which included increases in consumption taxes on value
added, fuels, tobacco, alcohol and so called luxury items as well as a
number of extraordinary taxes on profitable corporations, high personal
incomes and big estates are all subject to the development of this con-
jecture. A deepening of the recession will easily evaporate the projected
increase of revenue, undermining the effort of fiscal consolidation. On
the other hand only 30 per cent of the measures announced in this period
refer to cuts in expenditures or the freezing of increases in expenditure.
This is unfortunate since, according to Guichard et al. (2007), episodes
of fiscal consolidation that are based on government revenue increases
are generally less successful and long-lived than the ones that are based
on expenditure cuts. The size and historic growth rates of the wage bill
and the social security related items that have been mentioned singles
out these two items as the preferred targets for such cuts, as has already
been described. Such cuts will have also a further implication. Today the
numerous public sector employees that, relative to the private sector,
receive high pay and produce no value added contribute to the pattern
of disproportionally, when compared to other European countries, and
high consumption as a percentage of GDP that prevails today in Greece.
A reduction in the excessive public sector wage and public sector pensions
bill will contribute towards the rationalization of this statistic as well.
3.2 Recent developments and the memorandum

While the government, starting in January 2010, initially attempted to
solve the impasse solely through tax increases, in March of the same year it
took the step to actually target government expenditure and especially the
wage and pension bill of the public sector. The mustering of this political
courage can be explained by the fact that at this point, with money mar-
kets shut, the Greek government had no alternative but to demonstrate
at least the existence of a will to slash some expenditure. Yet the measures
140 The Euro Crisis
announced in March were later perceived by the markets to be too little

and too late, and in addition the targeted fiscal correction of these meas-
ures still amounted to only a small fraction of the government deficit of
well over 25 billion euros. The same can be said of a new tax law that
indeed tried to abolish some of the tax exemptions that made hitherto
so many professionals and self-employed pay so little personal income
tax and that made the everyday circulation of undeclared income so easy.
By then financial markets became completely aware of the cobweb of the
intervening problems of the uncompetitive Greek economy. And they
wanted to see a fiscal consolidation effort commensurate with the deficit
as well as a coherent reform strategy. Yet, by April 2010, they had not
received that, and they remained firmly shut for the Greek government,
leaving the government with only two options: default or seek financial
assistance. Contemplating the fall-out from a default, the government
chose to seek financial assistance, by sending in late April 2010 a letter
in which it requested the initiation of a process offered by the European
Commission, ECB and IMF in anticipation of the unfolding events. This
offer required the signing of a Memorandum of Understanding (hence-
forth: the Memorandum). It was ratified by the Greek parliament with law
3845/2010 of 6 May 2010, in which the Memorandum of Understanding
on Specific Economic Policy Conditionality described the measures the
Greek government had to implement in order for the 110 billion euro
loan facility agreement to be activated.
3.3 What the Memorandum initially provided

The Memorandum constitutes a brand new approach towards the imple-
mentation of a reform program in a country whose government seeks
financial assistance in an environment of fiscal and macroeconomic
pressures that it cannot manage any more by itself. This approach is
different from the one adopted by the IMF so far in countries that have
sought such assistance. In terms of the latter, once the political agree-
ment was stuck, the eurozone membership of Greece called for an active
involvement of the European Commission and the ECB, together with
the representatives of the IMF; the purpose is to draft the conditions set
and then supervise the implementation of the commitments made by
the Greek government.
This collaboration between the European Commission and the ECB on
the one side and the IMF on the other side brought together an unprec-
edented combination of expertise and capacity to formulate a detailed
plan to stabilize the finances of the Greek government and the macr-
oeconomic fundamentals of the Greek economy. A crucial ingredient has
been the, increasingly more advanced, benchmarking exercises that are

undertaken especially by the European Commission. The coincidence of
the know-how at the level of the European Commission to formulate the
precise details of the gravest failings of Greece that followed from these
benchmarking exercises, as well as the experience accumulated from
the Lisbon Agenda, allowed the European Commission to pinpoint the
exact contours of the conditions to be set in the case of Greece before the
financial support package could be activated. At the same time the IMF
had the necessary experience to oversee and implement such a program.
Furthermore, it has tried in the past years to improve the design of the
measures that countries that seek its help are asked to implement, in a
way that addresses the demonstrated weaknesses of these countries with-
out any prejudice towards the measures that have to be taken. Hence the
program designed for Greece did set a useful precedent concerning the
detailed knowledge of the challenges posed by a country with a politi-
cal system that demonstrates a consistent and deeply-rooted aversion
to useful reforms; this was combined with the accumulated expertise of
implementing such a custom-made program.
As a result, the Memorandum of Understanding on Specific Economic
Policy Conditionality provided measures that a) deal with the acute fiscal
imbalances of the Greek government; b) try to propose long-term solu-
tions to the underlying reasons that have allowed these imbalances to
emerge over many decades, and that relate to the inability of the general
government to supervise the use of public funds, control widespread tax
fraud and abolish tax exceptions by privileged professional groups; c) try
to deal with general government entities, from social security to the public
electricity company and public railroads, which have traditionally oper-
ated with complete disregard towards the realities of fiscal constraints; d)
try to remove the most important of the binding constraints that suppress
competition and productivity in product markets; and e) try to intro-
duce some flexibility in a better supervised labour market. As such, the
Memorandum is wide ranging. In all, it contained, in its original version,
over 200 separate actions that were planned to be taken until 2014, either
as small individual actions or as groups of separate actions that in the end
aim to secure the successful achievement of the set goals.
3.4 Implementing the Memorandum as of September 2011

and the Medium Term Fiscal Strategy
Regarding the core important reforms included in the Memorandum,
such as social security, the opening of crucial network industries
and services to competition, as well as the cost-cutting side of fiscal
142 The Euro Crisis
consolidation, one can identify during the first year of the implemen-
tation of the Memorandum an initial unwillingness of the responsi-
ble ministers to fully conform with the spirit of the Memorandum.
Subsequent and increasing pressure from the lenders led finally, with
great delay, to the presentation of initiatives that seem to conform with
the basic guidelines of the Memorandum. Road freight was deregulated,
with a three-year adaptation period, only after repeated oscillations by
the responsible ministers and after the exercise of intense pressure from
the lenders. An initial effort to deregulate professional services with
law 3919/2011 ultimately succumbed, at least partly, to the pressures
of the legal profession and, especially, engineering representatives. This
is clearly documented by the opinion 11/VI/2011 of the Competition
Authority, which was mandated by the Memorandum. Further uncer-
tainties regarding the genuine deregulation for the competitiveness of
the economy, job market and government budget professions emerged
with the postponement of the deadline for the deregulation of medical
professions to the end of 2011, which is to be added to the half-hearted
deregulation of the pharmacists profession, in which for example
constraints such as the mandatory ownership by a licensed pharmacist
remain. Regarding the reduction of red-tape, a one-stop shop for com-
pany start-ups was created, even though the underlying procedure was
not significantly simplified and its effectiveness seems to be questioned
by various observers. Furthermore, an action plan to identify 30 obsta-
cles to doing business still had not been implemented by summer 2011,
even though working groups supposedly made progress in their draft-
ing. Finally, regarding the energy market the entire main challenges
still remained by the summer of 2011. On other fronts though, some
behind-the-scenes progress was gradually becoming apparent, as for
example with the important issue relating to licensing and spatial plan-
ning, which is especially important to production and manufacturing.
By the summer of 2011 key pieces of legislation had been put in place,
for example, law 3982/2011 which significantly simplifies the process
for smaller establishments. By the summer of 2011 the new process for
environmental licensing, which is the crucial remaining obstacle for
larger establishments, was still in progress, though reportedly very
advanced. Also missing were a couple of secondary decrees, which were
expected to be completed within a reasonable amount of time. Drafts
for the two last were announced soon after a cabinet reshuffling in early
2011 and were due to be legislated by SeptemberOctober 2011.
Since product market reforms usually take some time to bear
fruit, the insistence to allocate them mostly towards the end of the
implementation agenda, as was already manifest in the initial draft of

the Memorandum, and then to further delay their real and aggressive
implementation, evidently risks exposing the economy to a longer, and
possibly unnecessarily deep, slowdown. The extent of this procrastina-
tion may in the end undermine even the fact that markets will price in
the anticipated impact of these reforms immediately. The way in which
structural reforms that can create a substantial upside to the Greek
economy have been promoted has also created the risk in implementing
these reforms after a prolonged recession and has weakened the domes-
tic financial institutions. This has been so to such an extent that they
will be unable to provide a speedy and strong support to initiatives that
aim to take advantage of this upturn.
On the other hand, regarding especially the Ministry of Finance, there
was, as mentioned, an initial reluctance to publicly admit the severity
of the situation and a failure to present for over a year the parameters of
a coherent and adequate exit strategy. But, finally, the additional meas-
ures described in the Medium Term Fiscal Strategy (MTFS), announced
in the context of the European Semester by May 2011, seem to have a
magnitude that seems proportionate to the problem in hand, regardless
of whether one can argue about the policy mix and the details of the
corrective measures. Furthermore, press reports and announcements
from officials of the Ministry of Finance and the tax authorities indicate
at least a genuine effort to end the days of unchecked tax evasion, tax
avoidance and tax fraud from private individuals as well as office abuse
and corruption from the side of employees. A census of public servants
was completed; a census for employees of public companies is planned
and the single payment authority for public employees is moving towards
completion more than two years after its initial announcement.
Furthermore, a number of initiatives included in the Memorandum,
some of which were already on the agenda, seem to receive increasing
attention and to make firmer progress under the supervision of the
lenders. Especially regarding the two laws on social security reform, law
3863/2010 and 3865/2010, their speedy implementation, following the
pressure of the lenders to do so, seems to alleviate the forecasts of crip-
pling future fiscal imbalances. These until now significantly burdened
the long-term creditworthiness of the Greek government. This signifi-
cance follows from the fact that pensions for former public employees
and contributions to social security funds are (as shown in Figure 4.10)
and together with government wages, among the largest and fastest
growing single expenditure items. These laws will contribute much to
the re-establishment of the creditworthiness of the Greek government
144 The Euro Crisis
as they remove some of the major uncertainties regarding the future

ability of the Greek government to honour its obligations. This is so
even before the full impact of these laws is felt and before the actuarial
studies currently being prepared are finished and published.
In any case, every measure that the Memorandum and its extention
(MTFS) have taken has a final target to tame the deficit and stabilize it;
and, of course, bring down the colossal debt. It is where we turn below,
namely dealing with the debt problem.
4 Dealing with the debt
At present, the most frequently asked question is whether the Greek

debt is sustainable or will it need some form of restructuring? In this
final section we deal theoretically with the debt issue in Greece and we
take a closer look at the evolution of the debt over time, which in order
to be sustainable needs the annual rate of change of debt to be zero and
if possible negative. We use the basic identity of debt dynamics that
also defines the main elements of the debt change and we construct five
main scenarios to test for debt sustainability.
4.1 Debt decomposition

The accumulation of the stock of public debt at the end of period t
depends on the interest payable on the inherited debt from the end of
the previous period plus the budget deficit or surplus during the period

t. If l is the debt-to-GDP ratio and l is the corresponding rate of change,
p is the primary surplus-to-GDP ratio, i is the interest payable on the
inherited debt as percentage of GDP, Y is the GDP at current market
prices and g the corresponding growth rate, then the rate of change of
the stock of public debt is given by (4.1):
Y / dt pY iY f Y.
d(lY) (4.1)
Where f is the term stock-flow adjustment as a percentage of GDP and

it includes various activities not reported in the government budget
like the accumulation of financial assets as well as changes in the value
of debt denominated in foreign currency. Such an activity is the sale
of 50 billion worth of assets by the Greek government.5 Expressing
the previous equation as a ratio to GDP we obtain the debt dynamics
identity (4.2):

l p (ig)
g f, (4.2)
which shows the change in the debt-to-GDP ratio in terms of primary

deficit ratio (p), contribution of interest and nominal growth (ig),
g also
called snowball effect,t and stock flow adjustment ratio (ff). A primary
surplus would reduce the debt, while also vital is the impact of the
snowball effect, i.e. low interest payments and strong economic growth.
Following the previously described debt dynamics in equation (4.2) the
debt would be stable or reduced if the annual rate of change is zero or

negative respectively, i.e. l 0. In an ideal situation all three elements
of equation (4.2) should be reducing or remain the same. Hence, there
should be a primary surplus, which appears to be one of the main tar-
gets of the rescue plan for Greece, along with a snowball effect with a
negative overall impact and, finally, if possible, considerable stock flow
adjustments. Thus, although one of two of the elements of equation
(4.2) might be increasing there must be at least one component with
a significant reduction to overcome any shortcomings. Figure 4.10 dis-
plays the Greek debt-to-GDP ratio since 1991 and its decomposition to
the parts presented in the previous equations.
The Greek debt-to-GDP ratio from 71 per cent in 1990 exceeded the
100 per cent threshold in 2000 and it is expected to reach 158 per cent
in 2011 and even higher in 2012. As Manessiotis and Reischauer (2001)
explain, the major increase of a magnitude around 20 per cent that is
noted in 1993 is due to the inclusion in the accounting of public debt
numerous liabilities in the form of loan guarantees to restructured
Cyclical Component Structural Component Stock Flow Adjustment

Rate Component Debt Growth
25
20
15
10
% GDP
10
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 4.10 Greek debt-to-GDP ratio since 1991 and its decomposition
Source: European Commission, AMECO database, 2011.
146 The Euro Crisis
enterprises through Greek government bonds;also, the consolidation

of government accounts with the central bank, which was a require-
ment for the second phase of EMU. A number of similar adjustments
followed in the period 19942001 as EMU requirements and these
can be seen in the significant impact of stock flow adjustments. Such
adjustments continued but especially so in the fiscal year 2009 when
the newly-elected government decided to proceed to incorporate in
the budget of 2009 certain expenditures that had been either kept
off budget, such as the procurement of hospitals, or that had not
been allocated to a certain fiscal year, like the settlement with former
Olympic Airways employees.
In anticipation of accession to EMU the strict implementation of a
restrained budget resulted to the primary deficit contributing to a reduc-
tion of debt accumulation for the period 19942002. Furthermore, the
contribution of primary deficit ratio can be expressed into the compo-
nents of structural (p*) and cyclical (p p*) contribution. The first
component is the debt-to-potential GDP and measures the impact of
the debt if the economy was operating at its full capacity. The second
component is the result of the economy operating below its full capac-
ity and it reflects the inefficiencies apparent in the economy. As may
be seen during the period 19942002, as Greece was improving its effi-
ciency and reducing its output gap, the structural component was con-
tributing significantly to debt reduction, while the cyclical component
had a minimal impact. However, the trend is reversed after 2003 and
the primary deficit amplified the debt especially in 2004. Although one
cannot ignore the steep rise in debt-financed spending for infrastructure
with respect to the 2004 Athens Olympic Games, overall it is evident
that the Greek government relaxed its control over its budgetary disci-
pline after its entry to EMU. The problem was mainly due to runaway
expenditures such as an increase in salaries that reflected the lack of
restraint in government hiring the previous years, increasing needs of
social security funds for unbudgeted cash infusions and increases in the
former public sector employees pension bill. Additionally, the snowball
effect on the increase of debt is minimal and even during 20018 had a
negative impact mainly due to the low interest rate environment that
Greece was operating in anticipation of EMU. This was especially so fol-
lowing EMU until the beginning of the global financial crisis combined
with the high growth rate.
Next a closer look at the various components of the Greek debt-to-
GDP ratio is undertaken along with how they are expected to develop
over the next period of five years.
l
4.2 Greek debt dynamics (l)
4.2.1 GDP growth (g)
According to the response of the Greek government to the updated
Stability and Growth Program submitted at the beginning of 2010,
the return of satisfactory growth from 2011 will gradually dilute the
ratio of general government expenditures to GDP. This is expected to
materialize without necessitating their decline in absolute size or even
permitting their increase after 2010. At the same time the increase of
taxable incomes and profits, along with the growth of GDP, will permit
an increase in the revenue of the general government not only as a per-
centage of GDP but, most significantly, by a sizeable absolute number.
Another path to the reduction of debt is via the snowball effect
which is the contribution of interest and nominal growth (ig). g The
success of this strategy evidently depends crucially on the ability of
the economy to return to the projected, as in the Stability and Growth
Program, positive growth rates after 2010. However, one cannot pre-
dict with relative certainty. According to the Hellenic National Reform
Programme 201114 (April 2011) the forecast for 2011 is 3 per cent
and for 2012 is +1.1 per cent. The main question here is what will
be the sources of growth: investment is falling, 16 per cent in 2010;
imports are also falling to 4.8 per cent for 2010 from 18.6 per cent
for 2009 while exports recorded a rebound in 2010 at 3.8 per cent of
GDP (as opposed to 20.1 per cent in 2009) and they are expected to
exceed 6 per cent in 2011 but they cannot compensate for the severe
domestic expenditure contraction. If the euro continues to recover as
has been observed during recent months, things will get worse. What is
more close to reality is Buiters et al. (2011) forecast for a negative real
growth of 1 per cent in 2012.
(p)
4.2.2 Primary budget (p
The primary budget is expected to be 0.9 per cent in 2012.6 This can
be mainly achieved with strengthening the revenue administration so it
can succeed in big revenue increases as well as with budgetary discipline
with a focus on expenditure cutting.
Greece collects less direct and indirect taxes as percentage of GDP
when compared to the average of EU with tax evasion being a system-
atic problem. The European Commission shows the collection of tax
revenue as percentage of GDP is almost half the amount that the EU
member states collect7 and so there is plenty of room for the Greek tax
authorities to broaden the tax base and substantially increase revenue
148 The Euro Crisis
from direct taxes, a fact that will help the country to show a positive
primary balance at least from 2012.
Here it is also worth noting that the income tax in 2010 compared to
2009 was reduced by 13.9 per cent and the estimated tax evasion dur-
ing the same period increased by a magnitude of 1 billion euros. The
tax amnesty in 2010 contributed almost 1 billion euros (0.4 per cent of
GDP) to revenues, but it also provided the incentive to continue such a
practice and thus it is expected to reduce future tax compliance further.
One should not forget that any great success on that issue, that is, suc-
ceeding in closing the tax loopholes, will always drag down GDP, which
on the other hand, is absolutely crucial to service the debt.
4.2.3 Interest rates (i) Spreads

At the end of 2009 there was a significant rise of 10-year Greek bond
rates that were implying approximately a 25 per cent possibility that
the Greek government would default on its debt. Since the adoption of
the Economic Adjustment Program for Greece in May 2010, the finan-
cial markets are shut down but in the secondary market spreads are sky
high. Apparently, interest rates as shown in Table 4.4 are not serviceable
rates as they cannot be matched by any realistic GDP nominal growth
even if the Greek economy recovers pretty soon, as is scheduled in the
Stability and Growth Program.
4.2.4 Stock flow adjustments

No privatizations occurred in 2009 or 2010 that could help with the
reduction of the debt. However, for the period 201115 they are expected
to reach 50 billion euros according to The Economic Adjustment
Programme for Greece Third Review (EC 2011), which corresponds to
a 14 per cent reduction to the debt magnitude (assuming a final debt of
Table 4.4 Interest payment on debt and interest as percentage of GDP
Year Interest payment on debt Interest as a % of GDP

2010 14.2 billion 5.5
2011 15.8 billion 6.5
2012 17.0 billion 7.5
2013 19 billion 8.0
2014 20 billion 8.3
Total 86 billion, 27% of current debt
Source: Authors own estimations from Ministry of Finance, Annual Budget Report 2011,
Athens 2011.
365 billion euros or around 22 per cent of the debt-to-GDP reduction).

This seems unlikely as the Greek government does not seem to be ready
for it maybe by only a fraction of this amount; it is currently estimated
at 13 billion euros, and it is rather unlikely that there will be sufficient
interest to attract potential investors in an environment of high regula-
tion and low competitiveness, as was explained earlier.
Another worrying aspect is the level of the expenditures kept off
budget (contingent liabilities which for 2011 are expected to reach
3 billion euros, i.e. 1.2 per cent of GDP). These will originate from the
rest of public organizations that will submit their balance sheets for the
first time. Also, part of state expenditure cuts were achieved up to now
by not paying bills both to the private sector and to the regional and
local authorities. Thus, out-of-budget expenditures are expected to bear
a supplementary weight during 2011.
Overall it would be more realistic to expect a stock flow adjustment
of around 20 billion euros, which would reduce the debt-to-GDP ratio
by 910 per cent and therefore the stock flow adjustments would have
a sizeable effect on the reduction of debt. Unfortunately it is a one-
off event and given the existing level of debt-to-GDP ratio its overall
impact to the debt-to-GDP ratio will not have such a crucial impact in
terms of reducing the debt-to-GDP ratio.
4.3 Debt sustainability scenarios

Now let us apply the key elements of the Stability and Growth
Program on the debt dynamics over the period 201115. During 2011
the debt-to-GDP ratio is expected to be at around 150 per cent. The
fiscal adjustment program includes consolidation measures amount-
ing cumulatively to 11 per cent of GDP by 2013, with 3.9 per cent
in revenue measures and 7.1 per cent in expenditure measures. The
(additional) effect of these measures is 2.5 per cent of GDP in 2010, 4.1
per cent in 2011, 2.4 per cent in 2012, and 2.0 per cent in 2013. Also
according to the plan a primary surplus of around 5 per cent of GDP is
expected to be maintained after 2013. However, this goal may not be
achieved as, at the end of 2009, the projected budget deficit was 12.7
per cent (revised finally at 15.4 per cent vs. expected 5.1 per cent of GDP
while the 2010 deficit was finally above 10 per cent) and a more realistic
figure for this period would be an average surplus of around 3 per cent.
We create three scenarios, which are presented along with the relevant
assumptions and calculations in Appendix A.
The first scenario (Scenario IMF A) is the base reform scenario, with an
average primary surplus of 5 per cent and zero snowball effect (ig = 0).
150 The Euro Crisis
When no stock flow adjustments are assumed the debt-to-GDP ratio

would drop to 125 per cent and with successful privatization it would
drop to 105 per cent. In both cases the rate of decline is not sufficient to
allow timely repayment of the received assistance and return to a ratio
that is below 100 per cent or closer to the perceived ideal of 60 per cent.
The second scenario (Scenario IMF B) is a more realistic scenario with
an average primary surplus of 3 per cent and a snowball effect (ig) g of
3 per cent to reflect concerns of lack of a timely and strong GDP growth.
When no stock flow adjustments are assumed, the debt-to-GDP ratio
would drop only to 150 per cent and with stock flow adjustments of 10 per
cent it would drop to 140 per cent. It can be clearly seen that in both cases
debt cannot be sustainable unless additional measures are taken.
The third scenario (Scenario IMF C) is an optimistic reform scenario,
with an average primary surplus of 5 per cent and a snowball effect (ig) g
of 2 per cent, which is the result of a robust growth of the economy
based on structural and institutional reforms that boost productivity,
significantly improve competitiveness, and boost the financial sector.
When no stock flow adjustments are assumed, the debt-to-GDP ratio
would drop to 115 per cent and with successful privatization it would
drop to 95 per cent. The last case is the only case that the debt-to-GDP
ratio falls marginally below the 100 per cent threshold but yet its effec-
tiveness is minor.
Recently, plans emerged about the reduction of the interest payments
with the decrease of the rate of interest along with the increase of the
loan period. As there are still on-going discussions about the imple-
mentation of such a plan between Troika members, Greece and private
investors, it is difficult to quantify the impact exactly. However, we
added two more scenarios to address these developments assuming that
the interest payments will be reduced.
Thus, the fourth scenario (Scenario IMF B plus an interest payment
reduction of 5 per cent) is the more realistic scenario with an average
primary surplus of 3 per cent and the snowball effect (ig) g changing
from 3 per cent to 2 per cent. The 5 per cent reduction of the snow-
ball effect will be mainly due to the reduction of the interest payment
as percentage of GDP (see Appendix A for more details). When no stock
flow adjustments are assumed, the debt-to-GDP ratio would drop only
to 125 per cent and with stock flow adjustments of 10 per cent it would
drop to 115 per cent. Although it is clearly an improvement on the
debt-to-GDP ratio the debt is still not sustainable.
Finally, the fifth scenario (Scenario IMF C plus a severe interest
payment reduction of 7 per cent) is the optimistic reform scenario,
with an average primary surplus of 5 per cent and the snowball effect
g changing from 2 per cent to 9 per cent. The rather optimistic
(ig)
7 per cent reduction of the snowball effect will be mainly due to the
reduction of the interest payment as percentage of GDP originating
from achieving the 30-year repayment period along with an average low
interest rate of 4.5 per cent for all the renewed bonds; this is explained
in Appendix A. When no stock flow adjustments are assumed the debt-
to-GDP ratio would drop to 80 per cent and with successful privatiza-
tion it would drop to 60 per cent. This is the only scenario that the
debt-to-GDP ratio falls below the 100 per cent threshold and becomes
sustainable and if additionally the privatization is successful, along with
no other out-of-budget expenditure surprises, the debt threshold that
the global financial markets would find sufficient is reached. All the
scenarios are presented in Appendix A.
Therefore even after a reduction of the interest payments a realistic
scenario indicates debt unsustainability and only the most optimistic
scenario brings the debt-to-GDP ratio to the acceptable levels. As most
likely the true state will be closer to scenario 4, it seems unlikely that
the debt-to-GDP ratio will fall below the 100 per cent at the end of
the 2015 or at best it will fall marginally below this threshold. Hence,
in the long run, a serious debt restructuring may be the only way
forward.
4.4 Is the debt sustainable?

Based on the above, while looking at the debt dynamics a massive fis-
cal adjustment is required that will transform the substantial primary
budget deficit into surplus. Also, as the official support that Greece
receives has the form of loans which must be repaid with interest, that
is, lower than the one that financial markets would require but at least
compensates official creditors for their own cost of funds, the interest
part of the snowball component will be disproportionally large com-
pared to the nominal GDP growth. Thus, the snowball effect will always
tend to increase the debt and cannot be ignored and the size of the pri-
mary surplus is required to be even higher. Hence, the option that needs
to be seriously explored is to focus on ways of reducing the interest pay-
ments. However, even in such a case it would be doubtful whether over
a longer period of time the debt will be sustainable. With the current 3
per cent GDP forecast for 2011, the endgame would rather entail a large
debt write-down, sooner or later, in order to bring the debt-to-GDP ratio
to a more healthy level that in the long run would restore the faith of
the financial markets to the sustainability of the Greek debt.
152 The Euro Crisis
5 Policy recommendations and conclusions
In this paper we have started out with a brief description and analysis
of the prosperous years 19952008 where high growth rates along with
high productivity prevailed. The prosperity was mainly due to demand
injections such as cheap credit, money from tourism and the shipping
boom, EU structural funds, the boost from the Olympic Games and
Athens area infrastructure, limited reforms (banking, telecoms, some
PrivatePublic Partnerships, but that is all, more or less) and most
importantly extensive public borrowing.
At the same time the falling competitiveness of Greeces economy was
indicated by persisting inflation differentials and double-digit current
account deficits and budget deficits as well as close to zero net FDIs. The
country in terms of competitiveness, business environment, administra-
tive cost and governance surveys was consistently ranked at a level that
is disproportionally low when compared to its per capita GDP or even
to GDP per worker.
Additionally we observe the presence of institutional weaknesses
and poor governance along with the incidence of extensive market
regulation that forced on both the real economy and the economic
institutions obsolete and rigid structures along with corruption. Both of
the above weaknesses were present for a number of decades and were
disregarded or set aside by looking only at the spectacular GDP growth
but they consistently led to the actual output of Greece to be lower than
its potential output (persistent inefficiency).
Finally, the high productivity is rather a deception as during that
period it is the result of a combination of an artificially ballooning
GDP (nominator) and low labour force participation rate (denomina-
tor). On the one hand, very few unregulated and tax evading self-
employed (over) work while, on the other hand, few salaried employees
work, within a context of closed and rigid product, service and labour
markets. So, unemployment and non-employed rates are very high,
especially among unconnected young.
All of the above had a major negative impact on the primary deficit
surplus/deficit and at the end of 2009 the projected budget deficit was
12.7 per cent vs. an expected 5.1 per cent of GDP (currently at 15.4
per cent). Initially the deterioration of the budget deficit and its impact on
public debt was masked by the low borrowing interest rate environment
that resulted from the EMU accession. However, as most EU countries
seemed to get out of recession at the end of 2009, Greece did not follow
and the result was the widening spreads during spring 2010. The Greek
debt-to-GDP ratio from 71 per cent in 1990 exceeded the 100 per cent
threshold in 2000 and it is expected to reach 158 per cent in 2011 and
even higher in 2012. Looking through the debt dynamics identity, the
contributing components of the debt (structural and cyclical primary defi-
cit ratio, snowball effect, which is mainly affected by the interest payments
and nominal growth, and the stock flow adjustment ratio) are discussed.
We constructed five scenarios regarding the level of public debt at the
end of the 201115 period in which it is commonly accepted that Greece
could return to global financial markets to finance its debt. We find that
only under a very optimistic scenario of robust growth of the economy,
based on structural and institutional reforms that boost productivity,
significantly improve competitiveness, and boost the financial sector, as
described in the Growth and Stability Program, can this happen. Only
under these conditions, along with a successful privatization of 50 billion
euros, the public debt to GDP ratio can reach the 60 per cent threshold
that the financial markets find comfortable. Alarmingly the more realistic
scenarios put the debt to GDP ratio above the 100 per cent threshold and
this raises many questions about the sustainability of the Greek debt.
So, the only possible options the Greek economy has are the follow-
ing: open markets; reduce unnecessary regulation; encourage reform in
education and job creation (through any kind of tax credits); fix public
finances by cutting public waste and taxing the untaxed privileged so as
not to hit domestic demand; create incentives for the black economy to
incorporate to the official one; and build well-functioning, independent
institutions and an administration not corrupted by the rents the closed
markets create now.
Notes
1. Parts of this paper have been presented at the LSE/HO seminar on 9 February
2010, at the Brookings Roundtable Series on the State of the Eurozone on
4 March 2011, and at the Bilbao Conference 27 June1 July 2011. It has
benefited from comments and suggestions from the audiences, especially
from J. Spraos, K. Featherstone, V. Monastiriotis, R. Henning, A. de Lecea,
C. Bastasin, J. Vaise, as well as from an anonumous referee. The paper
also draws from the work of T. Pelagidis with M. Mitsopoulos, especially
Mitsopoulos and Pelagidis (2011). The usual disclaimer applies.
2. Although to a certain extent, tourism that constitutes a significant part of
services should be considered also as a tradable service.
3. An indicative selection of related OECD and non-OECD related publications
is: OECD 2007a; Conway et al. 2006; Bassanini and Duval 2006; Nicoletti and
Scarpetta 2005; Nicoletti and Scarpetta 2006; Conway et al. 2005; Bassanini
and Ernst 2002; Scarpetta et al. 2002; Scarpetta and Tressel 2002; Nicoletti and
154 The Euro Crisis
Scarpetta 2003; OECD 2003; Alesina et al. 2003; Nicoletti et al. 2001; Conway
et al. 2006.
4. See Greek Stability and Growth Program, projections. January 2010, Greek
Government.
5. As this paper is written it is expected that this figure will be updated to
28 billion euros in the latest projections in The Economic Adjustment
Programme for Greece Fourth Review spring 2011 (European Commission
Directorate-General for Economic and Financial Affairs, 2011). As no specific
figures exist as of September 2011, we used the initial figure of 50 billion euros
in the scenarios for the progress of the public debt over the period 201115.
6. Bruegel Institute (http://www.bruegel.org/) estimates that to bring debt down
to 60%, the primary surplus should be strongly positive, around 8.4% during
201434. No country except Norway has managed to keep such a surplus
for so many years and without any negative repercussions on growth as it
requires large expenditure cuts and huge tax increases.
7. European Commission, Taxation Trends in EU, U Brussels, 2010.
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Appendix A
Applying the debt dynamics described in equation (1) on the five debt scenarios
the level of debt to GDP ratio at the end of 2015(_2015) is given in Tables 4.5
and 4.6. Table 4.5 assumes no stock flow adjustment while Table 4.6 assumes
that privatization will be fully successful raising 50 billion euros along with
minor budget expenditures (5 billion euros) related adjustments (scenarios
A and C) or partially successful raising 25 billion euros along with the same
minor budget expenditures related adjustments (scenario B).
1. Scenario IMF A: the base reform scenario, with an average primary surplus of
5 per cent and zero snowball effect (ig=0).
g
2. Scenario IMF B: a more realistic scenario with an average primary surplus of
3 per cent and a snowball effect (ig)
g of +3 per cent to reflect concerns of lack
of a timely and strong GDP growth.
3. Scenario IMF C: an optimistic reform scenario, with an average primary
surplus of 5 per cent and a snowball effect (ig)g of 2 per cent that is the
result of a robust growth of the economy based on structural and institutional
reforms that boost productivity, significantly improve competitiveness, and
boost the financial sector.
Table 4.5 Scenarios for debt dynamics (20112015), %
Annual
Scenarios without financial dl/dt
dl l_(2015)
l p ig f
adjustments
1 IMF scenario A 5 125 5 0 0
2 IMF scenario B 0 150 3 3 0
3 IMF scenario C 7 115 5 2 0
4 IMF scenario B plus 5 125 3 2 0
interest reduction 5
5 IMF scenario C plus 14 80 5 9 0
Table 4.6 Scenarios for debt dynamics (20112015), %
Annual
Scenarios without financial dl/dt
dl l
l_(2015) p ig f
adjustments
1 IMF scenario A 9 105 5 0 20
2 IMF scenario B 2 140 3 3 10
3 IMF scenario C 11 95 5 2 20
4 IMF scenario B plus 7 115 3 2 10
5 IMF scenario C plus 18 60 5 9 20
158 The Euro Crisis
Scenarios 4 and 5 assume that approximately 210 billion euros of the Greek debt
is due to be refinanced during the period (2011)15 with an average interest
rate of 13 per cent and average length of 7.5 years. Following the latest efforts
to reduce the Greek debt, a realistic scenario would be that these bonds will be
replaced by an average interest rate of 7 per cent and average length of 15 years
(or equivalently interest rate of 10 per cent and average length of 30 years) deliv-
ering an overall reduction to the snowball effect of 5 per cent. An optimistic
scenario would be that these bonds will be replaced by an average interest rate
of 4.5 per cent and average length of 30 years delivering an overall reduction to
the snowball effect of 7 per cent.
4. Scenario IMF B plus an interest payment reduction of 5 per cent: the more
g changing from 3 per cent
realistic scenario (2) with the snowball effect (ig)
to 2%.
5. Scenario IMF C plus a severe interest payment reduction of 7 per cent: the
optimistic reform scenario, with the snowball effect (ig)g changing from 2
per cent to 7 per cent.
5
The Irish Tragedy
Yiannis Kitromilides1
Abstract: This paper is an examination of Irelands rags to riches jour-

ney and its tragic collapse in 2008. Two policy decisions of the Irish
government were of particular significance in the light of subsequent
events: first, the decision to make Ireland an international off-shore
centre for the financial services industry with a light-touch regulatory
regime; second, the decision to join the euro-zone in 1999. After the
collapse in 2001 of the dotcom bubble in the US, construction replaced
Foreign Direct Investment by (mainly) US multinationals as the main
engine for growth in Ireland. The abrupt and catastrophic ending of the
long Irish boom in 2008 was primarily due to four interconnected causal
factors described in the paper: Irrationality; Imbalances; Incentives and
Imprudence. The irrational property price boom was fuelled by the bank-
ing system that was exploiting the euro-zones structural imbalances
and whose excesses, the result of an inappropriate incentives system,
were allowed and ignored by an imprudent regulatory regime. The main
conclusion of this paper is that no single causal factor in isolation could
have produced the kind of economic collapse that had occurred in
Ireland in 2008 whereby a banking crisis was transformed into a cata-
strophic fiscal crisis: euro-zone imbalances could not have produced the
banking collapse without regulatory imprudence; equally regulatory
imprudence could not have had such devastating consequences without
the capital flow bonanza induced by euro-zone imbalances. Both are in
need of fundamental reform but neither comprehensive redesign of the
euro-zone nor global financial regulation reform are anywhere in sight.
Keywords: Celtic Tiger economy, Foreign Direct Investment, euro-

zone imbalances, systemic risk, banking regulation, fiscal crisis
JEL Classification: O52, E60
159
160 The Euro Crisis
1 Introduction
Within the space of one year, over the period May 2010 and May 2011,
and at roughly equal intervals, there have been three bail-outs of euro-
zone economies. Ireland was the second economy to have received an
EU/IMF bail-out in November 2010. It was preceded by Greece in May
2010 and followed by Portugal in May 2011. The inclusion of Ireland
among the three euro-zone countries in need of an international bail-
out was surprising. This is because Ireland, unlike Greece and Portugal,
was a miracle growth economy, a Celtic Tiger that was transformed
in the space of 20 years from a poor, stagnant peripheral economy to
one of the richest in terms of per capita income economies in Europe.
In fact, Ireland became a role model for other peripheral economies.
This paper is an examination of Irelands rags to riches journey and its
tragic collapse in 2008. It begins by considering the main elements of
the Irish growth model and the various explanations for the astonish-
ing success of the model. It proceeds to review three periods of Irish
economic history: the protectionist and inward-looking period between
1922 to the early 1950s; the modernization period of the early 1950s to
the late 1980s that laid the foundations for an export-led growth strat-
egy relying on Foreign Direct Investment (FDI); and the Celtic Tiger
period of early 1990s to 2008.
It is worth repeating that Ireland does not fit in well either within the
group of countries that have received bail-out assistance or within the
wider grouping of the PIGS countries. (Portugal, Ireland, Greece, Spain,
to which Italy is sometimes added to give PIIGS.) The letter I in the
often-used acronym seems, at least geographically, out of place. Ireland
is not, of course part of southern Europe. Neither is the alternative (and
no less offensive) description of the heavily indebted economies of the
euro-zone countries as the siesta states2 remotely relevant in the case of
Ireland. What makes Ireland stand out, especially among the group of
euro-zone countries in receipt of an international bail-out is, above all,
the fact that unlike Greece or Portugal the Irish economy was considered
prior to the onset of the Great Recession in 2008 to be an example and a
role model for other small peripheral economies. From 1995 until 2007
Ireland experienced spectacularly high levels of economic growth which
produced a radical transformation of the Irish economy and society.
Unemployment, for long a persistent problem of the Irish economy,
was effectively eliminated. Moreover, a country used for long periods of
its history to seeing successive generations of its youth emigrating had
the novel experience of becoming a destination for immigrants, from
Yiannis Kitromilides 161
Eastern Europe, Africa, Latin America and Asia, attracted to Ireland by its
long economic boom. With regard to public finances and total indebted-
ness Ireland had consistently remained within the Maastricht criteria of
less than 3 per cent budget deficits and 60 per cent total debt-to-GDP
ratios. This economic boom made Ireland a Tiger economy, a term bor-
rowed from the success of the East Asian economies in the 1980s and
early 1990s (Kirby 2010b). Nothing of comparable size in terms of eco-
nomic growth and rise in per capita incomes occurred during the same
period in either Greece or Portugal. In fact, had the global financial crisis
occurred in 1988 instead of 2008 it would not have been at all surprising
to find Ireland grouped with Greece and Portugal as economies so dam-
aged by the crisis as to require international bail-outs. During the 1980s
Irelands total debt-to-GDP ratio had reached 125 per cent while eco-
nomic growth averaged only 1.9 per cent (Duff 2007, p. 2). This paper is
an examination of Irelands tragic journey: from the economic take-off
away from the periphery of Europe to the crash landing back into the
economic periphery in the space of 20 years.
The plan of the paper is as follows: section 2 briefly examines the
economic history of Ireland prior to the 2008 global economic crisis and
considers the nature of economic policymaking that produced the rags
to riches transformation of Ireland from one of the poorest economies
in terms of per capita GDP in Europe to one of the richest; section 3
describes the main features of the catastrophic collapse of the Irish
economy after 2008, while section 4 evaluates alternative explanations
concerning the underlying causes of the Irish crisis; section 5 considers
developments in Ireland and Europe since the Irish bail-out and section
6 summarizes and concludes.
2 The Irish economic miracle: the birth and death

of the Celtic Tiger
The modern state of Ireland was established in 1922 following inde-

pendence from Britain. It was first known as the Irish Free State and
after 1937 as the Republic of Ireland.3 The economic history of modern
Ireland prior to the current crisis can be divided into three distinct
phases: the post-independence period and the aftermath of World
War II until the middle of the 1950s; the modernization period of the
mid-1950s to the late 1980s; and the period between the late 1980s to
2008 known as the neoliberal era or the period of the Celtic Tiger.
The dominant feature of economic policymaking during the first
phase of modern Irish economic history was the attempt to establish
162 The Euro Crisis
economic autarchy by pursuing what Dorgan (2006) calls a policy of

economic nationalism. The country relied mainly on small-scale agri-
culture and exports of primary products predominantly to the UK mar-
ket. Political independence from British colonial rule was not followed
by economic independence from Britain. Although the post-colonial
period saw the first serious attempt at industrialization of the south of
Ireland, the protectionist policies of high tariffs and import substitution
pursued by Eamon de Valera after 1932 meant that whatever manufac-
turing there was catered mainly for the small domestic market. At the
same time the exchange rate was fixed at exactly one Irish pound equal
to one pound Sterling. Significantly the Control of Manufactures Act
1932 and 1934 prohibited foreign ownership of Irish industry effectively
conveying a message that in the unlikely event that foreign companies
wanted to invest in Ireland they were not welcome. Irelands population
in 1922 was just under 3 million and it remained marginally below that
level until the 1950s when it fell dramatically due to the emigration of
nearly half a million people in a single decade (Dorgan 2006).
The experience of economic stagnation and mass emigration in
Ireland contrasted sharply with other parts of postwar Europe where
rapid and steady recovery was taking place. By the mid-1950s the failure
of the policy of economic nationalism as well as the need for a change
in policy orientation became apparent. A first step towards a policy
shift from protectionism to outward orientation, which also marked the
beginning of Irelands low corporation tax regime, was taken in 1956
when tax relief on profits from export sales from Ireland was introduced.
Also the long-standing issue of foreign ownership was resolved in 1958
when all restrictions on foreign ownership of business in Ireland were
removed. The transition to a more open and less inward-looking
economy continued in the 1960s under the intellectual influence of
T.K. Whitaker, Secretary of the Department of Finance, and the political
leadership of Sean Lemass. Whitaker (1958) published a report, Economic
Development, t in 1958 critical of the protectionist infant industry strategy
and supportive of a strategy of attracting foreign capital through tax
concessions and other incentives. Implementation of Whitakers ideas
continued during the 1960s when Ireland sought membership of the
EEC, concluded a free trade agreement with the UK and joined the
General Agreement on Tariffs and Trade. At the same time foreign direct
investment was promoted and encouraged. A key role in this strategy
of attracting large-scale foreign investment was played by the Industrial
Development Authority (IDA), which was established in 1970 with
state funding but with independent board and staff. The IDAs principal
strategic aim was to target and entice investment in Ireland by high

technology and high-skills international companies. In order to achieve
this objective the government had to implement a number of related
and interconnected policies. It was recognized that simply adopting
free trade policies and offering favourable tax treatment of corporate
profits and other financial incentives were not by themselves sufficient
to attract foreign multinationals. Ireland also needed to have available
a highly-educated and technically-skilled low-cost work-force. It was
also essential that Ireland was able to provide foreign multinational
corporations an export platform and access to European markets.
During the second modernization phase of Irish economic history all
these complementary policies were gradually implemented: investment
in education became a top priority beginning in 1966 with the
introduction of free post-secondary education, and European accession
was achieved in 1973.
Although the strategy produced the intended outcome of attracting
foreign direct investment in Ireland from major international compa-
nies and for a period the Irish economic growth rate that was for so
long lagging behind the European average more than doubled, it was
not, however, all plain sailing. This phase of Irish economic history too
was not without its problems. In the first place the old indigenous firms
were not as well equipped to cope with the new open economy condi-
tions as their foreign counterparts. The net effect on job creation, there-
fore, of FDI was negative since the new jobs created were insufficient to
absorb the loss of jobs from failing indigenous businesses. Furthermore,
as a National Economic and Social Council (1982) report pointed out,
not only the employment effects of inward investment were exagger-
ated but also the expected linkages to the domestic economy were often
weak. Partly in response to rising unemployment, public expenditure in
all areas and public sector employment grew rapidly during the 1970s.
By 1980 a third of the labour force in Ireland was in public employment.
Expansionary fiscal policies in combination with international factors,
such as rising oil prices, produced high inflation which between 1971
and 1980 averaged an annual rate of 13.6 per cent. In 1981 inflation
in Ireland soared to 20.4 per cent compared to 11.9 per cent in the UK
and 12 per cent average in the EU (Dorgan 2006, p. 6). The economic
problems created by stagflation, not of course unique to Ireland during
that period, continued and were exacerbated during much of the 1980s
as the Irish government continued to pursue expansionary macroeco-
nomic policies of increased public spending and tax cuts. The result was
high inflation, high unemployment, balance of payments deficit due
164 The Euro Crisis
to the openness of the Irish economy and high emigration, this time
of highly-skilled young graduates. In addition to the many economic
problems, the 1980s was also a period of extreme political instability
with frequent changes of government punctuated with many instances
of political corruption. As Dorgan (2006) points out: The atmosphere
of the 1980s was more redolent of the dark years of the 1950s than of
the optimism that had permeated the two decades in between This
was not what the policies of the previous 25 years had been designed to
achieve. What had gone wrong? (p. 6).
Implicit in the what went wrong question in the quote above is
the assumption that the answer is to be sought outside the economic
model that underpinned the growth strategy and the economic policies
pursued during the second phase of Irish economic history between the
mid-1950s and the end of the 1980s: the assumption was that the model
was sound but there was something missing in its application. The cen-
tral elements of the neoliberal model were: trade liberalization; a low
corporation tax regime and other market-friendly public policies; unim-
peded access of foreign multinationals to the European market using an
English-speaking, highly-educated and low-cost work-force. Despite the
gradual introduction of all these measures the Irish economy during
the 1980s was in a critical state of high unemployment, high inflation,
high emigration, high public indebtedness and low economic growth.
According to Dorgan (2006) although external factors such as the weak
global economic conditions, persistent inflation and the fading impact
of EEC entry all contributed to the economic problems of the 1980s,
the principle cause of the Irish economic malaise was Big Government.
A similar conclusion was reached by Duff (2007). The missing element
for the successful implementation of the Irish economic model was of
course considered to be the establishment of small government, the
abandonment of Keynesian4 macroeconomic policies and the achieve-
ment of a climate of political stability. What this required was cuts in
public spending, reduction in public sector employment, a sustained
reduction in public indebtedness and budget deficits, and the establish-
ment of a political consensus on all of these objectives. Efforts towards
achieving a national consensus culminated in 1987 in a successful
Social Partnership Agreement, the result of negotiations organized by
the government and major employer and labour interests, which was to
mark the dawn of the Celtic Tiger phase of Irish economic history.
In 1987 the Fianna Fil party under the leadership of Charles Haughey
won power and, although largely responsible for huge increases in public
spending during their previous period in office and with a pre-election
commitment to increased public expenditure, the new government

announced a programme of savage austerity that included deep cuts in
public spending and public sector employment. The 1987 budget intro-
duced spending cuts in health (6 per cent), education (7 per cent), roads
and housing (11 per cent) and agriculture (18 per cent) (Duff 2007, p. 2).
Further spending cuts, the biggest Ireland had seen for 30 years, were
introduced by the 1988 budget. The opposition party of Fine Gael led by
Alan Dukes agreed under what has come to be known as the Tallaght
Strategy5 not to oppose the economic reforms and severe cuts proposed
by the Fianna Fil government thus departing radically from the tradi-
tional bitter divisions and rivalries, dating back to the civil war, between
the two main Irish political parties that marked previous decades. The
astonishing policy U-turn of Fianna Fil and the equally surprising deci-
sion of Fine Gael not to oppose the fiscal retrenchment measures could
be explained by the genuine fear of a financial melt-down due to the
real possibility of foreign and domestic financial markets refusing to roll
over Irelands huge public debt. The political consensus was followed
by a more general social consensus involving trade union leaders and
employers. The Social Partnership Agreement of 1987 was a three-year
national agreement that was to be renegotiated every three years and
sought to offset moderated wage increases with tax cuts and welfare
improvements. While these were essentially voluntary agreements, both
government and unions kept their side of the bargain and the three-year
national agreements were successfully renegotiated in subsequent years.
The trade unions kept demands for wage increase broadly in line with
what was agreed thus improving Irelands cost competitiveness. In short,
in the late 1980s a political consensus was reached in Ireland on limiting
the size of the public sector through cuts in public spending and taxes as
well a social consensus about a framework for reaching national agree-
ments on wages, taxation and economic policy. For many commentators
attempting to explain the Irish economic miracle the establishment
of economic and social stability was the missing ingredient, the final
piece of the jigsaw that needed to be put in place in order to create the
conditions for the birth of the Celtic Tiger. Put differently, according to
this viewpoint, the presence of the other ingredients of the Irish growth
model in previous decades, such as free trade policies, investments in
education, low taxation of corporate profits and European membership,
did not produce the intended outcome because of political instabil-
ity and fiscal mismanagement by big government. This according to
Dorgan (2006) is what went wrong with previous Irish development pol-
icies and, commenting on the remarkable policy shift of 1987, he points
166 The Euro Crisis
out that small government became part of the road to success (p. 7). It
should of course be noted here that the successful fiscal consolidation
that occurred in Ireland during this period was helped enormously by
the booming conditions in the UK economy which pushed up demand
for Irish exports.
After 1987 the Irish government continued to cut both public spend-
ing and taxes, maintaining some of the lowest levels, as a percentage
of GDP, in these categories in Europe. Small government, however,
did not mean that there was no state intervention in the economy.
The Irish state continued taking steps to promote business investment
and encourage FDI through measures, such as the creation of the
International Financial Services Centre in Dublin, and heavy invest-
ment in the telecommunications industry, which remained under
public ownership until the late 1990s.
The Celtic Tiger phase of Irish economic history between the early
1990s and 2008 can be divided into two sub-periods: the period before
and the period after the collapse of the dotcom bubble in 2001. The
dominant feature of the first sub-period was the huge influx of FDI, by
mainly US multinational corporations and mainly from the computer
and pharmaceutical sectors. In 1989, following years of efforts, the IDA
succeeded in persuading the Intel Corporation to build its first European
manufacturing centre in Ireland. Intel was soon followed by other lead-
ing-edge technology firms including Dell, IBM, Hewlett-Packard and
Microsoft. Ireland attracted, according to Duff (2007), over $70 billion in
investments from the US alone from 1993 to 2002. Undoubtedly FDI was
a significant contributory factor to the Irish economic success during this
sub-period. The favourable global economic condition of the 1990s was
another important contributory factor. A further contributory factor was
the role of EU economic transfers. The truly remarkable transformation
of the Irish economy from one of the poorest to one of the wealthiest
in Europe cannot be explained solely by the prevailing global economic
conditions or EU transfers. Similar global economic conditions prevailed
and comparable EU transfers were made to other peripheral European
economies without achieving similar growth. Economic growth in
Ireland rose to record levels, averaging 9.4 per cent per annum between
1995 and 2000. There were dramatic increases in employment growth
during the same period, while the unemployment rate fell from over
15 per cent in 1993 to just over 4 per cent by 2002. Average industrial
wages grew at one of the highest rates in Europe and at the same time
a striking reversal of previous trends in population growth and emigra-
tion took place: the traditional trend of net emigration was reversed as
Ireland became a destination for immigrants, mainly from citizens of

new entrants into the enlarged European Union, such as Poland and
the Baltic states. As a result of increased net migration, Irelands popu-
lation increased by 15 per cent between 1996 and 2005, many of the
new immigrants finding employment in the retail and service sectors
(Dorgan 2006, p. 1). Significantly, in the light of subsequent events, pub-
lic finances also improved spectacularly from the situation prevailing in
the 1980s with balanced public budgets and a sharp decline in public
debt-to-GDP ratio largely, of course, due to the dramatic rise in GDP.
Apart from Dorgan (2006) and Duff (2007), Grey (1997), Sweeny
(1988) and Barry (1999) also provided explanations for the Celtic Tiger
phenomenon: how was it possible for an economy with low growth,
high unemployment, chronic budget deficits, current account deficits
and chronic net migration be transformed in such a short space of time
into an economy of high growth, full employment, budget and current
account surpluses and net immigration? Murphy (2000) persuasively
argues that the lack of a domestic industrial base was a help rather than
a hindrance to the successful and speedy transformation of Ireland
from a pre-industrial to a post-industrial economy. Ireland was able to
leap-frog and skip the industrialization stage and this had two distinct
advantages. First, the lack of industrialization meant the absence of
obsolete capital stock and rigid labour practices, which made Ireland an
attractive destination for foreign Multi National Corporations (MNC).
Second, it also meant that there were no major local objections to the
granting of corporation tax concession and other incentives to foreign
MNC. Ireland was able to offer these tax concessions to foreign MNCs
which the UK and other mature industrial economies could not match.
Furthermore Ireland was far more committed to the process of European
economic and monetary integration than the UK, the other possible
English-speaking destination of US multinationals. The offer of low
corporate taxation, English-speaking young and educated work-force,
market-friendly policies and a full government commitment to the
Single European Market and European Monetary Union made Ireland an
irresistible magnet for US multinationals. According to Murphy (2000)
the comparison of the Irish economic miracle and growth performance
with the Asian Tiger economies is misleading.6 It is more appropriate
to describe the phenomenon as a predominantly US high-tech, multi-
national tiger nurtured in a special Irish tax reserve (p. 14). By 2002,
however, doubts had begun to emerge concerning the continuation of
this US-induced economic boom in Ireland. After seven years of con-
tinuous expansion, Irelands growth momentum slowed sharply.
168 The Euro Crisis
The bursting of the dotcom bubble in the US and the stalling of many
IT businesses produced the first warning signs of impending trouble for the
Irish Tiger economy. The slow-down in the US economy had an obvious
impact on the Irish economy, given the strong economic links between the
two countries and the leading role played by Ireland in the global IT indus-
try. The large reduction in investment in the global IT industry, therefore,
combined with the global economic slow-down had serious adverse effects
on Irelands high-tech export sector which experienced a decline in the
sectors growth by nearly half. GDP growth also declined but it remained
by international standards relatively robust. In fact the economic down-
turn in Ireland was merely a slow-down in the rate of economic expansion,
not a full-blown recession. There were signs of a recovery in late 2003 and
by 2004 Irish economic growth rates started accelerating again.
The resumption of another period of spectacular Irish economic growth
had been dubbed by the media as the Tiger 2 period. The main engine
for growth during this period was no longer the (mainly) US high-tech,
export-orientated FDI. Rapid economic growth during the Tiger 2 period
was predominantly the result of the activities of the domestic banking
and construction sectors. Understanding the inter-connections between
the two sectors and also the relationship of both sectors with government
is crucial in explaining the nature of the boom conditions in Ireland after
2004. The construction sector in Ireland accounted for nearly 12 per cent
of GDP and a large proportion of employment among young, unskilled
men. Between the early 1990s and 2007 employment in the construction
industry nearly doubled, from about 7 per cent to just over 13 per cent of
the work-force (see Honohan 2009, p. 212). In 2004 80,000 new homes
were constructed in Ireland, half as many as those completed in the
same year in the United Kingdom, which has 15 times Irelands popula-
tion. According to the 2006 census of population, about 15 per cent of
the housing stock was vacant at census date, indicating the speculative
nature of additional housing construction and purchases, mostly by pros-
perous households. One possible explanation for the gigantic construc-
tion boom is that what the large construction sector was doing during the
Tiger 2 period was merely catching up with the demand for construction
caused by the first boom. The first boom created not only big increases
in per capita income but also, for Ireland, an unprecedented increase in
net migration. The construction sector however would not have been
able to do so much catching up, let alone create a property price bubble,
without the finance provided by the Irish banking sector. At the peak of
the boom house prices (deflated by CPI) were rising at nearly 4 per cent
per annum (see Honohan 2009, p. 211). The banking sector, on the other
hand, would probably not have been able to finance the property bub-
ble to such a huge and unsustainable extent without two crucial policy
choices made by the Irish political system.
The first set of policy choices go back to the early 1990s when the Irish
government decided that Ireland should become a leading international
centre for off-shore financial services. The major additional attraction for
foreign financial services firms considering setting up operations in Ireland
was, of course, the countrys very light-touch, virtually no-existent, tax
and regulatory framework. This decision would have some unintended but
devastating consequences on the Irish economy: so light-touch and lax was
the countrys banking supervision and financial regulation that by 2005
the New York Times was describing Ireland as the wild west of European
finance (see Lavery and OBrien 2005). The wild west reputation of
Irish banking regulation led to the creation of the Irish Financial Services
Regulatory Authority, which however still failed to spot and prevent some
extremely dubious accounting practices by domestic banks, some of which
came to light after the 2008 crisis including revelations about the corrupt
relationships between the financial sector and Irish politicians. Connor
et al. (2010) put it in a nutshell when they point out: In addition to ignor-
ing, or even condoning, fraudulent accounting, the financial regulator and
Irish central bank made strategic errors in not responding to the build-up
of systemic risk to the banking system (p. 15).
The nature of these policy errors and the various basic warning
signs which the Irish system of prudential regulation and supervision
had ignored are fully analysed by Honohan (2009). First there was an
unhealthy over-expansion in the balance sheet of Irish financial institu-
tions. Balance sheet growth in excess of 20 per cent in any one year is
generally considered imprudent. Yet as Honohan (2009) points out:
(T)he balance sheet growth of some Irish financial institutions

expanded on average by more than 20 per cent every year between
1998 and 2007. One of them, Anglo Irish Bank, crossed it in eight of
nine years, and indeed its average annual rate of growth 19982007
was 36 per cent. Another, Irish Nationwide, crossed the line six out of
the nine years, for an average rate of growth over the nine years of just
above 20 per cent. So this was a very obvious and public danger sign
not only for these two banks, but because of the potentially destabilis-
ing effect of reckless competition on the entire sector. (p. 217)
The Irish regulator should have taken steps to prevent these danger-
ously high balance-sheet growth rates. Second, the Irish banking sectors
170 The Euro Crisis
over-concentration of lending activities on property development was

another obvious sign of systemic risk that the Irish regulator ignored.
Third, the clear distortion of the risk profile of individual institutions
was totally ignored. Irish Nationwide, a building society whose mission
was to provide retail mortgages to its members, was using 80 per cent
of its members fund for loans to a small number of property develop-
ers. Finally, another sign of possible systemic risk which the regulatory
system in Ireland had failed to act upon was the general loosening of
lending criteria. Some banks adopted aggressive lending policies with
money borrowed cheaply from the interbank euro market, which other
more conservative banks copied in order to preserve market share and
which, in turn, led to a general decline in lending standards. Unlike
the situation in the US where during the same period the decline in
lending standards occurred under the originate-and-distribute system,
in Ireland the lending standards decline took place under the more tra-
ditional originate-and-hold lending system. Monitoring credit quality
was, therefore, of far greater importance in the case of Irish banks where
almost all originated loans remained on their own balance sheets. Not
only had the Irish regulator failed to prevent the decline in lending
standards but it had also failed to act upon the excessive concentration
of bank lending to property development which made the loan books of
Irish banks dangerously undiversified (see Honohan 2009). The conse-
quences of the Irish regulatory failure to deal with the various warning
signs concerning systemic risk will be discussed further in section 4.
The second policy choice that had a significant impact on the Irish
banking sectors ability to fuel the property boom was Irelands decision
to join the euro in 1999. Before 1999, Irish banks were funded prima-
rily from domestic sources. After Irelands entry to the euro-zone, Irish
banks funded much of their lending with short-term foreign borrowing.
According to Honohan (2009): From 2003 the banks leveraged their
local resources with enormous borrowings from abroad (easily available
due to the global savings glut, and also to the lack of exchange rate risk
for euro borrowing). At the end of 2003, net indebtedness of Irish banks
to the rest of the world was just 10 per cent of GDP. By early 2008 they
had jumped to over 60 per cent (p. 209).
This allowed Irish financial institutions to extend much larger vol-
umes of credit to borrowers at considerably lower cost than would
have been the case had Ireland remained outside the euro-zone. In fact
Connor et al. (2010) estimate that had euro zone interest rates been
set in accordance with a Taylor rule for Ireland, the interest rate would
have been almost 6 per cent higher on average during the period, and
up to 12 per cent higher in 2000 (p. 12). The so-called basic design
flaws of the euro-zone are extensively discussed by Arestis and Sawyer
in Chapter 1 in this volume. They can be summarized as follows: first,
the centralization of monetary policy while keeping other instruments
of economic policy under national control is incoherent (Arestis and
Sawyer 2006a, 2006b, 2006c). Second, there is the problem of the one
size fits all interest rate policy: it is clearly impossible to determine one
interest rate level that is appropriate for the needs of 17 heterogeneous
economies. Third, members of a monetary union lack the capacity dur-
ing a crisis to stimulate their economy through the instrument of cur-
rency depreciation. Finally, a budget deficit in a member country can be
transformed by market sentiment from a liquidity crisis into a solvency
crisis, which in turn, through contagion, may threaten the stability of
the whole system. As DeGrauwe (2011) argues, the separation of mon-
etary and fiscal authority is likely to create vulnerabilities and fragilities
in individual member states that are not present in states not belonging
to a monetary union: in a monetary union, financial markets acquire
tremendous power and can force any member country on its knees
(p. 5). As McDonnell (2011) puts it: The absence of control over the
Lender of Last Resort (LOLR) can generate a liquidity crisis for member
states borrowing to support a budget deficit. A loss of confidence by
investors can become a self-fulfilling prophecy, and the liquidity crisis
can degenerate into a solvency crisis (p. 3). The so-called design flaws
of the euro zone, therefore, have not only contributed to the emergence
of the crisis in the periphery but also prevented and continue to pre-
vent, in the absence of radical reforms, its quick resolution.
In the case of Ireland there is little doubt that inappropriately low
interest rates, in combination with the large inflow of credit associated
with this distortion in interest rates and exchange rate risk premiums,
played a crucial role in the creation of the property bubble in Ireland. As
if additional fuel to the property bubble were needed, the Irish govern-
ment aided and abetted the construction frenzy by further providing a
high level of subsidy to the construction sector. It should be noted that
the construction boom and property bubble generated a very high level
of tax revenues from taxes based on property transactions. This tempo-
rary increase in tax revenue, however, was used as an excuse for reduc-
ing income tax and capital gains taxes. With the collapse of the property
boom in 2008, therefore, the Irish tax base had been narrowed to such
an extent that tax receipts collapsed by a third. Further consideration
of how the design flaws of the euro-zone impacted Ireland are given in
section 3 below.
172 The Euro Crisis
Critics of this strategy consider the Tiger 2 boom years as a lost oppor-
tunity for a radical change in policy direction. Clancy and McDonnell
(2011) insist that instead of an unsustainable construction boom Ireland
needed a significant increase in productive infrastructure:
Although the capital stock of the Irish economy soared by 157 per cent
in real terms in 20002008, housing accounted for almost two-thirds
of the increase. Private investment in core productive infrastructure
was described as pitiful in a report by Davy Stockbrokers. For example,
private sector net investment in the capital stock apart from retail,
storage, transportation and house building was only 14.5 bn euro
in the eight years to 2008 (in constant 2007 prices). That equates to
an increase in the volume of the capital stock of 26 per cent. Under-
investment in telecommunications is a particular concern, with Ireland
lagging badly behind for a range of broadband indicators. For example,
Irelands fixed broadband subscription rate per 100 people is the third
lowest in the EU. Ireland followed the low tax/low spend neoliberal
model during the years of the Celtic Tiger. Over the period 1995 to
2008 the level of public spending averaged 34 per cent of GDP, the
third lowest average level of public spending in the OECD during this
period. This was a time when Ireland had relatively low social welfare
demands because of low unemployment and relatively few pensioners.
Ireland failed to exploit this benign fiscal position to ramp up invest-
ment in critical areas such as education, research and development,
child care and social infrastructure, important for the future competi-
tiveness of the country and the long-term well-being of citizens. (p. 2)
Kirby (2010) also insists that the post-2001 period was a missed oppor-
tunity for Ireland to change its growth strategy to one that promoted
domestic industrial development. Once the risks of a growth strategy
that relies heavily on the prospects of foreign MNCs became appar-
ent in the early 2000s, Ireland should have changed course towards a
strategy of encouraging the development of a domestic industrial base
as well as a change in its taxation and distribution policy. This strategy
would have probably produced a less rapid but a more balanced and less
unequal growth path for Ireland.
Moreover, the benefits of rapid miracle economic growth have not
been equally distributed. As Dellepiane and Hardiman (2011) point out:
(While) Irelands income per capita ranked among the highest in

the OECD by 2007, the average levels of income inequality over the
period of the boom remained stubbornly high. Indeed, this indica-

tor reveals that on the inequality measure, Irelands performance is
similar to that of poorer Southern European countries such as Spain
and Greece, and only slightly better than other liberal market econo-
mies (Britain, New Zealand and Australia), with Portugal and the
USA being particular outliers in each of these groups. These measures
indicate that rapid growth and employment expansion, combined
with ongoing commitment to social partnership processes, have
not contributed either to a sustained reduction in domestic social
inequalities or to an expansion in the extent of social or collective
consumption. The expansion of public social spending that took
place did not keep pace with market-driven living standards. The tax
system favoured rather than contained the surge in higher income
rewards. Redistributive spending, while it grew over time and espe-
cially during the 2000s, continued to be disbursed on a residual
model, involving often complex means-testing and eligibility assess-
ments. (p. 5)
Although some of the most extreme levels of social deprivation

experienced a continuous decline this is attributed mainly to the drop
in aggregate unemployment. According to Nolan (2009), among those
who remained at serious risk of poverty, income and lifestyle depriva-
tion were severe, with households headed by someone who was unem-
ployed because of ill health, disability, single parents, or with low levels
of education and skills being the most vulnerable. Furthermore, levels
of income inequality during the Celtic Tiger period increased as a
result of the top section of the income distribution pulling away from
the median. Kirby (2010) also concludes that: While the increased liv-
ing standards and improved employment opportunities generated by
the Irish model benefited the lives of many, less attention was focused
on the increases in relative poverty and in inequality that in fact charac-
terized the boom years in Ireland, or on the failures to invest adequately
in quality social services, especially for the most marginalized (p. 46).
3 The main features of the Irish crisis and its aftermath
Instead of a change in policy direction the Irish government opted for

the easy solution of leaving it to the bankers and property developers
to generate rapid economic growth: construction and property devel-
opment were the main engines of growth during the Tiger 2 period.
With the onset of the financial crisis in 2007 the construction sector
174 The Euro Crisis
was the first to feel the impact of the global downturn and when the
property price bubble finally burst in early 2008 the consequences for
Ireland were disastrous: for the construction companies and the work-
ers employed in the industry; for the indebted households who found
themselves in negative equity territory; and for the Irish government
whose major source of revenue was property related taxes. For the Irish
banking sector, however, the consequences of the property crash were
devastating.
The problems for Irish banks caused by the domestic conditions in
the property market were, of course, compounded by the international
financial crisis during 2008. Not only Irish banks and financial insti-
tutions found themselves, owing to domestic factors, with a rapidly
deteriorating loan book but they also found themselves, owing to
international factors (mainly the global liquidity crisis), experiencing
difficulties of rolling over their huge foreign borrowings. As the global
financial crisis gathered momentum during 2008, culminating in the
collapse of Lehman Brothers, Ireland was inevitably engulfed in the
global turmoil over uncertainties concerning the health of the interna-
tional banking system.
As Dellepiane and Hardiman (2011) correctly point out, the Irish crisis
had three inter-linked dimensions: it was not only a financial crisis but
also a crisis in competitiveness and a fiscal crisis. The financial crisis
as we saw above had domestic origins but it was also greatly influ-
enced by Irelands euro-zone membership. Similarly the decline in the
relative competitiveness position of Ireland had domestic origins: the
inflationary effects of cheap credit and rising house prices, fuelled by
irresponsible lending by domestic banks led to loss of competitiveness.
The decline in competitiveness, however, was exacerbated, as was the
decline in the relative competitiveness of Greece, Portugal and Spain,
by structural imbalances between economies of the European single cur-
rency area: the counterpart to the loss of competitiveness in the periph-
ery was the gain in competitiveness in Germany and other countries of
Northern Europe. As already noted above, the domestic origins of the
financial and competitiveness crises need to be seen in relation to the
design flaws of the euro-zone. Undeniably the creation of monetary
union in Europe was as much a political as an economic project from
the outset. The ultimate objective of the political project was of course
closer European integration. The central dilemma was whether politi-
cal integration was a pre-condition for monetary union or whether a
common currency would become an instrument of closer integration.
Eventually the latter view prevailed that nominal unity through a
shared system of money would enforce closer alignments of policy and

convergence of economic performance thus making the task of closer
political integration easier.
As discussed above the crisis in the euro-zone exposed the vari-
ous design problems of the European Monetary Union. In particular
two design flaws have made economic convergence especially dif-
ficult. First, and as Dellepiane and Hardiman (2011) point out, while
Germanys ability to discipline domestic costs effectively over time was
retained, the same was not true in other euro-zone member countries
with very different political institutions and organized interests. As
Franzese and Hall (2000) and Hall (1994) explain, inflation control had
long been prioritized in Germany through the role of its strong and
independent Bundesbank, and the signalling mechanisms from the
Bank that any relaxation of fiscal disciplines, or any sign of inflation-
ary wage settlements, would be controlled through increases in interest
rates. Over-focus on price stability and stagnant wages in Germany
which suppress domestic consumption exacerbated euro-zone imbal-
ances rather than having the effect of promoting economic conver-
gence: exports in Germany, mainly to the euro-zone countries that
were unsuccessful in suppressing wage growth, between 2002 and 2007
accounted for 143 per cent of German economic growth, according to
the South Centre Report (2011).
Second, the one size fits all interest rate regime was patently unsuit-
able for countries with very different growth rates. The low interest rates
set to cater for the needs of the largest states had certain unanticipated
consequences. Instead of leading to economic convergence on low
German interest rates, the policy produced the opposite result: periph-
eral euro-zone countries suddenly experienced a massive surge in the
availability of consumer credit which was considerably cheaper than
could be justified by their own growth potential. Without the ability to
control domestic interest rates, according to Conefrey and FitzGerald
(2010) national governments proved unable or unwilling to exercise the
necessary fiscal disciplines on a scale that would have made any appre-
ciable difference in preventing the fiscal crises. The relative significance
of euro-zone membership as a contributory causal factor in the Irish
crisis is explored further in section 4.
The fiscal crisis in Ireland, however, was almost entirely due to the
mismanagement of risk by the domestic financial sector and the con-
sequent near melt-down of Irish banking post-2008. Irelands fiscal
profile for the period 19802010 shows that the large budget deficits
as a percentage of GDP of the 1980s were stabilized and replaced by
176 The Euro Crisis
virtually continuous fiscal surpluses since the mid-1990s until 2007

(see Dellepiane and Hardiman 2011, p. 29.) It should be noted however
that there were underlying weaknesses in both the revenue generating
capacity and in public spending patterns in Ireland. Irelands level of
tax receipts was consistently around 10 percentage points lower than
the EU average. Nevertheless the dramatic return of massive fiscal defi-
cits in Ireland from 2007 onwards cannot be explained simply by these
tendencies towards pro-cyclical fiscal policies. Although the fiscal defi-
cit is exaggerated by the sharp declined of GDP between 2007 and 2010
there is little doubt that the huge increase in Irelands budget deficit and
total indebtedness was the result of the governments blanket guarantee
and commitment to recapitalize the banking system.
At the start of 2008 the Irish economy, with quarterly GDP falls of
0.3 per cent (1Q ) and 0.5 per cent (2Q ), had officially entered a reces-
sion, the first of the euro-zone economies to officially do so during the
Great Recession. It also marked the end of the Celtic Tiger period of
Irish economic history since this was Irelands first recession since 1983.
By 2010 GDP had fallen 14 per cent when compared to 2008 and unem-
ployment had reached nearly 15 per cent (Kirby 2010a, pp. 434). The
blanket banking guarantee of September 2008, originally for two years,
failed to stabilize the Irish banking system and by December 2008 the
government announced a recapitalization plan of Irelands three main
banks, Allied Irish Bank, Bank of Ireland and Anglo Irish Bank to the tune
of 3.5 bn euro. The Irish banking system, however, had remained in a
zombie state and by September 2010 a huge amount of cash was due to
be rolled over, equivalent to 30 bn euro of government-guaranteed bank
debt. Owing to the Irish banks inability to raise new funding from the
markets, they became almost totally dependent on the willingness of
the European Central Bank (ECB) and the Irish Central Bank to provide
liquidity. Consequently Irelands market credibility nose-dived while
bond spreads worsened to such an extent that the sovereign temporar-
ily withdrew from the bond markets. By November, the ECBs exposure
to Irish banks had reached almost 130 bn euro (Clancy and McDonnell
2011). It appears that the ECB, having formed the opinion that the
situation was unsustainable and in need of decisive resolution, pressed
the Irish government into requesting a lending facility. Initially this
pressure to access a bail-out fund was resisted partly because the Irish
government had no pressing sovereign funding needs until the middle
of 2011 and partly because of fear of the inevitable political fall-out of
a bail-out. Ultimately, however, the Irish government acknowledged
that a deal was being negotiated and agreed. The falling from grace was
completed in November 2010 when the former Celtic Tiger economy

received an EUECBIMF international bail-out.
Having examined the likely factors responsible for the long Irish
boom or the Irish economic miracle and the main features of the Irish
crisis, we turn our attention next to the possible causes of the spectacu-
lar Irish bust or the demise of the Celtic Tiger.
4 The main causes of the Irish Tragedy
As already noted, the fact that Ireland was in need of an international

financial rescue package alongside Greece and Portugal was indeed
surprising because, unlike Greece and Portugal, Irelands Celtic Tiger
economy was the great economic success story of the previous two dec-
ades and a role model of economic transformation for other peripheral
economies with similar aspirations. What went wrong?
A similar question posed 20 years previously (see section 2 above)
resulted in a debate that produced the answer that big government
was responsible for Irelands economic woes in the 1980s. A national
political and social consensus emerged that small government and the
application of neoliberal economic policies was the way forward for the
country. It would be tempting but rather simplistic (although perhaps
fundamentally correct) to claim that in 2008 the exact opposite was the
case: the crisis was the consequence of small government and the way
forward is the abandonment of neoliberal economic policies. In 2008
Ireland was not the only country to be adversely affected by the global
financial crisis and therefore any discussion of the causes of the Irish crisis
must take place within this context. Apart from the Southern European
euro-zone countries, the financial crisis also affected a host of other
countries as diverse as the US, the UK, Iceland and Latvia. Although the
global financial crisis was precipitated by the sub-prime fiasco in the US,
the principal underlying causes of the ensuing crisis in each country were
different. With this caveat we proceed to examine the principal causal
factors responsible for the collapse of the Irish economy in 2008 result-
ing in the need for an international bail-out in November 2010. We will
follow the approach and the terminology of Connor et al. (2010) and dis-
cuss four closely interconnected factors which, although present in other
countries, particularly in the US, during the same period they operated
in a distinctive way in the case of Ireland. The four factors were: irrational
exuberance; capital flow bonanza; regulatory imprudencee and moral hazard.
The first factor irrational exuberance, a term associated with
Greenspan (1996) and Schiller (2005), refers to the behavioural anomaly
178 The Euro Crisis
observed in security markets when intermittent periods of aggregate

over-confidence and over-optimism produces over-inflated asset prices
and excessive aggregate risk-taking. In Ireland, the over-confidence was
the product of the Celtic Tiger period of miracle economic growth.
Prolonged periods of economic boom generated a feel good factor
which in turn led to a period of irrational exuberance among many
participants in the financial and property markets. The main effect
of this irrational exuberance was a sustained property price boom in
Ireland. As we saw above, the Irish housing boom was in fact a rational
response to increasing demand resulting from increase in per capita
income and net inward migration. Initially increases in supply were
inadequate to meet the increased demand and this resulted in a sharp
increase in prices, which however developed into a huge property price
bubble with the crucial help of the Irish banking system.
The second factor, termed by Reinhart and Rogoff (2008b) as capital
flow bonanza, refers to the sustained surge in capital inflows that took
place in Ireland prior to the crisis. According to Reinhart and Rogoff
(2009) this is a common feature during the run-up period to banking
crises. In the US, because of the well-known problem of global trade
imbalances, the bonanza took the form of huge foreign funds flow-
ing into US government debt and into an exotic variety of securitized
assets. In Ireland, as was noted above, the bonanza was initiated by Irish
banks exploiting imbalances in the EMU system, the result of the basic
design flaws of the euro-zone discussed in the previous section. It took
the form of huge borrowings from international capital markets. This
large flow of credit into Ireland would not have been possible without
Irelands membership of the euro-zone, which meant that the credit risk
premium of its foreign borrowing was much lower than would other-
wise have been the case. Consequently Irish banks were able to borrow
huge amounts of foreign money and lend it to domestic mortgage bor-
rowers and construction companies at interest rates determined by the
ECB. With nominal rates set to cater for the entire euro-zone, Ireland
had great difficulty controlling its inflation, leading to a period of very
low and sometimes negative, real interest rates. The ECB policy rate was
less than the Irish inflation rate for most of the ten years prior to the cri-
sis. Had Ireland maintained its own currency and not joined the euro in
1999 the exchange rate risk premium and nominal interest rates would
have been much higher and would have acted as a restraint to the
excessive foreign borrowing by Irish banks which fuelled the property
price bubble. Similar capital flow bonanza conditions were, of course,
experienced by other peripheral euro-zone economies.
The third factor accounting for the Irish crisis, also extensively
discussed in relation to the crises in other countries, notably the US and
the UK, was regulatory imprudence. As already discussed above, the
problem in Ireland was not so much a failure to regulatee but a failure to
supervisee the banking and financial system. The Irish financial system
neither produced nor consumed any of the toxic financial products that
the US regulators failed to control. The Irish regulatory system simply
failed in its macro-prudential function: it failed to heed all the warning
signs, discussed in section 3 above, concerning the increased systemic
risk that the reckless activities of Irish banks and financial institutions
had created.
The fourth factor contributing to the crisis was the moral hazard prob-
lem: the incentive to act recklessly because of the absence of any personal
consequences to an agents risky and reckless behaviour. There are several
types of moral hazard problems in the financial services sector: there are
moral hazard problems in the originate-and-distribute loan generation
system; in the performance-related bonus system of compensation which
encourages short-termism; and in the implicit government deposit guar-
antee because of the too big to fail or privatization of profits and sociali-
zation of losses argument. The latter moral hazard problem is, of course,
one of the central questions in the debate concerning the reform of the
international banking system in order to prevent recurrence of the crisis:
how to ensure systemic stability without encouraging reckless behaviour
by bankers? In the Irish crisis, however, according to Connor et al. (2010),
although the implicit government guarantee of bank deposits may have
encouraged reckless behaviour, the major source of moral hazard was
weak law enforcement and the ability of politically powerful interests
to manipulate regulatory and legislative processes to their advantage.
As they point out with regard to the two rogue institutions, Anglo Irish
Bank and Irish Nationwide Building Society, which stoked the fires of the
bubble with particularly reckless lending practices: When the magnitude
of the bad loans at the two institutions became clear, along with a host
of accounting and share trading irregularities, both of these bank heads
were forced into retirement. Both of the two rogue-bank heads retired
with their large fortunes intact, and there is little or any hope of financial
recourse by taxpayers or others (p.19). Weak law enforcement induced
reckless behaviour not only in the financial services sector but also in the
construction sector. Many large property developers in Ireland had very
close connections to the ruling political Fianna Fil party. As Kelly (2009)
explains, in the Irish business environment it was not a question of being
too big to fail but of being too connected to fail.
180 The Euro Crisis
An alternative mnemonic categorization of these factors is to describe

them as the four Is: Irrationality (leading to excesses in asset pricing);
Imbalances (leading to capital flow bonanza); Imprudence (leading to
regulatory failure) and Incentives (inappropriate incentives creating
moral hazard). All four factors were closely interconnected and mutu-
ally re-enforcing. Irrational exuberance may have convinced buyers
and lenders that record high property prices would go on rising forever.
The property price bubble, however, would not have been so enormous
without being fuelled by the capital flow bonanza, itself the product
of euro-zone imbalances. At the same time the capital flow bonanza
would not have been so damaging to the Irish economy had corrupt
and ineffective regulators not, essentially, turned a blind eye to the
many moral hazard problems and obvious excesses of the Irish bank-
ing and financial system. Equally, regulatory failures would not have
been so catastrophic in the absence of a property price bubble and
had Ireland remained outside the euro-zone. In other words, no single
causal factor in isolation could have produced the kind of devastating
economic collapse that occurred in Ireland in 2008.
It can be argued, of course, that each one of these causal factors was
the result of policy decisions produced by the Irish political system.
The Irish crisis, therefore, can be viewed as the inevitable outcome of a
series of policy mistakes. The really interesting question is to ask why
these policy mistakes occurred. Is it the case, as the Irish NESC (2010)
claims, that these policy mistakes were just policy mistakes from which
lessons can be learned without a fundamental shift in policy direction?
Or, is it the case that the policy errors were linked to a wider underlying
ideological position, in which case a more fundamental paradigm shift
is necessary in Irish economic policymaking? Among those who believe
that the policy mistakes were linked to a particular ideological position
two conflicting viewpoints emerge.
One line of argument sees a link between the policy errors and the
Irish governments uncritical embrace of neoliberal ideology and free
market principles. The Irish governments growth strategy was based
on neoliberal principles that involved the establishment of a small
government, a small welfare state and an environment supportive of
the private sector. Irelands export-led growth, unlike that of the Asian
Tiger economies, was based on improving the competitiveness and
facilitating the profitability of foreign-owned firms through lower taxes
and light-touch regulation. When this strategy was challenged by the
events of 2001 the Irish government did not change course in favour
of a policy of full state support to domestic industry. Instead it chose
a path consistent with its previous reliance on market-friendly state

policy: namely, leave it to the bankers and builders to generate rapid
domestic growth. Thus, according to some commentators, instead of a
smart economy Ireland chose to build a concrete economy. Had the
Irish government, during the Tiger 2 period, expanded the welfare state
sector it could have boosted the volume of domestic demand in the
traditional Keynesian manner and could have tied this boost in domes-
tic demand with a policy of expanding domestic industry (see also
Kirby 2004).
An alternative argument supported by the libertarian right or neo-
Austrian school of economics takes a diametrically opposite view: the
Irish government made policy mistakes not because it embraced free
market principles but because it had abandoned these principles. This
school believes that economic efficiency is maximized when there
is complete decentralization of economic activity and when market
prices are allowed to fluctuate freely in response to these decentralized
actions and thereby fulfil their resource allocation function. Market
prices incorporate not only the prices of goods and services but also
the price of money (interest rates) and the price of a countrys currency
(exchange rates). The decision by the Irish government to join the euro
is seen as a betrayal of free market ideology because the establishment
of a single currency and the centralization of monetary and interest rate
policies in the hands of the ECB distorted the key function of prices in
guiding resource allocation and disciplining economic agents such as
governments, corporations or banks. The problems in Ireland and other
euro-zone countries was the result of distortions in the determination
of interest rates and exchanged rates introduced by governments rather
than by the operation of free markets.
It may of course be the case that the Irish government did not have
an entrenched ideological commitment either to the cause of European
economic federalism or to the paramount importance of a globalized
neoliberal economy. It could simply be the case that the Irish govern-
ment, backed by the majority of the electorate, had a pragmatic com-
mitment to rapid economic growth and increase in material prosperity
even though this entailed certain costs and risks: rise in inequality,
a fall in state welfare and increased social insecurity. The so-called
policy mistakes of not encouraging the development of domestic
industry after 2001 or of joining the euro-zone in 1999 must be seen
in the context of this overriding objective: both decisions if reversed
could have resulted in a much slower, certainly not miracle, economic
growth. The majority of Irish people, however, wanted rapid miracle
182 The Euro Crisis
growth. It is not clear, of course, that the majority of Irish people, or

indeed American and European people, were in fact aware of the risks
of thick-tail uncertainty. In that respect Ireland is not alone in discov-
ering that deregulation of the financial services industry can produce
these so-called Black Swan events: events with small probability but
huge catastrophic impact (Taleb 2007). When they did occur, they left
Greenspan, the arch-apostle of deregulation, in a state of shocked dis-
belief and millions of people around the world without a job. Pointing
the finger at regulatory failure as ultimately the principal cause of the
Irish crisis is of course correct. Having learned this lesson, however, is
the world any closer to having a properly functioning global regulatory
system in place?
5 Ireland since the bail-out
In Ireland, following the bail-out, the government, led by the Fianna

Fil party which had held power since 1997, collapsed and early elec-
tions were held on 25 February 2011. A new government was elected
consisting of a coalition of the Fine Gael and Labour parties with a
strong majority in the Dil. The new Irish government immediately
announced its plans aiming at promoting national recovery and
declared its commitment to the fiscal consolidation programme agreed
in the EUECBIMF bail-out and to the target of achieving a fiscal defi-
cit of 3 per cent of GDP by 2015. In addition the Central Bank of Ireland
(2011) published the Financial Measures Programme (FMP) in which plans
were announced for comprehensive banking sector reforms aiming at
enabling the Irish banking system to resume its role of serving the needs
of the Irish economy and therefore contributing to the resumption of
economic growth. Economic recovery in Ireland is contingent upon the
success of these reforms which have three main elements: recapitaliza-
tion, deleveraging and restructuring of the domestic banks.
As far as recapitilization of the banking system is concerned the
Central Bank of Ireland employed Black Rock Solutions, a leading inde-
pendent consultant in analysing potential loan losses under stressed
conditions. The portfolios of the four main Irish-owned deposit banks,
Allied Irish Banks, Bank of Ireland, EBS Building Society and Irish Life &
Permanent, were subjected to stringent stress tests which produced
lifetime stress loan-loss estimates that the Central Bank emphasizes are
not considered likely to materialize: they are merely an input designed
to ensure that the associated capital requirements are fully convincing
to the market as being sufficient to cover even extreme and improbable
losses (p. 3). Capitalization needs of a 24 billion for the four domestic
banks have been identified by the 2011 Prudential Capital Assessment
Review (PCAR) whose calculations have been informed by the Black
Rock Solutions projections. These capital requirements should allow
the banks to offset potential losses and still meet 10.5 per cent and
6 per cent of Core Tier 1 capital ratios in base and stress scenarios,
respectively. The net fiscal cost is to be mitigated by liability manage-
ment exercises on subordinated debt assumed to be about a 5 billion
(see Central Bank of Ireland 2011).
With regard to the deleveraging of the Irish banking system the FMP
also included a Prudential Liquidity Assessment Review (PLAR) for 2011.
This review establishes funding targets for banks included in the PCAR
with the aim of reducing the leverage of the banking system and reduce
banks reliance on short-term, largely central bank, funding. Moreover
these measures ensure convergence to Basel III liquidity standards over
time, in particular a loan-to-deposit ratio of 122.5 per cent by end 2013.
The Central Bank of Ireland completed the assessment of the banks
restructuring plans to meet those targets.7
In addition to the recapitilization and deleveraging of the banking
system, the Department of Finance (2011) announced a reorganization
of the domestic banks around two pillar banks: the first pillar bank
will be created from the already strong franchise of Bank of Ireland and
the second pillar bank will be formed by strengthening the franchises
of Allied Irish Bank and EBS building society. As the Finance Minister
puts it: Each of these banks will re-organise their operations into
core and non-core functions. With a carefully managed programme
of deleveraging, by 2013, as the non-core assets which do not serve
growth on the island of Ireland disappear, the Pillar banks should
start to better serve the economy as functioning banks rather than the
oversized, overleveraged banks they now are (Department of Finance
2011, p. 1).
The Irish governments banking announcements at the end of March
2011 were welcomed by the EC, ECB and IMF as a major step towards
restoring the health of the Irish banking system. Market reaction to the
banking announcements was also positive since the markets considered
the Bank of Irelands PCAR/PLAR calculations credible. Initially bond
spreads declined but only temporarily. The upward trend in Irish bond
spreads resumed as soon as wider concerns reflecting developments
in Portugal and Greece and further ratings downgrades reflecting the
potential for debt restructuring and sovereign defaults in Europe started
dominating market sentiment.
184 The Euro Crisis
Undeniably the successful resolution of its banking crisis is vital

for Irelands economic recovery. Can the announced banking reform
measures, endorsed by ECECBIMF but received the thumbs down by
the markets, succeed in resolving the banking crisis without European
support? As already discussed above, the collapse of the Irish banking
system was the result of a plain vanilla banking crisis due to reckless
lending practices by Irish banks facilitated by imprudent regulation
and euro-zone capital flow imbalances. In Ireland, unlike Greece, it was
primarily the banking crisis that created a fiscal crisis. The Irish state,
saddled with the enormous debts of the banking sector, is not only
confronting a fiscal crisis but also facing a much more serious solvency
crisis. As McDonnell (2011) explains:
The imposition of the private banking debt on the State is impair-

ing the Irish sovereigns solvency. Ireland can avoid a sovereign debt
restructuring if it is able to decouple the banking debt obligations
from the States own sovereign debt obligations. The public, whether
Irish or Europeans, should not be obliged to pay for the private debts
of the European banking system. This should be the fundamental
principle underpinning any resolution to the banking crisis. The
transfer of debts from the private banking system to the general
public is amongst the largest per capita social transfers in modern
economic history and is deeply inequitable. (p. 2)
Starting from the principle that Irish and European taxpayers should
not to be obliged to honour any of the private debts of the failed banks
McDonnell (2011) recommends that the recapitalization process of the
Irish banking system proposed by the Irish government and endorsed
by the ECECBIMF should be halted immediately:
In a monetary union the banking system is most appropriately sup-

ported by a centralised institution. The appropriate institution in the
European Monetary Union (EMU) is the European Central Bank (ECB).
Thus, to prevent systemic contagion in the European banking system,
the ECB should be mandated and sufficiently resourced to recapitalise
viable working banks, where required, in exchange for an equity stake
in the bank. This recapitalisation should only occur as an absolute
last resort where there is clear and demonstrable evidence that failure
to recapitalise would lead to even greater costs for the Euro zone
economy. Irelands bank guarantee should be removed entirely and
immediately replaced by a guarantee covering deposits only. (p. 2)
Similarly, Clancy and McDonnell (2011) argue:
Because of the requirement to shoulder the banking debt along

with the sovereign debt, Ireland is now facing a solvency crisis. The
Governments open-ended commitment to cover all of the bank
losses needs to be reversed and as part of this renegotiation Ireland
must seek to push for a write-down of at least a portion of the bank-
ing debts. Alternatively, the bank debt could be exchanged for equity
stakes in the Irish banks. (p. 5)
A loan facility such as the one granted by the EUECBIMF to Greece,

Portugal and Ireland is an appropriate solution for a liquidity crisis but
not for a solvency crisis. Furthermore, as already discussed above, mem-
bers of a monetary union are vulnerable to market reactions whereby
loss of market confidence can become a self-fulfilling prophecy, which
can transform a liquidity crisis into a solvency crisis (DeGrauwe 2011).
The absence of a mechanism in the euro-zone for preventing a liquidity
crisis from becoming a full-blown solvency crisis is a basic design flaw
and is inherently destabilizing. Ultimately, the threat of insolvency and
debt restructuring in Ireland (or Greece or Portugal) will not be resolved
by additional loans and the imposition of even more savage auster-
ity policies but through a viable strategy to accelerate growth in the
European periphery and a rational redesign of monetary union.
In May 2011 the IMF in its Report (2011) commenting on develop-
ments in Ireland since the bail-out notes that: Risks to the program,
already high at program approval, have increased in some respects
while declining in others. Slower growth and higher unemployment,
further ratings downgrades, and developments in other Euro Area cri-
sis countries have contributed to a rise in bond spreads that hinders
Irelands prospects to regain market access on affordable terms in the
near future. (p. 1). The Reportt (2011) concludes that
The program risks must be actively managed with support from a more
comprehensive European plan. Timely implementation of the banking
strategy recapitalization, reorganizing and deleveraging the viable
banks, and resolving the non-viable banks remains critical for pro-
gram success in restoring the banking sector to healthy functionality
so it can begin to contribute to renewed growth. This intensive effort
must continue to be underpinned by fiscal consolidation and structural
reforms to overcome doubts regarding the feasibility of the fiscal adjust-
ment and regarding growth prospects in the medium term. (p. 1)
186 The Euro Crisis
According to the IMF Report (2011) the recession in Ireland has been
protracted and deep, with no firm recovery in sight.
A comprehensive European plan, however, so crucial, according to
the IMF, for the recovery in Ireland and by implication in other distressed
euro-zone economies is also nowhere in sight, despite the euphoria cre-
ated by the measures announced in July 2011 after the second bail-out
of Greece. These measures can be summarized as follows. First, Greece
is not only to receive more bail-out loans to the tune of 109 billion euro
but also some interest debt relief. Lower interest rates will be extended
also to Portugal and Ireland. Lower interest rates will undoubtedly ease
the debt burden in all three countries. However, whether by itself this
measure will make the debt load sustainable is a moot point. Second,
maturities on a chunk of Greek debt, currently estimated at 160 per cent
of GDP, will be pushed off well into the future up to 30 years while
some will actually be bought back and retired. A voluntary agreement by
private sector creditors to accept a hair-cut on their Greek debt was also
announced. What proportion of the Greek debt will actually be reduced
by this measure will depend to a great extent on how much voluntary
involvement the euro-zone gets from private investors. Third, the leaders
of the 17 euro-zone countries expanded the use of the European Financial
Stability Facility (EFSF) and the European Stability Mechanism (ESM).
The strengthening of the EFSF and ESM, if it materializes, will represent a
significant step towards the creation of a mini IMF for the euro-zone. By
permitting money to be used for weak euro members before their situa-
tion becomes critical future bail-outs in the euro-zone may be prevented.
Finally, euro-zone leaders announced a Marshall Plan to boost growth
in Europe. The Final Statement (2011) issued at the summit says: We call
for a comprehensive strategy for growth and investment in Greece. We
welcome the Commissions decision to create a Task Force which will work
with the Greek authorities to target the structural funds on competitive-
ness and growth, job creation and training. We will mobilise EU funds
and institutions such as the EIB towards this goal and relaunch the Greek
economy. Europes leaders made a bold commitment to stand behind the
euro-zones bailed-out economies indefinitely and according to the Final
Statement (2011): We are determined to continue to provide support to
countries under programmes until they have regained market access, pro-
vided they successfully implement those programmes (p. 1).
Similarly, Baroin and Schauble (2011), the finance ministers of France
and Germany respectively insist:
With this comprehensive set of measures, approved at the euro-zone

summit, we prevented Greeces sovereign debt crisis from becoming
a crisis that could damage the euro-zone as a whole, and the euro
as a consequence. But we are not naive. Rebuilding confidence
in the euro-zone will require patience, considerable stamina and
vision. We have embarked on a way to ever closer co-ordination and
co-operation of our national fiscal policies. Only by evolving the
European monetary unions institutional structures in such a way
that euro members are obliged to adopt a fiscal and economic policy
that reflects their joint responsibility for the common currency will
we master the challenges that lie ahead. (p. 1)
Do these measures represent the long-awaited comprehensive

European plan that the IMF (2011) considers, in combination with the
banking reforms and the continuation of rapid fiscal consolidation, as
essential for the recovery of the Irish economy? Are the announced
measures a timely demonstration of the determination by European
leaders to defend the single currency and prevent contagion to the rest
of the euro-zone which will make the task of recovery in Ireland that
much more difficult? At the time of writing, there are serious doubts
whether these measures could work even as a temporary remedy to the
euro-zone crisis let alone constitute a comprehensive plan for reform-
ing the European Monetary System.
First, as the markets scrutinize the agreement, there are serious con-
cerns that the announced measures may not in fact reduce the Greek
debt by any significant amount. Therefore, if the measures do not
reassure investors about the sustainability of Greek debt, the unappeal-
ing prospect of Greece having to be supported by its partners for an
indefinite period of time is not likely to be conducive to stability in the
markets. Such instability adversely affects Irish bond spreads and ratings.
Second, the Greek package does not directly deal with the debt prob-
lems elsewhere in the euro-zone. Although the new measures for Greece
will ease the terms of the bail-out loans to Ireland and Portugal, and the
strengthening of the EFSF and ESM offers countries like Spain and Italy
or other distressed members some precautionary financing and assist-
ance, there is no comprehensive arrangement in place. In fact, Europes
leaders went out of their way to convince and reassure private investors
that the second Greek bail-out package was nott a precedent for future
bail-out arrangements. According to the Final Statement (2011): As far
as our general approach to private sector involvement in the euro area
is concerned, we would like to make it clear that Greece requires an
exceptional and unique solution (p. 2).
The euro-zone leaders by specifically insisting that Greece was a spe-
cial case were attempting to stop contagion which will happen when
188 The Euro Crisis
private bondholders, expecting to incur losses, sell off the bonds of

other weak euro states, worsening the crisis. The euro-zone was sending
the signal that the losses taken on Greek bonds might not be repeated
on future bail-outs.
The plan agreed by European heads of governments and states on 21
July 2011, therefore, is hardly a comprehensive reform of the euro-
zone. As the details of the agreement unravel it may produce even more
destabilizing crises. Ireland and Portugal, apart from some welcome
reduction in the interest burden, are still left to deal with their debt
problems and implement austerity measures on their own. The prom-
ised precautionary and pre-emptive support for Spain and Italy does not
appear to be readily available. As Elliott (2011) notes:
When the heads of the 17 euro-zone governments met in Brussels

on July 21, they agreed not just to bail out Greece for a second time
but to put together a war chest that would enable them to take
pre-emptive action in countries seen as vulnerable to attack. The
message to the markets was clear: monetary union will be protected
come what may, so think twice before turning on Italy and Spain.
But it did not take long for the financial markets to unpick the
Brussels agreement. They quickly discovered that while there was
the promise of more money for the European Financial Stability
Facility, it would take months for the funds to arrive, and then only
if national parliaments agreed to pony up the cash. What looked
on the surface a once-and-for-all solution was exposed as a naked
attempt to buy time. (p. 25)
All these developments in the euro-zone following the second Greek

bail-out are not good news for the Irish economy. The possibility,
emphasized by the IMF (2011), that instability in the euro-zone might
de-rail the recovery in Ireland remains real. Furthermore, not only is
comprehensive reform absent but the EUECBIMF group insists that
the only means of preventing national insolvency in Ireland (as well
as Greece and Portugal) is the continuation of savage austerity meas-
ures. As argued elsewhere (Kitromilides 2011), whereas austerity in the
form of spending cuts and increases in income may be the only way to
prevent insolvency in the case of a single indebted individual it does
not necessarily follow, as Keynes (1936) was at pains to stress, that the
same result will be achieved when the austerity policy is applied to
the economy as a whole. The stubborn insistence by the EUECBIMF
troika for savage austerity as a means of achieving solvency in heavily
indebted economies has so far proved counter-productive. Their

declared determination, therefore, to press indebted euro-zone econo-
mies into quickly reducing budget deficits to below 3 per cent of GDP
is part of the problem rather than part of the solution.
Ireland went through three distinct phases in its economic history:

from independence to the mid-1950s; from the mid-1950s to the end
of the 1980s; and from the end of the 1980s to 2008, also known as the
Celtic Tiger period.
The first period was dominated by the philosophy of economic nation-
alism. Ireland was an inward-looking, protectionist, rural economy that
exported agricultural goods, mainly to Britain and imported manufac-
tured goods mainly from Britain. Despite political independence Ireland
remained within the British economic orbit throughout this period. An
attempt to escape from this economic domination was initiated during
the second period: by the mid-1950s a change in policy direction was
much in evidence and during the 1960s, under the political leadership of
Sean Lemass, the foundations of what was to become subsequently the
Celtic Tiger period were laid. During the second period Ireland sought
membership of the EEC, concluded a free trade agreement with the UK
and joined the General Agreement on Tariffs and Trade. At the same time
the principal feature of the Irish growth strategy, foreign direct invest-
ment, was promoted and encouraged mainly through the efforts of the
newly established IDA. Although the strategy succeeded in attracting FDI
and economic growth accelerated, by the 1980s, the whole process had
stalled: the economic picture in the 1980s was that of stagflation, mass
emigration, recession and huge fiscal deficits and public indebtedness. The
breakthrough came in 1987 when a national political and social consensus
was reached about the need for putting in place the so-called missing piece
in the Irish growth strategy: small government. The period of massive
economic transformation in Ireland, known as the Celtic Tiger period
began. This phase of Irish economic history is divided into two sub-peri-
ods: the period before the dotcom collapse in the US in 2001 where FDI
was the main engine of growth; and the Tiger 2 period after 2001 which
was dominated by the activities of bankers and construction companies. It
is by now well established that these activities, although resulting in rapid
economic growth in the short-run, sowed the seeds of the subsequent cri-
sis: over-reliance by Irish banks on short-term international borrowing to
finance poorly-monitored loans to an unsustainable construction boom.
190 The Euro Crisis
Throughout this period an open economy like Irelands was naturally

susceptible to a slow-down in the global economy. What the Irish regula-
tory system singularly failed to recognize was the Irish banking systems
immense vulnerability to a global banking and financial crisis. This vulner-
ability was despite rather than, as was the case in other countries, because
of the exposure of Irish banks to exotic financial products from Wall
Street: the vulnerability was due to an old-fashioned plain vanilla type of
banking excess which could and should have been stopped. In 2008 the
Irish taxpayer ended up picking up the bill for these excesses when the
Irish government gave a blanket guarantee not only for all bank deposits
but also for all bank liabilities: the fiscal crisis in Ireland that culminated in
the international bail-out of 2010 was primarily the inevitable by-product
of the Irish financial crisis that preceded it.
The main conclusion of this paper is that the Irish tragedy was not
the result of one single causal factor but instead the result of different
but interrelated factors. Following Connor et al. (2010) we distinguish
four factors which we describe in this paper as the four Is: Irrationality,
Imbalances, Imprudence and Incentives. Although all four factors con-
tributed significantly to Irelands crisis none of them in isolation would
have caused the crisis. Even the two chief culprits, the design failure
of the euro-zone and the failure of regulation, would not by themselves
have produced the crisis: structural imbalances in the euro-zone would
not have produced a property bubble and a banking collapse if regula-
tors in Ireland had done their job properly; and regulatory failure would
not have been so serious if there was no capital flow bonanza as a
result of Irish membership of the euro-zone.
Meanwhile the absence of a comprehensive plan to reform the euro-
zone, despite the measures announced in July 2011 after the second
bail-out of Greece, together with the imposition of synchronized
austerity and too rapid fiscal consolidation in Europe, the end of the
tragedy in Ireland and elsewhere in Europe is nowhere evident.
Finally, a clarification about the use of the term tragedyy in the title of
this paper is in order. The term, of course, has been widely used recently
to describe the general economic condition that heavily indebted coun-
tries under pressure from international creditors to repay their debts
have found themselves during the Great Recession. This is not surpris-
ing since the first country to experience this pressure was Greece, the
birth place of tragedy, which is defined as an art form based on human
suffering that paradoxically gives pleasure to its audience. I do not of
course consider the suffering of Greek, Portuguese and Irish people
remotely pleasurable and therefore I do not use the term tragedyy in this
sense. Instead I am using the term in the ordinary dictionary definition

of a sad event or a calamity, even though in examining these recent
events one cannot help thinking of some of the works of Aeschylus,
Sophocles, Euripides and Shakespeare.8
Notes
1. The author is Visiting Research Fellow at the Centre for International Business
and Sustainability, London Metropolitan University. He has previously
taught at the University of Greenwich, University of Westminster, University
of Middlesex, and at the School of Oriental and African Studies, University of
London. He is grateful for helpful comments by the participants to the 8th
International Conference, entitled Developments in Economic Theory and Policy,
held at Universidad del Pais Vasco, Bilbao, Spain, 29 June1 July 2011. He
is particularly grateful to Philip Arestis, Gary Dymski and Photis Lysandrou
who, of course, are not responsible for any remaining errors and omissions.
2. The term siesta states was first used by Liddle (2010).
3. In 1937 the Eamon de Valera government introduced, after referendum, a
new constitution, replacing the one agreed after the formation of the Irish
Free State. According to the new constitution the Irish Free State was to be
renamed Eire and the head of state would be an elected president, not the
British monarch.
4. The ideological attack on the failure of Keynesian policies during this period
ignores the fact that Keynes (1936) in the Notes on Mercantilism in the
General Theory advised caution on the use of expansionary fiscal policy in an
open economy.
5. The strategy was named after a speech given by Alan Dukes to the Tallaght
Chamber of Commerce on 2 September 1987.
6. The term Celtic Tiger was first used by Gardiner (1994). The East Asian
tiger economies are normally taken to refer to South Korea, Taiwan,
Singapore and Hong Kong. In the case of South Korea and Taiwan, their
export-led growth was based on developing the competitiveness of domes-
tically-owned firms; in the case of Ireland, its export-led growth was based
on developing the competitive capacity and profitability of foreign-owned
(mainly US) firms.
7. See BIS (2010) for full details on Basel III.
8. For an interesting article, exploring some parallels between the ancient Greek
tragedy of Antigone by Sophocles and contemporary austerity protests in
Greece see Higgins (2011).
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6
Portugals Best Way out of
Economic Stagnation: Institutional
Reform of the Eurozone
Pedro Leao
ISEG, Technical University of Lisbon, and UECE, Research Unit on Complexity and
Economics, Portugal
Alfonso Palacio-Vera
Universidad Complutense de Madrid, Spain*
Abstract: Since the creation of the Economic and Monetary Union

(EMU), the Portuguese economy has exhibited real divergence vis--vis
the wealthier Eurozone countries, tremendous current account imbal-
ances and a sharp increase in foreign indebtedness. We argue that the
causes of the underperformance and of the external imbalance of the
Portuguese economy in the last decade were excessive private consump-
tion growth fuelled by historically low nominal and real interest rates,
steep increases in oil prices, rising relative unit labour costs vis--vis
other Eurozone countries, and fierce competition from China and
Central and Eastern European Countries affecting Portugals traditional
exports. We discuss the different macroeconomic policy options cur-
rently available to the Portuguese government and conclude that, in the
face of the terrible short-term economic hardships that Portugal would
face were it to withdraw from the Eurozone, the best way forward for
it is to join forces with other peripheral Eurozone countries in order
to push for institutional reform of the EMU along the following lines:
replacement of the Stability and Growth Pact by ceilings on the current
account balances of individual Eurozone countries; a temporary increase
in inflation to (say) 5 per cent to allow for a more rapid decrease in rela-
tive unit labour costs in Eurozone countries exhibiting current account
deficits; implementation by the ECB of asset-based reserve requirements
on Eurozone banks; issuance of Euro-bonds to fund credit towards
Eurozone countries facing liquidity crisis, and empowerment of the ECB
to purchase these bonds.
195
196 The Euro Crisis
Keywords: Fallacy of composition, Euro-bonds, Stability and Growth

Pact, ECB inflation target, current account imbalances
JEL Classification: E32, E65, F32, F41, J50
1 Introduction
The sovereign debt crisis in 2010 of Greece and other peripheral Eurozone
countries like Portugal has brought to the fore the rising heterogeneity
observed within the Eurozone and the macroeconomic imbalances that
have led to such heterogeneity. First, there has been a persistent loss in
international competitiveness (measured by relative unit labour costs) in
the four Mediterranean Eurozone countries (Greece, Italy, Portugal and
Spain) vis--vis Germany since the launch of the Euro in 1999. According
to Lapavitsas et al. (2010), this is largely the result of a race to the bottom
led (and won) by Germany encouraging flexibility, wage restraint, and
part-time work even more than peripheral Eurozone countries.1 Secondly,
the vigorous process of financial integration between the North and the
South has also contributed to the emergence of large macroeconomic
imbalances within the Eurozone by boosting demand, particularly private
consumption and real estate investment, in the countries of the South.
These two phenomena have led to large current account (hereafter CA)
deficits in Greece, Portugal and Spain (and Ireland) against Germany as
well as high levels of indebtedness by both the private and public sector.
Despite the proposition of Frankel and Rose (1998) that the suitability
of European countries for EMU [Economic and Monetary Union] can-
not be judged on the basis of historical data since the structure of these
economies is likely to change dramatically as a result of EMU (p. 1011),
the evidence so far suggests that, except for financial integration which
has admittedly proceeded apace, there is no clear pattern of economic
integration among Eurozone countries (Santos Silva and Tenreyro
2010). In the last decade, growth in Mediterranean Eurozone countries
and Ireland has mainly come from expansion of consumption financed
by rising private sector indebtedness (as in Greece and Portugal) or vig-
orous investment linked to real estate bubbles (as in Ireland and Spain).
Therefore, the integration of peripheral countries into the Eurozone has
so far been one-sided in the sense that it has largely consisted of a rapid
process of financial integration whereby these countries have financed
their large CA deficits by way of increasing their indebtedness vis--vis
core Eurozone countries, predominantly Germany.
Pedro Leao and Alfonso Palacio-Vera 197
In turn, this scenario made them particularly vulnerable to the crisis

of 20079 that subsequently led to the European sovereign debt crisis
that erupted violently in Spring 2010 in the wake of the Greek sovereign
debt crisis. Having now embarked upon ambitious fiscal consolidation
and very unpopular structural reforms, countries like Greece, Portugal,
Ireland and Spain face a long period of economic stagnation and high
unemployment. Predictably, social unrest and domestic pressure on
governments to escape from the Eurozone with the aim of easing
adjustment by means of devaluation may become a serious possibility
in the coming years.
The main purpose of this study is to evaluate the root causes of the
economic malaise that afflicts Portugal in order to assess the different
policy options available to the Portuguese government. In addition, we
identify several key shortcomings of the institutional design of the EMU
and make several proposals for its reform which, in our opinion, would
go a long way towards alleviating them. Our main conclusion is that,
in the absence of deep reform of the governance structure of the EMU,
Portugal (as well as other Mediterranean members of the Eurozone)
faces a long period of economic stagnation. However, in view of the ter-
rible short-run economic costs and tremendous legal barriers that any
individual country would have to overcome were it to withdraw from
the Eurozone, we conclude that pushing for reform of the EMU at the
political level currently represents the best way forward for Portugal.
The study is organized as follows. The next section reviews the lit-
erature on the intra-EMU CA imbalances with special attention to the
Portuguese case. Section 3 analyses the main causes of the emergence
of the large macroeconomic imbalances currently exhibited by the
Portuguese economy. Section 4 discusses various economic policy strat-
egies currently available to Portugal. Section 5 contains several propos-
als for institutional reform of the EMU that, according to us, would
correct the macroeconomic imbalances and resume healthy growth in
the Eurozone. Finally, section 6 summarizes and concludes.
2 A review of the literature about intra-EMU

macroeconomic imbalances
As we mentioned above, a key dimension of the rising heterogeneity

within the EMU is the emergence of large CA deficits in the periph-
eral economies coupled with large trade surpluses in the core coun-
tries, especially Germany. Although the dominant view is that these
macroeconomic imbalances reflect a rising divergence in relative
198 The Euro Crisis
competitiveness within the Eurozone, some scholars have suggested

instead that the former are closely related to differences in GDP per
capita and real interest rates.2 In the latter case, the policy implication is
that such imbalances would tend to disappear overtime provided there
is real convergence among Eurozone countries. The purpose of this
section is to review the literature that has discussed the causes of such
macroeconomic imbalances.
An early study to address this topic is in Blanchard and Giavazzi
(2002). They use an open-economy model to show how, for relatively
poorer countries, goods and financial market integration are likely to
lead to both a decrease in the saving rate and an increase in investment,
and so to a larger CA deficit. They document that the changes in the
CA balances of Portugal and Greece are part of a more general trend:
the dispersion of CA positions among OECD countries has steadily
increased since the early 1990s, and CA positions have become increas-
ingly related to countries per capita GDP. They show that this trend is
visible within the OECD as a whole but is stronger within the Eurozone.
They go on to argue that the channel through which this occurs appears
to be a decrease in private saving in the countries with widening CA
deficits, rather than an increase in investment. Focusing on the cases
of Portugal and Greece, they conclude that lower private saving, espe-
cially household saving due both to internal and external financial
liberalization but also to better growth prospects and, to a much lesser
extent, higher investment appear to be the main drivers of the current
account deficits. They add that financial liberalization led to substantial
decreases in nominal and real interest rates because the adoption of the
Euro eliminated country risk thus opening the Euro inter-bank market
to Portuguese and Greek banks.
Ahearne et al. (2008) examine whether capital tends to flow from
rich to poor Eurozone countries and whether the creation of the Euro
has affected such flows. They run simple OLS regressions to examine
the determinants of trade balances in individual European countries
and any possible relationship between trade balances and per capita
income. They find that trade surpluses in the EU are a positive func-
tion of relative per capita GDP and that the relationship is strongly
significant, i.e., countries with a larger per capita GDP have larger
intra-EU trade surpluses. According to the authors, these results suggest
that EMU has increased capital market integration in Europe, with the
result that capital flows are now more in line with what neoclassical
theory predicts thus indicating that the monetary union works well.
They predict that, as capital flows from high- to low-per capita GDP
countries, these flows will promote economic convergence among

Eurozone countries.
Holinksi et al. (2010) disagree somewhat with the conclusion of
the previous studies, i.e., that imbalances can be attributed to inter-
temporal maximization and thus to the existence of a European con-
vergence process. According to proponents of this argument, countries
with lower per-capita GDP and productivity will attract foreign capital
investment and, in the adjustment process, relative inflation will rise
thereby leading to real exchange rate appreciation and, hence, loss of
relative international competitiveness. As a result, during the conver-
gence process, CA deficits arise that match the surpluses on the capital
accounts in surplus countries. Their disagreement with the so-called
economic convergence hypothesis runs as follows. First, they find that
the gap in terms of GDP per capita between Northern and Southern
countries within the Eurozone has not narrowed over the period
19922007 so there has been little real convergence. In their view, the
main reason for this is diverging total factor productivityy between the two
country groups over the period 1992 through 2007.3 Second, they argue
that a better measure to determine the external price competitiveness of
a country is its terms of trade, that is, the ratio of export over import
prices which excludes the non-tradable sector. By looking at the evolu-
tion of the terms of trade of countries, they show that the relative loss
of competitiveness of Southern countries is far less pronounced than
inflation rate differentials suggest. Finally, they conclude that a more
plausible explanation for the macroeconomic imbalances is that rela-
tively higher inflation in the Southern countries lowered ex-ante real
interest rates in these countries and induced higherr consumption and
investment.
A thorough discussion of the causes of the underperformance of the
Portuguese economy is in Blanchard (2007) who blames an unfortu-
nate combination of slow productivity growth and fast nominal wage
growth for the loss of international competitiveness and the systematic
CA deficits exhibited by Portugal since the launch of the Euro in 1999.
He notes that, with low unemployment, nominal wage growth was
substantially higher than labour productivity growth in the last decade
thereby leading to growth in unit labour costs (hereafter ULC) higher
than in the rest of the Eurozone which accounts for over 70 per cent of
Portuguese foreign trade. According to Blanchard (2007), the effects of
real overvaluation were compounded by composition effects in exports
associated to direct competition from China and other Asian countries
(see also Ahearne and Pisani-Ferry 2006). He points out that 60 per cent
200 The Euro Crisis
of Portuguese exports are in low tech goods compared to an average of

30 per cent for the Eurozone and concludes that, even in the absence of
overvaluation, the CA balance would have deteriorated because of these
composition effects. According to him, in the absence of draconian
economic policy measures, the most likely scenario is one of competitive
disinflation, that is, an extended period of sustained high unemployment
until competitiveness has been re-established. The economic policy
measures to be adopted include structural reforms aimed at increasing
productivity and an across-the-board cut in nominal wages.
Ahearne and Pisani-Ferry (2006) also claim that above-average
inflation led to a marked deterioration in Portugals competitiveness,
which has depressed exports. They note that Portugal enjoyed a spurt
in growth in domestic demand and in the construction sector by the
second half of the 1990s as real interest rates declined by more than
6 percentage points. However, by 2001 the economy started to slow
down as the loss of competitiveness eventually began to dominate.
According to them, slow productivity growth and the composition of
its exports left Portugal vulnerable to competition from low-cost pro-
ducers, especially China. In addition, membership of EMU exacerbated
the loss of competitiveness and narrowed the policy options to offset
the external shocks. They claim that, for countries like Portugal, there
is no solution other than the long hard slog of structural adjustment
(Ahearne and Pisani-Ferry 2006, p. 6) and, hence, they recommend
wage restraint and increased competition in goods and services markets
to keep inflation below the Eurozone average.
Finally, Zemanek et al. (2009) also find that, ever since the creation of
EMU, the competitiveness of Eurozone countries has steadily diverged.
They analyse the behaviour of unit labour costs from 1999 to 2007
and find that, while Germany and Austria have kept the level of 1999,
in Ireland, Portugal, Spain, Greece and Italy, unit labour costs have
increased significantly by up to 30 per cent compared to 1999. They
list several reasons for the divergence in inflation rates: (i) differences
in inflation traditions and expectations, (ii) faster rate of growth of the
price level in relatively poorer Eurozone countries as predicted by the
Balassa-Samuelson effect, (iii) idiosyncratic business cycles which lead
to long-lasting but nevertheless transitory differences in real interest
rates and (iv) differences in the rates of wage and productivity growth.
However, they concede that, besides ULC divergences, non-price com-
petitiveness may also help explain intra-EMU CA imbalances. The
former covers variables such as sectoral and geographical specialization
of the export sector, production and technology structure, and the
quality of products. Finally, they argue that the only way out of the
current dilemma is to implement structural reforms. They deny that the
former will actually lead to a race to the bottom with respect to wage
cuts. Instead, they predict that intra-euro area current account imbal-
ances would diminish and the international competitiveness of Europe
as a whole would rise (Zemanek et al. 2009, p. 31).
To conclude this section, we should like to mention that the different
explanations for the large intra-EMU CA imbalances that we reviewed
above are potentially compatible with each other. The initial differ-
ences in GDP per capita and inflation rates at the time of the launch
of the Euro can be blamed for the intense capital flows from relatively
rich/high-saving to relatively poor/low-saving Eurozone countries
observed ever since 1999. The intensity of these flows was probably
augmented by the fact that real interest rates were relatively high in the
former and relatively low (or negative) in the latter because of differ-
ences in their initial inflation rates. Eventually, large intra-EMU capital
flows fuelled credit-led economic growth in peripheral Eurozone
countries and this, in turn, led to further deterioration in their rela-
tive competitiveness. This suggests that the institutional framework
currently underlying the EMU has failed to devise mechanisms that
properly take account of the large and persistent structural differences
exhibited by Eurozone countries and enable them to reach a sustain-
able and robust growth path.
3 Rising heterogeneity within the Eurozone:

the case of Portugal
As explained in the previous two sections, there has been a steady diver-
gence in terms of relative competitiveness, inflation, and CA balances
among Eurozone countries ever since the launch of the Euro in 1999.
The purpose of this section is to analyse the causes behind this phenom-
enon by focusing on the case of Portugal.
3.1 The Portuguese economy in 1999

After a strong economic expansion driven by a boom in domestic
demand in the run-up to the creation of the Euro, the Portuguese
economy eventually reached full employment in 1999 (see Table 6.1
below). Concomitantly, as shown also in Table 6.1, the CA deficit reached
8.5 per cent of GDP in 1999. Therefore, there can be no doubt that in
1999 the Portuguese real effective exchange rate (REER) was well above
its equilibrium value and that Portugal entered the Eurozone with an
202
Table 6.1 Portugal, main macroeconomic indicators, 19992009
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Private consumption 5.3 3.7 1.3 1.3 0.2 2.5 1.9 1.9 1.7 1.7 0.8
Public consumption 4.1 3.6 3.3 2.6 0.2 2.6 3.2 1.4 0.0 1.1 3.5
Investment 7.8 3.5 1.0 3.5 7.4 0.2 0.9 0.7 3.1 0.7 11.1
Domestic demand* 6.2 3.6 1.8 0.1 2.2 2.7 1.6 0.9 1.9 1.3 2.8
Total exports 3.0 8.4 1.8 1.4 3.9 4.0 2.1 8.7 7.8 0.5 11.6
Service exports 2.8 9.0 2.3 0.4 2.8 5.8 2.1 11.7 12.9 1.5 6.5
Imports 8.6 5.3 0.9 0.7 0.9 6.7 3.5 5.2 6.1 2.7 9.2
Net Exports* 2.4 0.3 0.2 0.7 1.4 1.2 0.7 0.5 0.0 1.2 0.1
Unemployment 4.4 3.9 4.0 5.0 6.3 6.7 7.6 7.7 8.0 7.6 9.5
GDP 3.8 3.9 2.0 0.8 0.8 1.5 0.9 1.4 1.9 0.0 2.7
Current account 8.5 10.2 9.8 8.0 6.0 7.5 9.4 9.9 9.4 12.0 10.3
Int. Inv. Position 33.1 41.1 48.6 57.1 59.0 63.8 70.0 81.1 92.4 99.2 111.5
Note: * Contribution to GDP growth in percentage points.

Source: Bank of Portugal (2009a and 2010).
over-appreciated real exchange rate.4 According to Garcimartn et al.

(201011, p. 295), between 1991 and 1999, the Portuguese escudo depreci-
ated by 16.3 per cent while its purchasing power parity (PPP) equilibrium
value dropped by 27.4 per cent which implies a 11.1 per cent appreciation
against its PPP value.5 They add that the escudo/deutsche mark exchange
rate was irrevocably set at 102.5 while, according to their estimates, the
equilibrium exchange rate should have been 129.9. The CA deficit of 8.5
per cent of GDP in 1999 was associated with a deficit in the trade balance
of about 12 per cent of GDP, which included a deficit in the energyy account
of 1.8 per cent of GDP (see Table 6.2). The trade deficit was partially offset
by surpluses in both the balance of services and the net remittances of
emigrants over immigrants. More specifically:
Current account trade balance balance of services net remittances

8.5% GDP 11.9% GDP 1.6% GDP 2.6% GDP
What about Portugals International Investment Position (IIP) in 1999?6

From 1985 through 1995, the Portuguese CA was roughly in equilib-
rium. The first significant deficits started in 1996. However, in 1999
the Portuguese net external debt only amounted to 12 per cent of GDP.
Thus, when Portugal adopted the Euro in 1999, it was only beginning
to descend from the recently reached peak of its cycle so its CA showed
a large deficit and, as noted above, the value of its currency was very far
from its equilibrium PPP value. Likewise, the nett stock of both foreign
direct investment and foreign investment in stocks was also relatively
small. As a result of it, the IIP of the Portuguese economy solely repre-
sented 33.1 per cent of GDP in 1999 (see Table 6.1). In turn, this small
negative IIP led to net factor payments (interest and profits) to foreigners
of only 1.4 per cent of GDP (see Table 6.2).
3.2 What happened after 1999?

Domestic demand increased at a rapid pace between 1995 and 1999. In
20001 it continued to grow, albeit at a lower rate. As a result, the CA
deficit continued to increase, reaching 10 per cent of GDP, unemploy-
ment continued to fall to 4 per cent, and inflation shot up to 4.4 per cent
in 2001. In the next eight years, from 2002 to 2009, domestic demand
growth virtually disappeared (annual growth of only 0.4 per cent). This
was one of the two factors the other was the adverse behaviour of net
external demand that led to stagnation in the eight years up to 2009
(annual GDP growth of 0.35 per cent), and to a steady increase in unem-
ployment (to more than 10 per cent by the end of 2009).
204
Table 6.2 Portugal, current account, per cent of GDP, 19962009
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Current 4.2 5.9 7.0 8.5 10.2 9.8 8.0 6.0 7.5 9.4 9.9 9.4 12.0 10.3
Account
Goods 8.4 9.4 10.8 11.9 12.9 12.0 10.4 9.1 10.3 11.0 10.8 10.8 12.8 10.5
Services 1.2 1.3 1.6 1.6 1.8 2.3 2.5 2.7 2.9 2.7 3.3 4.0 4.0 3.7
Factor 0.8 1.2 1.3 1.4 2.1 3.0 2.3 1.7 2.1 2.6 4.0 4.2 4.7 4.8
Incomes
Remitt. 2.9 2.9 2.7 2.6 2.7 2.6 1.8 1.4 1.4 1.2 1.2 1.2 1.1 1.1
Source: Bank of Portugal (2007, 2009a, and 2010).

As is well known, a stagnant domestic demand often translates

into low growth of imports and an improvement in the CA balance.
However, instead of improving, the Portuguese CA deficit actually
worsened from 1999 through 20059, from 8.5 per cent of GDP to 10.2
per cent of GDP (see Table 6.3). This larger CA deficit in spite of a stag-
nant domestic demand is a clear indication that, at least since 2005, the
Portuguese REER strayed even farther from its equilibrium level than it
was in 1999. What led to this increase in the deviation of the REER from
its equilibrium level between 1999 and 20059? We tackle this issue in
what follows.
3.3 Trends affecting the current account

A look at the evolution of the various items of the CA in Table 6.3
below helps shed some light on this issue. On the one hand, three
factors affected favourably the evolution of the CA between 1999
and 20059. A first favourable factor was a decline in the trade deficit
excluding energy associated to stagnant domestic demand and rapid
growth in some key trading partners. The second favourable factor
was an improvement in the surplus of the balance of services. The last
favourable factor was a reorientation of Portuguese exports of goods and
services towards new markets. On the other hand, five factors affected
unfavourably the evolution of the Portuguese CA in the same period:
(i) an increase in relative ULC; (ii) the emergence of new (direct) inter-
national competitors; (iii) a shrinking of net remittances from abroad by
1.5 per cent of GDP; (iv) an increase in the oil price since 1999 which
enlarged the energy deficit by 2 per cent of GDP; and (v) a worsening in
the net external financial position which resulted in an increase of 2.7
per cent of GDP in net income payments to the rest of the world.7
Table 6.3 Portugal, current account, per cent of GDP, 20059 vs. 1999
Balances (per cent of GDP) 1999 20059

Goods without energy 10% 7.6% +2.4%
Services 1.6% 3.6% +2%
Goods and services without energy 8.4% 4% +4.4%
Remittances 2.6% 1.1% 1.5%
Energy 1.8% 3.8% 2%
Net income payments 1.4% 4.1% 2.7%
Current account 8.5% 10.2% 1.7%
Source: Bank of Portugal (2010, p. 173 and p. 176); authors calculations.

206 The Euro Crisis
Let us start off by looking at the three favourable trends. First, the
trade deficit excluding energy declined from about 10 per cent in 1999
to about 7.3 per cent of GDP in 20059.8 This was due mainly to a
combination of a stagnant domestic demand in Portugal which exhib-
ited 0.4 per cent annual growth and d a strong growth of imports of the
main Portuguese trading partners amounting to 5.2 per cent average
annual growth. In fact, the stagnant demand prevented a rapid growth
of imports of goods in 20028 (3 per cent average annual growth). In
turn, the strong growth of imports of goods by Portugals main trading
partners led to a more rapid growth of goods exports in 20028 (3.7
per cent average annual growth). The key contributors to the growth of
Portuguese exports were Angola and Spain. In 20028, goods exports to
Spain and Angola grew at annual average rates of 10.1 and 21 per cent
respectively.
A second favourable factor affecting the Portuguese CA was the evolu-
tion of the balance of services, whose surplus rose from 1.6 per cent in
1999 to an average of 3.6 per cent of GDP in 20059. This was the result
of an excellent performance of export of services, especially since 2006.
In nominal terms, the exports of services grew by 19.9, 15.6 and 5.3
per cent in 2006, 2007 and 2008, respectively (Bank of Portugal 2010,
p. 148, Table 5.4). These rates exceeded the growth rates of nominal
imports of services in the same years, which were 15.9, 8.4, and 5.1
per cent respectively (Bank of Portugal 2010, p. 149, Table 5.5), and led
to an increase in the weight of services in total exports from 27 per cent
in 2005 to 33 per cent in 2009. Further, it should be noted that this was
an acceleration of a trend dating back to 1996, when services made up
only 24 per cent of total exports. In fact, between 1996 and 2009 export
of services grew at twice the annual average rate of exports of goods: 7.9
per cent compared to 3.9 per cent (Cabral 2010). One consequence of
this development is that in 20079 the surplus in the balance of serv-
ices already covered 35 per cent of the deficit in the balance of goods
compared to only 14 per cent back in 1996 (see Table 6.2). In turn, these
numbers tell us that the specialization of Portugal has been switching
towards the exports of services. In this respect, it is remarkable to note
that by 2008 the weight of services in total exports, 33 per cent, was
more than three times the weight of textiles, clothes, and footwear 9.5
per cent which used to be the major Portuguese export sectors. Lastly,
the high growth of export of services in the last decade or so did not
reflect the behaviour of its main sector tourism.9 Instead, the high
growth of export of services can be ascribed mainly to the behaviour of
transport and professional services. These two types of services grew
at double digit rates in 20068 and accounted for 26.5 and 30 per cent
of export of services in 2008 and 2009, respectively (Bank of Portugal,
2010, p. 148).
The third and last factor that affected favourably the evolution of
the Portuguese CA was the reorientation of Portuguese exports over the
last decade from its traditional markets to other countries outside the
EU-15. Indeed, the share of Portuguese exports in the EU-15 declined
by one third between 2003 and 2009 (Constncio 2010).10 Yet, over the
same period the market share of goods exports in its main 34 trading
partners declined by only 13 per cent.11 This difference was due to the
fact that from 1999 to 2008 exports to new markets grew at an annual
average rate of 13.8 per cent, compared to only 3.8 per cent in the case
of EU-15 markets.
Next, let us address two key trends that affected the Portuguese CA
adversely. First, that relative prices and ULC in Portugal increased in this
period owing to an especially high excess of nominal wage growth over
labour productivity that was equal to 2.7 percentage points per year
compared to only 1.7 percentage points on average in the Eurozone.
Indeed, according to the IMF (see Figure 6.1 below), the Portuguese
REER rose by about 13 per cent between 1999 and 2008, measured both
in HICP and in ULC. Most of this increase occurred between 1999 and
2003.12 This diagnosis is supported by the results in Felipe and Kumar
(2011) who proposed measuring aggregate ULC as the economys labour
share times the price deflator. Their analysis shows that Greece and
Portugal experienced much faster increases in aggregate ULC than the
other Eurozone countries in the period 19802007. Portugals loss of
international competitiveness is also depicted in Figure 6.2 below which
shows the presence of a positive differential between the average rate of
inflation in the Eurozone and the rate of inflation in Portugal in the
period 19972007.
Second, and crucially, over the same period Portugal was subject to
a marked increase in competition from China and Central and Eastern
European (CEE) countries (Ahearne and Pisany-Ferry 2006). This led to
an increase in the penetration of imports in the Portuguese market and,
simultaneously, to a sharp decline in the market share of Portuguese
exports in the EU-15. In particular, between 2003 and 2008 imports
grew at an annual average rate of 3.9 per cent, more than twice the rate
of total demand. In addition, the market share of Portuguese exports
in the EU-15 declined by 33 per cent between 2003 and 2009, mainly
in favour of China and the CEE countries (referred to as the new 10
countries in Figure 6.3). In fact, the market shares of these two regions
208
ITA IRL PRT ESP FRA DEU
140 140 140 140

REER (HICP) REER (ULC Total Economy)
130 1995=100 130 130 1995=100 130
120 120 120 120
110 110 110 110
100 100 100 100
90 90 90 90
80 80 80 80
70 70 70 70
60 60 60 60
95
97
99
01
03
05
07
95
97
99
01
03
05
07
19
19
19
20
20
20
20
19
19
19
20
20
20
20
Figure 6.1 REER based on HIPC and ULC, 19952008
Source: IMF (2010).
Differential Euro Area Portugal
% 6
0
Jan-97
Feb-98
Mar-99
Apr-00
May-01
Jun-02
Jul-03
Aug-04
Sep-05
Oct-06
Nov-07
Jan-09
Feb-10
Figure 6.2 Inflation in Portugal and in the Eurozone, 19972010

Source: Constncio (2010).
400
375
350
China
325
300
275
250
New 10
225 countries
200
175
150
125
Spain
100 Italy
75
Greece Portugal
50
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 6.3 The evolution of market shares (goods) in the EU-15, 19952009
Source: Constncio (2010). 1995 = 100.
exports to the EU-15 increased substantially over that period (see

Figure 6.3).
The new international environment faced by the Portuguese economy
since the beginning of the twenty-first century deserves a brief com-
ment. In 1993, a Uruguay Round agreement established a progressive
elimination of export quotas of textiles, clothing and footwear from less
developed to developed countries over a 10-year period (19952005).
As a result, the market share of China in the EU-15 increased sharply
at the expense of several Southern European countries, mainly Portugal
and Italy. In 20008, Portuguese exports of textiles, clothing and foot-
wear suffered steep declines: average annual declines of 6.1, 21.2 and
4.5 per cent, respectively (Bank of Portugal 2010, p. 211, Table A.5.11).
Consequently, the share of these three goods in total goods exports fell
from 25 per cent in 1999 (40 per cent in 1993) to only 14 per cent in
2008 (Bank of Portugal 2009b p. 294).
Likewise, Portuguese exports of medium-to-high tech products
like vehicles and electrical machines also lost market share over the
last decade, especially to CEE countries which have benefited from a
combination of lower wages and a more skilled labour force (Bank of
Portugal 2010, pp. 1445). In this respect, we may note that in 2000
the average hourly wage in Portugal in manufacturing was equal to
$5.67, roughly twice that in Poland, the Czech Republic, Slovakia
210 The Euro Crisis
and Hungary.13 In addition, as noted in Constncio (2010), the

qualification of the Portuguese work-force lagged and still lags far
behind that of the CEE countries. As a result, over the last decade the
CEE countries attracted large flows of FDI into medium-to-high tech
sectors, which formerly had headed towards Southern Europe, includ-
ing Portugal.
We may summarize this section by saying that in 1999, the REER
of the Portuguese economy was well above its equilibrium value. The
CA deficit was equal to 8.5 per cent of GDP at full employment.
Since then, the evolution of the Portuguese CA has been determined
by several trends. Between 1999 and 20059 the trade deficit without
energy fell by 2.4 per cent of GDP, due mainly to the stagnation of
domestic demand coupled with strong growth in some of the main
Portuguese trading partners. In the same period, the surplus in the
balance of services increased by 2 per cent. As a result of this, the
deficit in the balance of goods and services without energy improved
by 4.4 per cent of GDP between the two periods (see Table 6.3).
Yet, the CA deficit actually increased by 1.7 per cent of GDP in the
same period, due to: (i) a decline in the surplus of remittances, (ii)
an increase in the energy deficit, and (iii) a growing external debt
service. The combined effect of these three adverse trends was to
increase the CA deficit by 6.2 per cent of GDP and, hence, to push
the equilibrium REER even farther below its initial equilibrium level
back in 1999.14
4 Can economic growth in Portugal be restored?
What can be done to resolve the problems afflicting the Portuguese

economy the budget and current account deficits, the stagnant output
and the high and increasing unemployment rate? This section discusses
the economic policy alternatives available to Portugal and their likely
consequences.
4.1 An increase in the private saving rate

As illustrated in Figure 6.4, investment in Portugal fell from 27.8 per cent
in 1999 to an average of 22.5 per cent of GDP in 20058, while domes-
tic saving dropped from 19 per cent down to 10 per cent of GDP over
the same period. Therefore, the increase in the Portuguese CA deficit
was mainly the expression of a larger decline in private saving than
in investment: 9 per cent versus 5.3 per cent of GDP. These facts have
Figure 6.4 Portugal, saving, investment and the current account, 19962009
Source: Bank of Portugal (1997, 2005, 2009a, and 2010).
led to the suggestion that the current Portuguese malaise can be solved
through an increase in the saving rate by the private sector.15 Indeed,
an increase in the saving rate, by reducing consumption, would trim
down imports, and lead to a smaller CA deficit. However, an increase
in the private saving rate would also have some adverse effects. First,
by depressing sales, the ensuing cutback in consumption would have
a negative impact on investment, which after almost uninterrupted
declines in the last eight years, is already well below its 2001 level.
Second, it would also slash the demand faced by Portuguese busi-
nesses thus bringing about further increases in unemployment.
4.2 An increase in public saving

Pressed by a sharp increase in the spread of the public debt, the
Portuguese government has embarked on successive fiscal programs, the
last one agreed in May 2011 with the European Commission, the ECB,
and the IMF aimed at cutting the budget deficit down to 3 per cent
by 2013. What are the predictable effects? Under normal circumstances,
and in addition to a smaller budget deficit, the effects would be equiva-
lent to an increase in the private saving rate, i.e., a smaller CA deficit
coupled with lower aggregate output and higher unemployment.
Yet, the current circumstances are not normal insofar as most, if not
all, Eurozone countries and other important trading partners like the US
and the UK are simultaneously applying fiscal consolidation strategies.
In such circumstances, a cutting down of public spending in a single
country will lead to a fall in aggregate income in that country as well as,
albeit less markedly, in all its trading partners. Since all the countries are
212 The Euro Crisis
simultaneously implementing the same policy, aggregate income will

be negatively affected in all countries. Thus it is unclear, a priori,
whether a sharp decrease in public spending in Portugal and elsewhere
in the Eurozone will successfully translate into an actual increase in
public saving in the former. In short, simultaneous attempts by coun-
tries belonging to a currency union to increase public saving may be
self-defeating and push the economy into a vicious circle character-
ized by stagnation, high unemployment, reduced revenues and further
budget cuts.16
4.3 A boost to net exports

The Portuguese private and public sector deficits along with high unem-
ployment are mere symptoms of a deeper problem: the large external def-
icit. For this reason, they can only be addressed if there is a large enough
expansion of net exports. In fact, an increase in net exports would help
boost domestic output with two consequences. First, even if the saving
ratee is unchanged, aggregate saving would increase thereby leading to a
smaller private sector deficit. Second, even if government tax rates remain
constant, fiscal revenue would grow and bring about a smaller budget
deficit. In short, an expansion of net exports would bring unemployment
down and, at the same time, slash the various deficits of the Portuguese
economy. So, the crucial question for the Portuguese economy in the
years ahead is this: how can a large boost to net exports be engendered?
Figure 6.5 depicts a representative Portuguese tradable sector. The
horizontal price line results from the fact that the market price in a
typical Portuguese tradable sector is determined by international com-
petition in the Eurozone. The upward-sloping supply curve UCT reflects
the fact that in a typical industry there is a spectrum of firms, ranging
from the lowest-cost to the highest-cost firms.17 In this setting, the size
of a representative tradable sector is determined by the number of firms
whose unit production costs happen to be below the market price. This,
in turn, has the following implication: an upsurge in the size of the
overall Portuguese tradable sector and thus in net exports can only
be achieved through cutbacks in its unit production costs.
Now, there are only two ways of reducing unit production costs: to
increase productivity and/or to trim down the prices of inputs. Blanchard
(2007) makes a number of suggestions for enhancing Portuguese aver-
age productivity. But, as he nevertheless admits, productivity growth is
unlikely however to increase overnight (Blanchard 2007, p. 8). Hence,
the only way to boost net exports in the short-to-medium run is to slash
the price of its inputs. This, in turn, can be done either through a long
Figure 6.5 The situation of the typical Portuguese tradable sector
competitive disinflation or through an across-the-board significant

cut in nominal wages. The rest of the section discusses the likely conse-
quences of these two scenarios.
4.3.1 Competitive disinflation

The evidence shows that, even when faced with a prolonged period of
high unemployment, Portuguese workers are reluctant to accept lower
nominal wages. For example, since 2005 unemployment has stood
above 7.5 per cent and rising, and yet nominal wage growth has shown
no signs of abating. From 2005 to 2009 annual nominal wage growth
was equal to 3.3 per cent up from an average of 2.7 per cent in the
period 20024 when unemployment was below 6.8 per cent (figures
calculated from data in Bank of Portugal 2010, p. 214, Table A.6.2). So,
zero nominal wage growth is the most that may realistically be expected
in Portugal in the years ahead.
Now, in the current Eurozone low inflation environment this con-
straint severely limits the speed at which Portuguese competitive-
ness can be refloated. Suppose that the required adjustment in unit
labour costs is about 30 per cent, that over the next decade nominal
wages in the Eurozone will grow at the trend of the last decade, 2.4
per cent, and that productivity growth in the Portuguese tradable sec-
tor will be the same as in the Eurozone.18 Hence, zero nominal wage
growth in Portugal will improve competitiveness by only 2.4 per cent
214 The Euro Crisis
a year. Therefore, Portugal will have to endure more than a decade of

high unemployment until competitiveness improves, the CA deficit
decreases, and vigorous output growth resumes.
4.3.2 An across-the-board reduction in nominal wages

Blanchard (2007) proposes an alternative way to regain competitive-
ness quickly: an across-the-board reduction in nominal wages say, of
30 per cent. Although reckoning this is almost an impossible task, he
presents a sketch of the implications. First, he notes that any decrease in
nominal wages implies a smaller decrease in real (consumption) wages.
Indeed, let us assume that tradable prices remain unchanged [deter-
mined by competition in the Eurozone], and that non-tradable prices are
set by a markup on wage cost (Blanchard 2007, p. 16). Then, a decrease
in nominal wages of 30 per cent leads to a decrease in the price of
non-tradables of 30 per cent as well. Assuming further that the share of
tradables is roughly 50 per cent, this leads to a decline in the consumer
price index of 15 per cent, and thus to a reduction of real (consumption)
wages of 15 per cent: only halff of the nominal decrease.
What would be the effects on the Portuguese economy? For simplic-
ity, let us assume that labour and non-tradables are the sole inputs used
in the production of tradables. Then, a decline of 30 per cent in both
nominal wages and non-tradable prices would reduce ULC in the trad-
able sector by roughly 30 per cent. Since the price of tradable goods is
fixed by competition within the Eurozone, the number of viable firms
in the Portuguese tradable sector would increase thereby boosting net
exports.19 This is captured in Figure 6.5, where the nominal wage cut
shifts the upward-sloping unit cost curve (UCT) to the right thus letting
output in the tradable sector increase.
However, a large cut in nominal wages and, hence, in non-tradable
goods prices would also have adverse effects. This is because both the
Portuguese public sector and many Portuguese businesses and house-
holds are heavily indebted and, as a result of it, are committed to debt
payments fixed in nominal terms.20 Hence, a 30 per cent decline in
nominal wages and the resulting fall in prices in the non-tradable sector
would make many indebted households and businesses unable to hon-
our their debt service.
Next, note that if the Euro freely floats vis--vis other currencies so as
to keep the Eurozone current account with the rest of the world in bal-
ance, then any improvement in relative competitiveness in an individual
Eurozone country not achieved through an increase in productivity
will in the absence of real depreciation of the Euro be exactly offset
by a worsening in the relative competitiveness of other Eurozone

countries.21 In other words, changes in relative competitiveness not
achieved through increases in productivity do nott represent Pareto-
improving changes for EMU countries but rather constitute zero-sum
games.22 Another way of putting this is that changes in relative com-
petitiveness within the Eurozone achieved by way of wage deflation
entail a fallacy of composition whereby what holds for an individual
country that it can increase its net exports and expand employment in
the tradable goods sector by cutting down nominal wages does not nec-
essarily hold for the Eurozone as a whole. The reason is straightforward:
if the nominal exchange rate of the Euro floats freely then an increase in
net exports in any individual Eurozone country will be exactly matched
by a decrease in net exports in one or several other Eurozone countries.
In turn, the adjustment of the exchange rate occurs since, as argued in
Kregel (1999), any decrease in averagee ULC in the Eurozone leads in the
long run to a nominal appreciation of the Euro against other currencies,
the real effective exchange rate remaining constant. Last, but not least,
if all Eurozone countries cut nominal wages in step with each other,
the benefit to any individual country is likely to be meagre since its net
exports will hardly increase and may even decrease. Whether such policy
would be beneficial for the Eurozone as a whole is discussed in turn.
The crucial issue when gauging the viability of an (export-led)
growth strategy for the Eurozone as a whole based on nominal wage
cuts or, more generally, on wage restraint is whether or not nominal
appreciations of the Euro will offsett decreases in ULC (measured in
Euros) so as to maintain the real effective exchange rate constant. If so,
decreases in nominal wages either in an individual country or across the
Eurozone will not lead to an increase in net exports for the Eurozone
as a whole. Zemanek et al. (2009) implicitly reject this prediction and
argue that nominal wage cuts in Eurozone countries exhibiting a CA
deficit will increase the international competitiveness of Europe as a
whole (Zemanek et al. 2009, p. 31). By contrast, Mitchell and Muysken
(2006) argue that the European Central Bank (ECB) should support the
Eurozone export sector since the euro is overvalued and exporters can-
not achieve the necessary growth that is required to boost the domestic
economies (p. 6). To them, the viability of an export-oriented growth
strategy in the Eurozone as a whole ultimately hinges on whether the
ECB is willing to engineer a real depreciation of the Euro.23
Admittedly, this controversy cannot be easily resolved. Notwithstanding
it, a formal analysis of this issue is presented in Godley and Lavoie
(2007) who perform a simulation exercise in a stock-flow consistent
216 The Euro Crisis
model with three economies (two Eurozone countries and the US) and
two currencies (the US dollar and the Euro) where output is demand-
determined. Their results suggest that a decrease in ULC in an individ-
ual Eurozone economy will tend to be offset by nominal appreciations
of the Euro thus leaving the real exchange rate roughly constant. In
particular, they simulate the impact on the relative income levels of
three economies (the US economy and two Eurozone economies) of an
increase in the import propensity in one of the Eurozone economies.
They find that, after an initial and temporary increase, the US GDP set-
tles at the initial level in the new stationary-state owing to the relative
appreciation of the US dollar vis--vis the Euro. Crucially, they find that,
owing to the relative depreciation of the Euro, the GDP of the Eurozone
economy whose import propensity initially increased settles at a lower
level whereas the GDP of the other Eurozone economy settles at a higher
level. Importantly, this exercise confirms that, were the import propen-
sity of an individual Eurozone economy to decline due, for instance, to
a decrease in its nominal wage costs, there would be a relative (nominal)
appreciation of the Euro so that, in the new stationary state, the GDP
of the Eurozone economy whose import propensity initially decreased,
would settle at a higher level, whereas the GDP of the other Eurozone
economy would now settle at a lowerr level. In other words, the decline
in nominal wages in an individual Eurozone economy does not lead to
an increase in the GDP of the Eurozone as a whole but rather redistrib-
utes a given level of output between the two economies.
4.4 Withdrawal from the Eurozone

Neither the founding treaties of the European Union (EU) nor the succes-
sive amending treaties made until the ratification of the Treaty of Lisbon
include any provision for a Member States withdrawal (negotiated or
unilateral) from the EU or EMU. This situation has changed now that the
Lisbon Treaty has been ratified by all 27 Member States. Article 50 of the
Lisbon Treaty explicitly makes provision for the voluntary withdrawal of a
Member State from the EU. Athanassiou (2009) provides a detailed discus-
sion of the legal aspects of a withdrawal by a Member State. As far as that
study is concerned, a key issue raised by the exit clause is that it does not
make any special provisions for the withdrawal of EU Member States who
also participate in the EMU. In any case, he concludes that: (i) negotiated
withdrawal from the EU would be legally problematic, (ii) that a Member
States exit from EMU without a withdrawal from the EU would be legally
inconceivable, and (iii) that a Member States expulsion from the EU or
EMU would be legally next to impossible (Athanassiou 2009).
Next, a withdrawal from the EMU in the case of Portugal would pre-
dictably lead to a large depreciation (perhaps of 50 per cent) of the old
national currency (the Escudo) vis--vis the Euro as currency markets
may initially overreact because of the pervasive uncertainty gener-
ated by the countrys complex withdrawal from the EMU. Hence, it
would give, after one or two years, the tremendous boost to net exports
Portugal needs if it is to resume sustained economic growth. Yet, the
large depreciation would also produce three adverse consequences in
the short run.24 First, any hint that a Member State plans to withdraw
from the Eurozone would likely unleash both massive capital outflows
and withdrawals of deposits from domestic banks. In the latter case,
holders of deposits denominated in Euros would try hard to avoid the
devaluation implied by the conversion of their deposits into the reintro-
duced old national currency. To staunch this bleeding, the government
would need to impose limits to bank deposit withdrawals as well as
to introduce severe capital controls. This scenario resembles the tragic
situation Argentina went through in 2002 in the wake of the collapse
of the currency board that pegged the exchange rate of the peso to the
US dollar.25 In turn, it is very likely that the adoption of such measures
would result in a credit crunch and, hence, in a further contraction
of aggregate demand, output and employment. Secondly, and to the
extent that debt contracts set up prior to withdrawal from the EMU
would still be denominated in Euros, the depreciation of the domestic
currency would perilously raise the level of indebtedness of households,
businesses, and the government. Finally, the large depreciation would
increase sharply the prices of imported goods drastically depressing real
incomes. From all this we conclude that withdrawal from the EMU is
not a sensible option for Portugal and that, instead, efforts should be
directed towards institutional reform of the EMU itself.
5 Some proposals for reform of the EMU
In this section we outline some reforms in the governance structure of

the Eurozone that would go a long way towards solving the two major
problems that currently afflict it: the CA imbalances of individual coun-
tries and the sovereign debt crisis.
5.1 Intra-EMU CA imbalances

Figure 6.6 depicts the evolution of the CA averages of two distinct
European regions between 1992 and 2007: the North, composed by
Germany, Austria, Finland and Holland, and the South, consisting of
218 The Euro Crisis
Figure 6.6 Current account (per cent of GDP), 19922007

Source: Holinski et al. (2010, p. 3).
Portugal, Ireland, Greece and Spain. In the first half of the 1990s, the
CAs of both groups of countries were close to equilibrium. Afterwards,
the CA balance of the South deteriorated dramatically reaching a defi-
cit of almost 10 per cent of GDP in 2007, while at the same time the
CA of the North improved continuously into a surplus of more than 6
per cent of GDP in 2007. The increase in the CA surplus of the North
from 1999 through 2007, of 4 percentage points of GDP, was basically
associated with an increase of 3 percentage points of GDP in private
saving (see Holinski et al. 2010, Figure 4). This, in turn, may have
reflected the strong wage restraint engendered in Germany over the
last decade and the associated increase in personal income inequality
(see Table 6.4).
In addition, the magnitude of the imbalances created since the crea-
tion of the Euro is remarkable: in 19992007, the CAs in the South and
in the North were on average equal to 6.8 per cent and 4.6 per cent
Table 6.4 Inequality of income distribution Gini coefficient, 19992008
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
North
Germany 25 25 25 : : : 26.1 26.8 30.4 30.2
Netherlands 26 29 27 27 27 : 26.9 26.4 27.6 27.6
Austria 26 24 24 : 27.4 26 26.2 25.3 26,2 26.2
Finland 24 24 27 26 26 26 26 25.9 26.2 26.3
South
Portugal 36 36 37 : : 38 38.1 37.7 36.8 35.8
Ireland 32 30 29 : 30.6 32 31.9 31.9 31.3 29.9
Greece 34 33 33 : 34.7 33 33.2 34.3 34.3 33.4
Spain 33 32 33 31 31 31 31.8 31.2 31.3 31.3
Source: Eurostat.
of GDP, respectively (Holinski et al. 2010, p. 4). However, no sign of

correction has emerged yet. By contrast, the CA of the Eurozone as a
whole has remained roughly in equilibrium over the same period (see
Figure 6.6). Why this marked disparity?
The automatic adjustment of the REER of the Euro has probably con-
tributed to the equilibrium in the CA of the Eurozone as a whole. By
contrast, the process of financial and monetary integration in Europe
led to increasing external deficits in Southern countries. Beginning in
the mid-1990s the decline and subsequent elimination of exchange
rate risk provoked a drastic reduction in nominal and real interest rates
in Southern countries towards the levels observed in the North.26 As a
result, there was an acceleration of investment and consumption in the
South, financed by Northern savings and greatly based on imports from
the North. The result was that Southern countries ran large CA deficits
and accumulated foreign debts and, symmetrically, Northern countries
ran large CA surpluses and acted as their foreign creditors.27
Now, the completion of this process ought to involve a subsequent
future period in which Southern countries switched from net import-
ers to net exporters and thereby repaid the accumulated debts. Which
mechanisms were supposed to bring about this switch? The newly
invested capital would boost productivity growth supposedly in the
tradable sector and thereby enhance competitiveness and net exports.
If that boost in productivity happened to be insufficient, nominal
wages would fall so as to improve competitiveness further and gener-
ate the additional net exports needed to pay back the accumulated
debts.
220 The Euro Crisis
In practice, however, these mechanisms have not operated. To begin

with, the CA deficits of the South reflected mainly increases in private
consumption (in the case of Portugal) and in housing investment (in
the cases of both Spain and Greece) and not the upsurges in produc-
tive investment that were supposed to boost competitiveness.28 Hence,
instead of catching up, productivity in the South has drifted below that
of the North. Secondly, most of the increase in investment in the South
went into non-tradable sectors and thus hardly led to an increase in
either productivity or productive capacity in the tradable goods sectors.
Finally, the financial inflows that occurred during the supposedd conver-
gence process boosted domestic demand and output in some Southern
Eurozone countries above full employment. As a result, inflation in
the South especially in nominal wages and non-tradable prices rose
relative to the North and, thus, competitiveness in the South declined
relative to the North (in the case of Portugal see Figure 6.2).
If Southern countries had not joined the Eurozone their large CA
deficits would have, by now, led to the real exchange rate deprecia-
tion needed to boost their competitiveness and switch their CAs into
surpluses. In theory, the same could be achieved through equivalent
declines in nominal wages. Yet, wages exhibit downward nominal
rigidity and, hence, ULC have for several years remained too high in
the South and too low in the North, preventing the correction of the
imbalances between the two regions.
5.2 Imposing limits on the CA imbalances of individual countries

As we have seen, the process of financial and monetary integration led
to large CA imbalances in Europe with no mechanism guaranteeing their
subsequent correction. It is therefore surprising that a simple rule, had it
been adopted 1015 years ago, could have prevented the developments
that have led to the situation the peripheral Eurozone countries are now
locked in. Specifically, instead of imposing limits on budget deficits, we
believe the Eurozone should have imposed strict limits on the CA imbal-
ances of individual Eurozone countries.29 Which instruments could have
been used to guarantee the compliance with this rule?
5.2.1 Expansionary fiscal policy in the North

Now that the Eurozone is trapped in tremendous intra-EMU CA imbal-
ances, what can we do? As already explained, provided there is not fiscal
consolidation in the North, fiscal consolidation in Southern Eurozone
countries will help them reduce their imports and CA deficits only at
the expense of even higher unemployment. Moreover, the reduction in
imports of the South from the North exports of the North to the South
will also depress output and employment in the North. Hence, we may
say that the Stability and Growth Pact imparts macroeconomic policy
in the Eurozone with a deflationaryy bias by making the whole burden
of the adjustment fall on the Eurozone countries running CA deficits
(Stockhammer 2011).
Is there an alternative? At the moment, expansionary fiscal policy
in the South is clearly nott an option: financial investors would simply
refuse to advance the required financing. But even if they did and
Southern economies enjoyed a short-lived boost, it could be argued that
it would merely lead the South to resume its unsustainable path of the
last decade: high CA deficits and ever-growing external indebtedness.
A comprehensive (long-term) solution for the problems of Southern
countries public, private and external deficits, stagnant output and
rising unemployment must ultimately involve robust growth of their
net exports. Indeed, besides cutting the CA deficit in the South, it would
boost their output and employment and this, by raising tax revenues,
would slash their budget deficits as well. So the crucial question is: how
can export growth be boosted in the South?
We believe that the best option is through expansionary fiscal policy
in the North.30 Indeed, this would, in a first stage, boost output and
employment in the North and afterwards, once full-employment was
reached, increase wage and price inflation there. And these two develop-
ments in the North would correct the imbalances currently affecting
the Eurozone: not only the CA imbalances, but also unemployment,
which stands at 10.1 per cent for the Eurozone as a whole and afflicts
the North and the South alike (see Table 6.5).
How would expansionary fiscal policy in the North lead to the correc-
tion of these imbalances? First, the acceleration of demand growth in
the North would not only reduce unemployment there but also boost
its imports and lessen its CA surplus. Secondly, the increase in wage and
price inflation in the North would reduce its competitiveness vis--vis the
South and thereby shift demand from the North to the South, further rais-
ing imports of the North from the South and reducing the Northern CA
surplus. Finally, the increase in imports of the North from the South
exports of the South to the North would raise output and employment in
the South and, at the same time, narrow its budget and CA deficits.31
Hence the question: what could force Northern Eurozone countries
to implement expansionary fiscal policies? If they faced an upper limit
on their CA imbalances of (say) 2 per cent of GDP, they would have no
alternative.
Table 6.5 Unemployment rates and CAs in the Eurozone, 2010
Eurozone Germany Belgium Ireland Greece Spain France Italy Portugal Slovenia Slovakia Finland Austria Netherlands Estonia
Unemploy- 10.1 7.1 8.3 13.7 12.6 20.1 9.7 8.4 11 7.3 14.4 8.4 4.4 4.5 17
ment rates
CAs (% of 0.35 5.1 2.7 0.7 11.8 4.5 3.5 4.2 9.8 0.9 2.9 2.8 3.2 6.8 2.8
GDP)
Source: AMECO database.

Unfortunately, this solution faces two serious obstacles. First, there

is the agreed tightening of the asymmetric Stability and Growth Pact.
The proposals advanced in the draft legislative package adopted by
the European Commission on 29 September 2010 aim at reducing the
room for discretion by strengthening the rule-based character of fiscal
surveillance. The latter is to be achieved by introducing new sanctions
and making them semi-automatic for those countries which exceed
the budget deficit limit (Larch et al. 2010; European Commission
2010, p. 3). Second, Germany recently adopted the so-called debt
brake whereby the nation is limited to federal government structural
budget deficits of no more than 0.35 per cent of GDP from 2016 (see
Proissl 2010). According to this law, the German government can only
violate the deficit threshold in case of deep recessions and natural
disasters and always provided there is a 2/3 majority in Parliament.
Hence, the debt brake severely restricts the German governments
ability to run budget deficits. Both the reinforcement of the Stability
and Growth Pact and the debt brake will enhance the asymmetry of
the macroeconomic adjustment within the Eurozone, with countries
exhibiting large public deficits being forced to adopt a more restrictive
fiscal policy stance thus effectively swamping the stabilizing effect
of automatic stabilizers whereas countries with either low budget
deficits or budget surpluses do not come under pressure to adopt a
more expansionary stance.
5.2.2 Letting inflation rise temporarily in the Eurozone

It is important to unveil the underlying logicc behind our previous pro-
posal of expansionary fiscal stances in the North under the current
circumstances. There are currently two problems in the Eurozone: a
lack of global demand (unemployment is at about 10 per cent) and a
bias of demand in favour of the North. Both problems can be solved by
raising demand and inflation in the North through expansionary fis-
cal policies of the respective governments. Put another way, in a large
economic space like the Eurozone with neither fiscal federalism nor
significant labour mobility there must be some mechanism to change
relative prices and thereby shift demand from surplus to deficit countries.
Since prices are rigid downwards and debt-payments are fixed in nomi-
nal terms, that change in relative prices must involve higher inflation
in the North.
If Northern Eurozone countries adopted an expansionary fiscal policy
stance along the lines proposed above, wage and price inflation would
eventually rise in the North thus helping Southern Eurozone countries
224 The Euro Crisis
increase their relative competitiveness. But, crucially, higher inflation

in the North would only be possible if the ECB abandoned its current
inflation target of 2 per cent. It is for this reason that we dare to think
the unthinkable: it would be helpful if the ECB abandoned its infla-
tion target and be prepared to let inflation rise up to (say) 5 per cent,
at least during the time span necessary for the correction of the current
imbalances.32
Let us dwell on this point. As is well known, real wages tend to grow
in line with productivity in the long run. Productivity growth in the
Eurozone has been close to 1 per cent since 1999. If this growth rate
continues over the next decade, real wages in the Eurozone will proba-
bly grow at an annual rate of 1 per cent. With average inflation remain-
ing at 2 per cent across the Eurozone, this means that nominal wages in
the Eurozone will tend to grow on average at 3 per cent per year. But the
high unemployment rates may halt nominal wage growth in Southern
Eurozone countries. Hence, if the required relative nominal wage reduc-
tion in these countries is equal to about 30 per cent, then the necessary
period of high unemployment in the South will be about 10 years.
By contrast, suppose that the ECB let inflation in the Eurozone rise
to 5 per cent over the next few years: 6 per cent in the North (because
of over-employment engendered by expansionary fiscal policies) and
1 per cent in the South (because of high unemployment). With average
productivity growth in the Eurozone at about 1 per cent, this implies
that nominal wages will grow at 7 per cent in the North. But, again,
because of high unemployment, nominal wage growth in the South
will be zero. Hence, if the required relative nominal wage reduction in
Southern countries is near 30 per cent, it would now take them only
about 4 years to close their present competitiveness gap.
5.2.3 Adjustable asset-based reserve requirements

As documented above, the major source of the current Southern CA
deficits and the symmetric Northern surpluses was the credit-driven
ballooning of consumption and housing investment in the South.
Now, the development of those imbalances could have been contained
through the use by the ECB of asset-based reserve requirements (ABRRs).
A detailed explanation of the stabilizing properties of ABRRs can be
found in Palley (2004). If the ECB implemented ABRRs on banks operat-
ing in the Eurozone, the latter would be obliged to hold reserve balances
against different types of assets, with the reserve requirements being
adjustable at the discretion of the ECB. In the context of the Eurozone,
the significance of ABRRs is that, by targeting across all banks operating
in the Eurozone regardless of the country where the bank is actually

located assets which are liable to generate both bubbles and excessive
indebtedness in the private sector (e.g. mortgage loans), the ECB may
obstruct the flow of saving from creditor to debtor Eurozone countries
and, hence, attenuate the emergence of the type of intra-EMU CA
imbalances generated over the last decade or so.33 Importantly, this pro-
posal does not require the imposition of different reserve requirements
according to the Eurozone country where the bank is located which
might give rise to some political susceptibilities but rather entails
imposing different reserve requirements depending on the composition
of each banks asset portfolio.
With the benefit of hindsight, if the ECB had implemented ABRRs at
the time of the launch of the Euro, mark-ups on mortgage loan rates
in Southern Eurozone countries would have risen, thus mitigating (and
possibly preventing) the emergence of real estate bubbles in Ireland
and Spain and, more generally, helping contain the large intra-EMU CA
imbalances generated throughout that period (see also the discussion in
De Grauwe 2011).
5.3 Euro-bonds and debt monetization

Besides large CA imbalances, there is currently a problem in the
Eurozone, related to the peculiar nature of sovereign debtt in a currency
union, which needs to be tackled if future sovereign debt crises are to
be avoided. The Euro solved Europes problem of exchange rate specu-
lation by creating a single currency but, in doing so, it replaced the
exchange rate speculation problem with a bond market speculation
problem (Palley 2011, p. 2). As argued by De Grauwe (2011), members
of a monetary union issue debt in a currency over which they have no
control which, in turn, downgrades them to the status of emerging
economies. He explains that, when investors fear a default by a given
Eurozone country, they sell the bonds issued by the government of that
country and thereby raise the interest rate paid on its public debt. As
a result, the government experiences a liquidity crisis, i.e., it cannot
obtain enough funds in capital markets to roll over its debt at reasonable
interest rates. In turn, the unreasonably high interest rates may force a
country into default.34 If so, the feared default eventually becomes a
self-fulfilling prophecy, that is, the country has become insolvent because
investors fear insolvency (De Grauwe 2011, p. 5). By contrast, the possi-
bility of default in a country that issues its own currency is quite remote
provided sovereign debt is denominated in its own currency for, in that
case, default would be a matter of choice and not of necessity. Indeed,
226 The Euro Crisis
if investors feared that its government might default on its debt, they
would still sell their bonds and drive up interest rates but, crucially, were
the government unable to roll over its debt at reasonable interest rates,
the countrys central bank would buy up that debt. The superior force
of last resort, the central bank, would thus prevent investors from trig-
gering a liquidity crisis and the ensuing default.35
How can the fragility of Eurozone countries issuing debt in a cur-
rency over which they have no control be addressed? In the wake of the
Greek sovereign debt crisis which erupted in Spring 2010, the European
Council decided to set up the so-called European Stability Mechanism
(ESM) that will enter permanentlyy into force on 1 January 2013 and
whose main aim is to provide financial assistance, under strict condition-
ality, to those Eurozone countries exhibiting severe financial problems
(European Council 2011).36 The ESM will be funded by contributions
from Eurozone countries, will (initially) have an effective lending capac-
ity of a500 billion and will be enshrined into Article 136 of the Treaty
of Lisbon.
Unfortunately, the fact that Eurozone countries applying for financ-
ing will have to adopt austerity measures will aggravate their reces-
sions. Moreover, the high interest rate the ESM will charge on loans
(two hundred basis points above its funding rate) and the collective
actions clauses on new government bonds (asking private bondholders
to share in the restructuring of the debt) may jeopardize the wanted
financial stability (see De Grauwe 2011). Therefore, the current chal-
lenge to European authorities is to devise a financial mechanism that
reaches a compromise between the need to make some room for the
working of fiscal automatic stabilizers at the national level and simul-
taneously discourage governments from pursuing unsustainable fiscal
policies. In this sense, we believe that one way forward is to allow the
ESM to issue Euro-bonds in order to fund loans at a preferential rate to
Eurozone countries with financial problems and then allow the ECB to
subsequently buy these bonds either directly or in secondary markets.37
The monetization of Euro-bonds would both help reverse the divorce
between monetary and fiscal policy currently embedded in the Treaty
of Lisbon and reduce the political cost inflicted upon some EU national
governments as a result of being perceived by their respective elector-
ates as bailing-out irresponsible countries. In any case, we believe that,
in the long run, guaranteeing financial stability in the Eurozone will
require consolidating national government budgets into the federal
budget so that a system of fiscal transfers among Eurozone countries
can be duly set up. Needless to say, this objective requires a good deal of
further political union and we do not currently see this process coming
about in the near future.
The purpose of this contribution has been to analyse the causes of the
Portuguese economic malaise, evaluate the different policy options
currently available to the Portuguese government and make several
proposals for institutional reform of the EMU. Our main conclusion is
that, given the terrible short-term economic consequences that Portugal
would face were it to withdraw from the Eurozone, the best way forward
for it is to join forces with other peripheral Eurozone countries in order
to push for reform of the EMU along the following lines.
First, the limits on budget deficits imposed by the Stability and
Growth Pact should be replaced by (legally-binding) ceilings on the CA
imbalances of individual Eurozone countries, so that the latter resort
assiduously to discretionary fiscal policy in order to fully comply with
the previously agreed ceilings on CA imbalances. More specifically,
countries exhibiting a CA surplus (deficit) that exceeds the agreed ceil-
ing would be forced to adopt an expansionary (restrictive) discretionary
fiscal policy. Second, the ECB should let inflation temporarily rise to
(say) 5 per cent so as to create a mechanism that helps change relative
levels of competitiveness in the Eurozone, and thereby shifts demand
from surplus to deficit countries. Third, the ECB should impose adjust-
able asset-based reserve requirements on banks to prevent the develop-
ment of bubbles in the real estate sector and stock market of individual
Eurozone countries. Fourth, the European Stability Mechanism should
be allowed to issue Euro-bonds to fund credit at reasonable interest rates
aimed at Eurozone countries facing liquidity crises. Last, but not least,
the ECB should be empowered with a superior force of last resort and
be allowed to purchase Euro-bonds if needed.
We believe that an institutional reform of the EMU along the lines
proposed above is necessary if the current intra-EMU macroeconomic
imbalances and deflationary bias that currently pervade macroeco-
nomic policy in the Eurozone are to be overcome. Failure to address
these two problems will painfully delay the much needed economic
recovery in the Eurozone and imperil the whole European political inte-
gration project. European policymakers stand at a crossroads and they
cannot afford to repeat the mistakes of the past by adopting ill-designed
macroeconomic policies. Future generations will judge them by their
current policy decisions. Let us hope they get it right in time!
228 The Euro Crisis
Notes
* This paper was presented at the Conference titled The Greek and Euro Crisis
held at the University of the Basque Country, Bilbao (Spain) on 17 December
2010 and at the 8th Conference on Developments in Economic Theory and
Policy held also at the University of the Basque Country on 30th June 2011. The
authors would like to thank Philip Arestis for kindly inviting them to participate
in both Conferences. They also wish to thank participants in the Conferences
and the editors of IPPE for their useful comments and suggestions. Of course, the
authors are responsible for any remaining errors.
1. This dim state of affairs was long predicted by Kregel (1999) who propheti-
cally wrote that Germany might be said to be exporting its unemployment
to the rest of the EU member countries. The other member countries can only
allow their nominal wage levels to evolve independently of Germany to the
extent they can rely on productivity growth in excess of that of Germany
The result will be that beggar-thy-neighbor nominal exchange rate deprecia-
tions are replaced by beggar-thy-neighbor reductions in wage costs and prices
(p. 40).
2. Although not reviewed here, a recent study by Barnes et al. (2010) attributes
a substantial part of the blame for the current account imbalances exhibited
by Eurozone countries to different demographic trends and initial net foreign
asset positions.
3. See, in particular, their Figure 11 (Holinski et al. 2010, p. 14).
4. When an economy is at full employment, the value of its CA provides an
indication of the deviation of the REER from its equilibrium level. More
specifically, a CA deficit signals a REER that is above its equilibrium value,
a surplus indicates a REER below it, and a zero CA balance suggests that
the REER is at its equilibrium value. The same does nott hold if an economy
is below full employment. In this case, we cannot say a priori whether the
REER is at or out of equilibrium since, for instance, a CA surplus may reflect a
deficient domestic demand. If so, an increase in domestic demand up to full
employment will raise imports and thus make the CA balance worsen at an
unchanged REER.
5. By contrast, they estimate that the Spanish peseta was only appreciated
around 6 per cent against the Deutsche mark when Spain joined the Euro in
1999 which, according to them, explains the much better performance of the
Spanish economy until 2007.
6. IIP = external reserves of the Portuguese monetary system (net external
debt + net stock of foreign direct investment in Portugal + net foreign
holdings of Portuguese stocks).
7. The net external financial position of a country is the difference between the
market value of foreign assets owned by residents and domestic assets owned
by non-residents.
8. These values were obtained by adding the values of the goods and services
balances shown in Table 6.2 and subtracting for each year the corresponding
value of the energy balance provided by the Bank of Portugal (2010, p. 173
and p. 176).
9. Tourism has accounted for about 40 per cent of total Portuguese services
exports in the last decade.
10. The EU-15 is the main destination of Portuguese goods exports, having
accounted for 71 per cent of the total in 2008. It includes Austria, Belgium,
Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal, Spain, Sweden, and the United Kingdom.
11. These partners currently account for roughly 85 per cent of Portuguese
exports and include, besides the EU-15, Angola and the US (see Bank of
Portugal 2010, p. 146).
12. HIPC harmonized consumer price index; ULC unit labour cost. The REER
based on ULC indicates the relation between ULCs in Portugal and in its
main trading partners when expressed in the same currency. An increase in
this indicator thus reveals that the ULC has risen by more in Portugal than
in its trading partners, i.e., that Portuguese competitiveness has deteriorated.
The REER based on HIPC indicates the relation between consumer prices in
Portugal and its main trading partners. An increase in this indicator there-
fore implies that consumer prices have grown by more in Portugal than in
its trading partners.
13. By 2008, however, the hourly wage in these countries had risen to almost
the Portuguese level, $12.23 (see Bureau of Labour Statistics, International
Labour Comparisons homepage).
14. To this we may add the fact that since the onset of the financial crisis the
real effective Euro exchange rate has appreciated slightly by about 5 per cent
(Wyplosz 2010, p. 14).
15. This suggestion has been recently made by many Portuguese economists
including President Anbal Cavaco Silva, a retired Economics Professor
(Cavaco Silva 2010).
16. As Bohle (2010) aptly puts it while so-called responsible governments
pretend that they are still living in a slow sort of country, where youd
generally get to somewhere else if you ran very fast for a long time, what
governments really are suggesting is to move on to a place where it takes
all the running you can do, to keep in the same place (p. 7).
17. The height of the supply curve reflects the level of unit production costs
including the normal profit margin of the successive firms.
18. From 1999 to 2008, productivity growth in Portugal and the Eurozone was
similar, slightly less than 1 per cent a year.
19. However, it is unclear whether the boost to net exports would be substan-
tial. For instance, Felipe and Kumar (2011) argue that the increase in rela-
tive competitiveness vis--vis Germany of an across-the-board reduction
of money wages in peripheral countries would be meagre since Germanys
export basket is very different from that of Southern Eurozone countries and
Ireland.
20. At the end of 2009, the total debt of households reached 99.1 per cent of GDP,
the total debt of non-financial firms rose to 151.3 per cent of GDP, and govern-
ment debt represented 76.8 per cent of GDP (Bank of Portugal 2010). These
debts add up to 327.2 per cent of GDP. Who owns these debts? Slightly less
than one-third of the total debt is owned by non-residents. The rest comprises
domestic savings in bonds and deposit accounts as counterparts.
21. This assumption is realistic since the CA of the Eurozone vis--vis the rest of
the world has been broadly in balance ever since the launch of the EMU in
1999.
230 The Euro Crisis
22. By contrast, improvements in relative competitiveness in an individual

Eurozone economy achieved by virtue of an increase in productivity do rep-
resent Pareto-improving changes. In that case, real (consumption) wages in
the tradable goods sector would remain roughly constant but employment
would expand due to the increase in net exports, and output in the Eurozone
as a whole would increase. If the increase in relative competitiveness in an
individual Eurozone economy is instead the result of a wage cut, then real
(consumption) wages in the export sector will decrease whereas, as before,
employment in that sector will expand. As for the non-tradable goods sector,
an increase in productivity will bring about increases in real (consumption)
wages (for workers in both the tradable and non-tradable sector) whereas the
impact on employment in that sector is a priori uncertain. Finally, a wage
cut in the non-tradable goods sector will lead to a decrease and an increase
in real (consumption) wages in the non-tradable and the tradable goods sec-
tor respectively, the effect on employment in the non-tradable goods sector
being also uncertain.
23. However, as Arestis and Sawyer (2006) point out, targeting the exchange
rate would require direct intervention by the ECB in the exchange markets
and, therefore, this would require a broadening of its mandate to allow it to
pursue an exchange rate target.
24. This is besides the serious legal problems and uncertainties faced by any
Member State which opted for a withdrawal from the EMU (Athanassiou 2009).
25. However, as noted by the editors, unlike Portugal, Argentina had its own
currency already in existence when the devaluation took place which made
things easier than the scenario that any Eurozone country attempting to
defect from EMU would face.
26. In Portugal, both rates declined by almost 10 percentage points between
1995 and 1999: the nominal interest rate fell from 15.4% to 6% and the real
rate from 13% to slightly more than 3% (Bank of Portugal 1998 and 2000).
27. Portugals foreign debt has already surpassed 100% of GDP, whilst Greek and
Spanish foreign debt is still slightly below that figure (AMECO Database).
28. The Portuguese saving rate continuously declined from 20% in 199598
to 9% of GDP in 2009. Housing investment more than doubled in Spain
between 1997 and 2007 and in Greece between 1996 and 2006. In marked
contrast, housing investment in Portugal increased by only 33% and dur-
ing a brief period of time (between 1996 and 2000), having subsequently
exhibited a sharp contraction. In 2011, it is 40 per cent below its 1996 level!
(AMECO Database).
29. The ultimate justification for this rule is simple: with the CA of the Eurozone
as a whole usually close to equilibrium, an Eurozone country with a CA sur-
plus exports unemployment to an Eurozone country with a CA deficit. Hein
et al. (2011) also advocate the replacement of the Stability and Growth Pact by
the imposition of limits on CA imbalances of individual Eurozone countries.
30. As emphasized in Fats and Mihov (2009), while there is no unanimity, the
empirical evidence shows that on average fiscal policy multipliers are signifi-
cantly greater than one.
31. This proposal accords with Keyness position in 1944 at the Bretton Woods
Conference based in his (sadly rejected) proposal to create an institu-
tional arrangement compatible with global full employment and vigorous
economic growth. In particular, as emphasized in Davidson (2009, ch. 8),

Keynes concluded that an essential ingredient of an international payments
system consisted of transferring the major onus of macroeconomic adjust-
ment from debtor to creditor nations by forcing the country exhibiting a
favourable CA balance to initiate most of the effort necessary to eliminate
this trade imbalance, while maintaining enough discipline in the debtor
countries to prevent them from exploiting the new ease allowed them
(p. 129). As Keynes explained, this would substitute an expansionist, in
place of a restrictive, pressure on world trade (Davidson 2009, p. 129).
32. As with our previous proposal for setting up ceilings on the CA imbalances
of individual Eurozone countries, this proposal faces a serious obstacle.
Article 127.1 of the Treaty of Lisbon states that the primary objective of
the ECB is to maintain price stability and that the basic task of the ECB is
to define and implement the monetary policy of the Union. In turn, the
Governing Council of the ECB clarified in 2003 that it aims to maintain
inflation rates below but close to 2 per cent over the medium term (ECB
2004, p. 51). Therefore, under the current institutional setting, the ECB inde-
pendentlyy decides the quantitative definition of price stability so it is unlikely
it will voluntarily accept to revise its inflation target upward to help grease
the wheels of labour markets in troubled Eurozone countries.
33. Indeed, this would have predictably resulted in an increase in mortgage loan
rates owing to the banks obligation to maintain a relatively higherr propor-
tion of their mortgage loans in the form of reserve balances at the ECB.
34. This is because a necessary condition for solvency is that the primary budget
surplus is at least as high as the difference between the real interest rate and
the rate of growth of real output times the actual debt-to-GDP ratio.
35. In this respect, Bell (2003) insists that the inability of Member States to issue
their own currency is, by far, the most important constraint imposed by the
Maastricht Treaty in that national governments no longer have the ability
to print money in order to pay interest on sovereign bonds and, hence, they
truly face financing constraints.
36. Presumably, the strict conditionality clause represents a device aimed at pre-
venting abuse of the ESM by irresponsible countries. However, as claimed
by De Grauwe (2010), the only case where it can be maintained that the
main cause of the sovereign debt crisis in the Eurozone is fiscal profligacy is
Greece. On the contrary, he argues that the root cause of the sovereign debt
crisis in other peripheral Eurozone countries is to be found in the unsustain-
able debt accumulation of the private sector.
37. For instance, Palley (2011) proposes to create a European Public Finance
Authority (EPFA) along these lines. We may add that Article 123.1 of the
Treaty of Lisbon expressly prohibits the ECB or any national central bank
to purchase public debt directlyy albeit it does not expressly prohibits the
purchase of sovereign debt in secondary markets.
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234 The Euro Crisis
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7
The Economic Crisis in Spain:
Contagion Effects and Distinctive
Factors
Jess Ferreiro and Felipe Serrano
Department of Applied Economics V, University of the Basque Country
Abstract: Since the year 2008, the Spanish economy has been immersed
in the deepest crisis of its history. From being one of the most dynamic
European economies in the decade of the 2000s, Spain has moved to
be a nearly stagnant economy whose short-term prospects are far from
being optimistic, clearly worse than those of most European countries.
The aim of the chapter is to provide an explanation of the bad perform-
ance of Spains economy since 2008. In this chapter we argue that the
current economic problems of Spain can be found in the unsustainable
strategy of economic growth that was followed since the early 1990s.
This expansion was based on an excessive resource to the external fund-
ing, leading to an unsustainable growth of the external debt, whose
problems unleashed, first with the financial turmoils that took place in
the years 2007 and 2008, and, second, with the crisis of the sovereign
debt in the euro area that started with the crises of Greece, Ireland
and Portugal. Also, there is the existence of unsolved structural prob-
lems in the labour market, namely the excessive use of the fixed-term
employment contracts, which since the early 1990s have contributed to
amplifying any shock affecting the Spanish economy, making it more
unstable and pro-cyclical; and, finally, the wrong fiscal policy imple-
mented both before and during the crisis, which led to a pro-cyclical
fiscal stance before the crisis, to the generation of an unsustainable fis-
cal deficit at the very beginning of the crisis, and to a pro-cyclical fiscal
stance during the crisis because of the need to adjust the fiscal deficit.
Keywords: Spain, euro, fiscal policy, financial crisis, economic crisis,

labour market, external imbalances, public debt
JEL Classification: E620, E62, E63, E64, H6
235
236 The Euro Crisis
1 Introduction1
At the beginning of the year 2008, during the electoral campaign of

the parliamentary elections that took place in March 2008, the Spanish
Prime Minister suggested that Spain would, in the near future, be play-
ing in the Champions League of the European economies, and that
the next administration would be the one of full employment for the
Spanish economy. These statements were made some months after the
financial turbulences that had generated the crisis of the sub-prime
mortgages in the summer of 2007 in the United States. This crisis had
already moved from this small segment of the US financial market to
the international financial and banking market, and there were some
voices arguing that Spain, like most developed and European econo-
mies, would soon enter into a recession. However, some prominent
members of the government and the Socialist party defined these opin-
ions as anti-patriotic.
The lack of realism of those official statements was soon confirmed,
as is well known by now. At the present time, the summer of 2011, the
Spanish economy, contrary to what is currently happening in other
European economies, like France or Germany which have reached
the exit of the tunnel of the crisis, remains stagnated. Even worse, the
poor performance in terms of the rate of economic growth has been
associated with poor employment creation and high unemployment
rates, which are far above those registered in the main European econo-
mies, and are getting closer to those registered in the crisis of the early
1990s. Moreover, the economic forecasts for Spain in the short and the
medium term are also worse than those for the main economies of the
euro area. All in all, this means, first, that the Spanish economic crisis is
deeper than in the rest of the European countries and, second, that the
length of the crisis will also be longer in Spain.2
However, the origin of the crisis is not to be found in Spain. As in
the rest of the world economies, both developed and developing and
emerging economies, the international financial turbulence unleashed
in the summer of 2007 has had a deep adverse impact on the Spanish
real economy. The Greek sovereign debt crisis of 2009 gave rise to
a second round of financial turbulences, now in the markets of the
European sovereign debt, in which, again, Spain got involved (Arghyrou
and Kontonikas 2011).
Therefore, a great many of the current problems in the Spanish econ-
omy are due to the financial turbulence generated outside its borders.
However, it is also true that the higher seriousness and depth of the
Jess Ferreiro and Felipe Serrano 237
Spanish crisis can, and must, be explained by domestic elements. These

elements also help to explain why Spain is at the centre of the turmoil
generated in the markets of European sovereign debt, which has led
to the rescue of three economies in the euro area (Greece, Ireland and
Portugal), putting Spain on target by the financial speculators. Actually,
Spain, in terms of its current levels of public and private indebtedness, is
far away from the three economies mentioned and closer to other coun-
tries unaffected by the turmoil. However, there is a general consensus
in considering Spain a likely candidate to be rescued in the short term.
This valuation of the Spanish situation is a clear indication of the exist-
ence of severe problems that are not common to the rest of euro area
member states that have similar ratios of indebtedness (or even higher,
like Germany, for instance) but are not affected by these problems.
In this chapter we focus on three elements that we believe are the
main reasons for the seriousness of the Spanish economic crisis: the high
levels of external indebtedness, the inefficient design of the Spanish
labour market, and the inappropriate management of the fiscal policy in
Spain both before and during the crisis. Also, we consider the problems
that emanate from the application of economic policies, which burden
the credibility of the economic authorities and the associated imple-
mented measures.
We pay special attention to these elements in the present chapter
but before dealing with these problems we make a short analysis of the
behaviour of the Spanish economy in the decade before the crisis. This
analysis is necessary for understanding the deep structural roots of the
current economic problems.
2 The Spanish wonderful decade (19972007)
The years preceding the current crisis were the most lasting and success-
ful period of economic growth of the Spanish economy in the last five
decades. Since 1996 Spain entered on a path of high economic growth,
reaching a peak in the first quarter of 2000 when Spain registered an
annual rate of growth of its GDP of 5.8 per cent. After that date, as in
the rest of the developed economies, the Spanish GDP growth slowed
down. As a result, in the third quarter of 2002, Spain registered the low-
est rate of economic growth of this period, with the real GDP growing
at a rate of 2.6 per cent. Since then, the Spanish economy accelerated
again, and in 2006 Q3, the GDP grew at a rate of 4.1 per cent.
The true dimension of this expansion phase can only be properly
understood from a long-term perspective. What is remarkable about
238 The Euro Crisis
the last boom period is not only the intensity of the expansion. Indeed,
in the year 1977, or even in the years preceding the economic crisis of
the early 1990s, high rates of economic growth were also registered,
even higher than those registered in the last decade. The novelty of the
decade 19972007 is the higher length of the expansion. The Spanish
economy grew at year-on-year rates above 2.5 per cent during 51 con-
secutive quarters: from 1996 Q3 to 2008 Q1 inclusive.
Moreover, the economic expansion in Spain was much more intense
than that registered in most European countries, clearly greater than
that registered in the bigger European economies. According to the data
obtained at the AMECO database,3 between the years 1996 and 2007,
the real size of the Spanish economy (measured as the increase in real
GDP) increased by 51.1 per cent, 20 percentage points higher than the
accumulated growth registered in the European Union EU-27, 23 per-
centage points more than in the euro area, and, of course, much more
than in the four main European countries, i.e., France (29.1 per cent),
Germany (19.5 per cent), Italy (17.6 per cent) or the United Kingdom
(37.4 per cent).
The high rates of economic growth led to an outstanding increase in
the Spanish GDP per capita. Between 1997 and 2007, the real GDP per
capita increased by 28.1 per cent, from 13,900 to 17,800 euros. This
increase in the income per capita was well above that of other countries
in the European Union, the euro area or the main European countries.4
But if we measure the GDP per capita in purchasing power standard
units, the increase in the GDP in Purchasing Power Standard (PPS) units
per capita is even much higher: 73.5 per cent.5
When we measure the relative size of the Spanish GDP per capita, com-
paring it with that of other European countries, we can see that the gap
between Spain and the rest of Europe falls, and even, in some significant
cases, disappears. If we focus on the European Union (EU-27), the Spanish
GDP per capita rose from 79.9 per cent of that of EU-27 to 82.4 per cent.
When the comparison is made with the euro area (17 countries) the
Spanish GDP per capita rose from 70.2 per cent in 1997 to 75.1 per cent
in 2007. The fall in that gap is even more intense when the GDP per capita
is now measured in PPS units. Now, the Spanish PPS GDP per capita
increased from 93.2 per cent of that of EU-27 in 1997 to 104.8 per cent
in 2007. If the focus is made on the euro area, the Spanish PPS GDP per
capita increased from 82.5 per cent of that of the euro area (17 countries)
in 1997 to 96.3 per cent in 2007, exceeding that of a country like Italy.6
It must be noted that this outstanding performance of the Spanish
income per capita takes place in a context of an unparalleled growth
in the population. According to the data of the National Institute of

Statistics, the total population in Spain, which amounted to 39,852,651
people on 1 January 1996, reached the figure of 46,157,822 on 1 January
2008. This means a population increase of more than 6.3 million people,
equivalent to a population growth of 15.8 per cent.7
In order to get a clear picture of the behaviour of the Spanish
economy during the current crisis, as we develop later, it is important
to know the determinants of the economic growth during the expan-
sion phase. With that aim, it is useful to study the contributions to the
economic growth registered in Spain from 1997 to 2007 of the different
items of economic activity, both from the supply and the demand side.
To make this analysis we use data obtained from the Eurostat Annual
National Accounts, and Eurostat National Accounts by 6 Branches,
August 2011.
From the perspective of the different components of the aggregate
demand, the main engines of the increase in economic activity in that
period have been private consumption and gross capital formation, with
public consumption playing a minor role. The increase of household
consumption explains 62.8 per cent of the increase of Spanish GDP,
while gross capital formation explains 45.1 per cent of that increase and
the final consumption of the general government explains 22.9 per cent
of the growth in the GDP. Regarding the contribution to economic
growth of foreign trade in goods and services, there has been a remark-
able increase in the real value of exports, and thus the increase in the
exports of goods and services amounts to 41 per cent of the increase of
the GDP. However, this positive contribution of exports was more than
offset by the even higher growth of the imports of goods and services.
The rise of imports amounted to 75 per cent of the increase in Spanish
GDP. As a result of these skyrocketing imports, the trade balance con-
tributed negatively to the Spanish economic growth by 34.5 per cent.
On the other hand, from the point of view of the aggregate supply,
the increase in the activity of the agriculture and fishing sector explains
0.9 per cent of the increase of the gross value added in Spain, the
manufacturing explains 12 per cent of the growth in gross value added
(GVA), construction explains 13.4 per cent, wholesale and retail trade,
hotel and restaurants and transport explain 21.1 per cent, financial
intermediation and real estate explain 31.2 per cent, and, finally, public
administration and community services and activities of households
explain the remaining 20.7 per cent of the higher GVA.
As a consequence of the different rates of growth of the items of
spending and the productive sectors, the Spanish economy is involved
240 The Euro Crisis
in a process of re-composition. From the point of view of aggregate

demand, both the spending in gross capital formation (GCF) and
exports of goods and services registered a remarkable increase in their
respective shares of the GDP between 1997 and 2007: GCF increased
from 22.9 per cent to 29.8 per cent GDP, and exports increased from
26.1 per cent to 30.7 per cent GDP. However, the higher increase took
place in the case of the imports of goods and services, whose weight
rose from 25.6 per cent to 41.1 per cent GDP. This enormous increase
in imports, as we further analyse later, makes for a strong deterioration
of the Spanish trade balance in this period. Thus the trade balance
changed from a trade surplus of 0.5 per cent GDP into a trade deficit of
10.4 per cent GDP. In the case of the aggregate supply, both the manu-
facturing and the primary sectors, and the sector of wholesale and retail
trade, hotels and restaurants, as well as transport, lost weight in the
Spanish gross value added (from 20.9 per cent to 18.3 per cent, from 4.6
per cent to 3.5 per cent, and from 27 per cent to 25.2 per cent, respec-
tively). The relative size of the public administrations remains almost
unchanged (from 21.4 per cent to 21.2 per cent GDP). The sectors that
gain relevance are the construction sector (from 7.8 per cent to 9.5 per
cent GDP) and, mainly, the financial sector (from 18.3 per cent to 22.3
per cent GDP), the latter the true engine of the economic activity during
the expansion period.8
Perhaps, the most outstanding consequence of the high and sus-
tained economic growth can be found in the performance of the
Spanish labour market. The crisis of the two-year period 199293 led to
strong and abrupt destruction of employment.9 Thus, according to data
from the Spanish National Institute of Statistics, Labour Force Survey
(2011 Q2) the level of employment registered in 1991 Q3 (13.1 million
of employed workers), the highest record in the history of Spain, was
not be reached again until six years later, in 1997 Q1. However, between
then and 2007, Spain enjoyed a sustained process of employment crea-
tion. As a result, in the 2007 Q3, the figure of employed workers was
more than 20.5 million people. This means that during those ten years
a total of 7.4 million new jobs were created, which represents a 56.2
per cent increase.
To be able to make a proper comment on the intensity and magnitude
of this employment increase, it is worth mentioning that, according to
the figures of employment (following National Accounts criteria) pro-
vided by the AMECO database, in the year 1996 employment in Spain
amounted 6.8 per cent of total employment in the European Union
(EU-27), 8.9 per cent of the employment in the EU-15, and 10.9 per cent
of employment existing in the euro area (17 countries). So, between

1997 and 2007, the increase of employment registered in Spain was
equivalent to 30.7 per cent of total employment created in the EU-27,
28.7 per cent of the creation of employment in the EU-15, and 33.6
per cent of the employment created in the euro area.
The intense process of employment creation took place in the context
of an increase in the size of working population, which rose from 16.8
million people in 1997 Q1 to 22.6 million people in 2008 Q1, which
involves an absolute increase of 5.8 million people entering the labour
market. The increase in the working population was fuelled by three
sources: the increase in the Spanish population, the increase in the rates
of activity, mainly as a result of the incorporation of female population
in the labour market, and, finally, the increase in net population inflows
resulting from the strong immigration process.
As a result of the intense process of employment creation, the Spanish
economy was able not only to absorb the new working population but
it was also able to significantly reduce the huge massive unemploy-
ment. The figures of unemployment entered a declining trend: unem-
ployment fell from 4 million unemployed workers in 1994 Q1 to 1.8
million unemployed workers in 2007 Q2.
The fall in the figures of the unemployed workers, along with the
simultaneous rise in the working population, led to an unparalleled fall
in the Spanish rate of unemployment, from 24.5 per cent registered in
the first quarter of 1994 to 8 per cent registered in the second quarter of
2007, a rate that was not registered in Spain since 1978. Actually, this
rate meant that in 2007 the Spanish rate of unemployment was similar
to that of the rest of Europe. Thus, and according to the data of the
Eurostats Labour Force Survey, in 2007 Q2, the unemployment rate in
the European Union (EU-27) was 7.3 per cent, and the unemployment
rate in the euro area was 7.7 per cent. But perhaps the most surprising
fact was that, for the first time in decades, the unemployment rate in
Spain was lower than that existing in countries like France (8.4 per cent)
or Germany (9 per cent).
3 The performance of the Spanish economy in the crisis:

200811
The economic expansion in Spain ended abruptly in 2008 when the

Spanish economy fell into the deepest recession of its history. The
economic growth in Spain started to slow down in the second quarter
of 2008, with the result that, for the first time since the year 1993,
242 The Euro Crisis
the quarterly year-to-year rates of economic growth reached negative

figures. From 2008 Q4 to 2010 Q1 Spain experienced six consecutive
quarters with negative records of economic growth. The trough of the
recession (taken to be when the 12-month GDP growth rate is at the
lowest) took place in the second quarter of 2009, when the year-to-year
rate of growth of the GDP was 4.4 per cent. Since then, the economy
started a slow process of recovery, leading to a rate of growth of 0.7
per cent in 2011 Q2.
To understand the real dimension of the current slowdown, it is worth
mentioning that until 2008 the Spanish economy had suffered only two
recessions since 1970. The first recession lasted only three quarters,
from the first quarter to the third quarter of 1979, with the trough being
registered in 1979 Q2, when the year-to-year rate of growth of the GDP
had a fall of 0.7 per cent. The second recession lasted four quarters,
from 1992 Q4 to 1993 Q3, with the trough taking place in 1993 Q1,
when the year-on-year rate of growth of GDP registered a negative
record of 2.5 per cent.
In terms of the impact of the crisis on the labour market, between
2007 Q4 and 2011 Q1, more than 2 million jobs (2,174,000) were lost
in Spain, representing a destruction equivalent to 10.6 per cent of total
employment existing in 2007 Q4. Regarding the figures of unemploy-
ment, in this period the number of unemployed workers increased by
2,982,000 workers, with the total figure of unemployed workers, accord-
ing to the Labour Force Survey of the Spanish National Institute of
Statistics, amounting to 4,833,700 people in 2011 Q1. As a result of the
skyrocketing unemployment, the rate of unemployment climbed from
8.6 per cent in 2007 Q4 to 20.9 per cent in 2011 Q2.
In a similar way to the previous section, it is useful to analyse the
change registered between 2007 and 2010 in the main components
of the economic activity in Spain, both from the perspective of the
aggregate demand and supply. Again, we use the date obtained at the
Eurostat Annual National Accounts, and Eurostat National Accounts
by 6 Branches, August 2011. Contrary to what happened in the period
1997 to 2007, now, in the period 200710, economic activity in Spain,
measured in real terms, experienced a decline of 3 per cent in the
aggregate demand (GDP) and of 2.7 in the aggregate supply (gross value
added). Consequently, we explain now the determinants of the decline
in economic activity.
It is important to note that economic activity declined in this period
in all the components, with the exception of the economic activity
of the public administration. Thus, from the perspective of aggregate
demand, the final consumption of the general government increased in

8.5 per cent, representing the 53.6 per cent of the decline in the GDP.
From the perspective of aggregate supply, the gross value added of the
public administration and community services and activities of house-
holds increased 8.4 per cent, amounting 66.5 per cent of the decline in
the Spanish GVA.
This behaviour of the public sector talks of the important stabiliza-
tion role played in the crisis by the public sector, offsetting more than
half the decline in economic activity. Although this reflects a positive
view of the fiscal policy in Spain, however, as we will see in following
sections, this positive impact is conditioned by the huge fiscal impulse
adopted by the public authorities.
From the perspective of the different components of the aggregate
demand, the main determinants of the decline in economic activity
have been private consumption and gross capital formation. The house-
hold consumption rate has fallen in these three years by 3.7 per cent,
with this decline representing 72.7 per cent of the decline in Spanish
GDP. In the case of gross capital formation, investment fell 25.1 per cent,
which represents 246.5 per cent of the decline in GDP. Exports of goods
and service also fell at a rate of 3.6 per cent, which amounts to 36.1
per cent of the decline in GDP. Despite the lower exports, the contribu-
tion of the trade balance of goods and services was positive, because
the trade deficit fell 60.2 per cent, an improvement of the trade balance
that in absolute terms (49,959 million euros) was more than double the
decline of the GDP also in absolute terms (21,195 million euros). The
improvement in the figure of the trade balance is explained by the deep
fall in the imports of goods and services: by 58,705 million euros, what
represents a fall of 17.9 per cent
If we make the analysis from the point of view of the components
of the aggregate supply, as we mentioned above, all the economic sec-
tors face a decline in their respective GVA, with the exception of the
public administration. The GVA of the agriculture and fishing sector
declined in 2.4 per cent, representing 3.1 per cent of the decline in the
total GVA; GVA of the manufacturing sector declined in 12.6 per cent,
representing 86.1 per cent of the decline in the total GVA; GVA of the
construction sector declined in 13.5 per cent, representing 48 per cent
of the decline in the total GVA; GVA of the wholesale and retail trade,
hotels and restaurants, and transport sector declined in 0.2 per cent,
representing 1.6 per cent of the decline in the total GVA; and, finally,
GVA of the financial intermediation and real estate sector declined
in 2.3 per cent, representing 19.6 per cent of the decline in the total
244 The Euro Crisis
GVA. In percentage terms, therefore, the construction sector registered

the highest fall of its economic activity. However, in absolute values, it
is the manufacturing sector the sector most affected by the crisis, with
a decline in its real GVA of 16,482 million euros, much higher than the
decline in the construction sector (amounting to 9,200 euros).
As a result of this different evolution of the components of
the economic activity, and from the perspective of the aggregate
demand, between 2007 and 2010 the spending on public consump-
tion increased its participation in Spanish GDP (from 19.1 per cent
to 21.4 per cent), the exports maintain their participation (from 30.7
per cent to 30.6 per cent), and the trade deficit falls dramatically (from
10.4 per cent to 4.3 per cent GDP). But the most remarkable outcome
is the fall of investment by almost seven percentage points of GDP
(from 29.8 per cent to 23 per cent). From the aggregate supply side, the
activity of public administrations gains weight (from 21.2 per cent to
23.6 per cent), while the services sector remains quite stable. In contrast,
the construction and the manufacturing sectors reduce their respective
shares (from 9.5 per cent to 8.4 per cent, and from 18.3 per cent to
16.4 per cent, respectively), clearly showing where the main impact of
the economic crisis in Spain has been concentrated.10
Again, when we compare the respective economic performances of
Spain and the rest of European countries, we can get a concrete idea of
the gravity of the economic crisis in Spain. As mentioned above, one
of the characteristics of the current economic situation in Spain is that
the financial crisis of the years 20079 did not have a greater impact
than in the rest of European countries. If we focus on the performance
of the GDP growth, both in 2008 and in 2009, the decline in economic
activity was much more intense in the whole European Union and in
the euro area: thus, in 2009, the Spanish GDP fell 3.7 per cent, while
economic activity fell 4.1 per cent in the euro area, and 4.2 per cent
in the European Union. However, while in the latter areas economic
activity starts to accelerate from 2010, the Spanish economy remained
stagnant: thus, the forecasts of the GDP growth for the year 2011 are 0.8
per cent for Spain, and 1.8 per cent for the euro area and the European
Union. It is worth mentioning that in 2009 the fall in economic activity
was more intense than in Spain in 9 countries members of the euro area
and in 11 out of the 12 European economies that are not members of
the euro area. But, barely a year later, in 2010, only Greece and Ireland,
in the euro area, and Latvia and Romania, outside the euro area, have a
worse economic performance. Actually, the forecasts for 2011 indicate
that only Greece, Ireland and Portugal will have a rate of growth in their
GDP worse than that of Spains. As a result of the declining economic

activity, Spain suffers an intense process of destruction of employment,
with a rate of unemployment that is twice the European average, well
above that registered in any European economy: the forecasts for the
unemployment rate in 2011 are 20.6 per cent for Spain, 10 per cent for
the euro area, and 9.5 per cent for the European Union.11
But, all in all, what is even more worrying is the fact that the short-
term forecasts for Spain are not optimistic. Thus, the forecasts of the
GDP growth for the years 2011 and 2012 are below those for most
European countries. Moreover, the more recent forecasts show a wors-
ening in economic growth expectations. Thus, the expected rates of
growth of GDP for 2011 and 2012 (as in the Spring 2011 European
Economic Forecast) are below those included in the forecasts elaborated
in Autumn 2011, with a similar predictions for the evolution of employ-
ment and unemployment.
It is in this context that it is worth wondering about the reasons that
explain the fact that a global crisis, which, in an early stage, affected the
Spanish economy less intensively compared to other European coun-
tries. Spain is one of the most damaged economies by the crisis, and, at
the present time, is one of the economies whose exit of the crisis will
happen later.
4 The amplifying elements of the financial and

economic crisis in Spain
As mentioned in previous sections, the origin of the current economic

crisis in Spain must be found in the crisis unleashed in the second half
of 2007 in the international financial markets. This was a global crisis,
affecting all world economies, in general, and European economies, in
particular. However, Spain has been particularly badly affected by the
crisis, both in terms of intensity and duration.
Proof of the seriousness with which the crisis has affected, and is
still affecting, the Spanish economy, is the impact of the financial
turbulence generated by the financial and fiscal problems suffered by
economies such as Ireland, Greece and Portugal, and more recently
Italy. Despite the fact that debt levels, regardless of whether they are
public or private, domestic or external, of the Spanish economy are not
significantly higher than those in other members of the euro area, the
turbulences in the European sovereign debt markets have, however,
affected Spain more than in another countries, leading to an outstand-
ing increase in the risk premium paid by the Spanish public debt.
246 The Euro Crisis
Until the beginning of 2008 the spread of the Spanish public debt in
relation to the German public debt (measured by the ten-year spread
over German bund in basic points) was nearly zero. Since then, the
turbulence in the financial markets has moved the yield of the Spanish
10-year bonds far away from the German ones.12 Thus, in February 2009,
the spread of the Spanish bonds reached 128 basis points, but since then
the spread started to fall. In any case, the spread widens in the context
of the declining yield of Spanish bonds. It was in March 2010, at the
beginning of the turbulence that affected the Greek economy, that the
yield of the Spanish 10-year bond started a rising path.
At the time of the rescue of Greece, on 3 May 2010, the yield of
the Spanish 10-year bond was 4.149 per cent, with the spread to the
German bund reaching 99 basis points. Since then, both figures have
grown without interruption. On 24 November 2010, at the time of the
Irish rescue, the yield of the Spanish 10-year bond had climbed to 2.016
per cent, and the spread with the German bund was 246 basis points.
On 6 April 2001, at the time of the Portuguese rescue, the yield of the
Spanish bond was 5.224 per cent, but the spread with the German bund
had fallen to 182 basis points. But, since that date, both rates have been
rising, and thus, On 2 August 2011, the yield of the Spanish 10-year
bond had reached 6.323 per cent, and the spread with the German
bund was placed at 390.5 basis points, both figures unparalleled since
the creation of the euro.
According to the data of the Spanish Ministry of Economics and
Finance,13 in July 2011 the average interest rate of the outstanding public
debt (denominated in euros) of the central government was 3.9 per cent.
This average interest rate is much higher than the official forecast (April
2011) of nominal growth (2.6 per cent) for Spain in 2011.14 This involves
a snowball effect that, in the absence of an offsetting increase in the
primary balance, will keep pushing upwards the current size of the fiscal
deficit and the size of the outstanding public debt.
It is important to emphasize that the problem with the interest rate
of the public debt is not the nominal interest rate. Despite the hike of
the interest rate paid in the public debt issued, the nominal interest rate
of the outstanding public debt is below that paid since 1999, when the
nominal interest rate of the central government outstanding debt was
5.65 per cent.15 The problem has a twofold origin. On the one hand,
the real interest rate of the public debt has significantly increased since
then. In 1999, the real interest rate of the outstanding debt (calculated
as the nominal interest rate of the outstanding public debt minus the
GDP deflator) was 2.85 per cent. Since then, the real cost of that debt
started to fall, and in 2005 it even reached a negative figure of 0.11

per cent. With the beginning of the crisis, and the fall in the inflation
rate, the real cost of the Spanish central government outstanding debt
started to rise, with the result that in 2010 the nominal and the real
interest rates of the outstanding public debt were, respectively, 3.57
per cent and 2.57 per cent.
On the other hand, the poor performance of the Spanish economy
contributes to generating the snowball effect increasing the relative
size of the public debt measured as a percentage of GDP. Thus, until
2007, the real interest rate of Spanish public debt was below the rate
of growth of real GDP, thus contributing to reducing both the size of
the fiscal deficits and the public debt as a percentage of the GDP. This
situation reversed in 2008 when GDP grew at a rate of 0.9 per cent, and
become catastrophic in 2009, when the Spanish real GDP fell at a rate
of 3.7 per cent, and in 2010 when the rate of growth was 0.1 per cent.
Consequently, the main problem with the evolution of public debt is
not the interest rate of that debt but the low growth of the Spanish
economy, which is causing the current situation of fiscal imbalances
in Spain to be unsustainable in the absence of a strong and deep fiscal
adjustment.
Although a great deal of these movements in the financial markets, in
general, and in the sovereign debt markets, in particular, are explained
by speculative elements, it is also true, however, that not all members
of the euro area are affected in the same way by this turmoil and that
only a few countries (the three economies that have already been res-
cued, Greece, Ireland and Portugal, plus Italy and Spain in the summer
of 2011) are now the target of speculative attacks against the sovereign
debts.
So, what makes Spain different from other European economies that
are less affected by the crisis and that are now leaving it behind? In
our opinion, there are three elements behind this. The first element is
related to the higher dependence of the Spanish economy on interna-
tional financial markets. This higher dependence of external finance
makes Spain more subjected to and affected by the financial turmoil,
with the final result that Spains access to external funding has been
negatively affected both in terms of quantity and price (i.e. rate of inter-
est). The second element relates to a series of structural elements of the
Spanish economy, mainly those existing in the institutional configura-
tion of the labour market, that amplify any shock affecting the Spanish
economy, regardless of whether this shock has an external or domestic
origin, or it has a financial or real nature. The third and last element
248 The Euro Crisis
concerns inappropriate macroeconomic management, mainly in the

field of fiscal policy management both before and during the crisis. We
will analyse these three elements in the following sections.
5 The institutional design of the Spanish labour market
Most existing studies on the behaviour of the Spanish labour market

agree that this market is highly dysfunctional.16 The Spanish labour
market has demonstrated a great capacity to create employment in net
terms during the boom phases, but it also shows its reflect: that is, an
enormous capacity to destroy employment at great speed during slump
periods. Consequently, the current design and working of the labour
market in Spain is characterized by its high cyclical component, which
is much higher than that existing in other European economies. This
explains why during recessions both the figures of destruction of jobs
and the increase in the rates of unemployment are much more marked
than in other European countries. This distinctive pattern of behaviour
gives the Spanish labour market a marked pro-cyclical nature.
This pro-cyclical working of the labour market does not only have an
impact on the performance of the employment and unemployment.
It also has a macroeconomic impact, making economic activity more
sensitive to any domestic or external shock that can affect the labour
market (the evolution of the figures of employment and unemploy-
ment), increasing the volatility of the Spanish economy above that
existing in other European countries. The reason for this pro-cyclical
performance is to be found in the impact generated by job destruction
in the behaviour of households savings, which increase at great speed
in the periods of strong employment destruction.
The economic crisis, and the consequent process of jobs destruction,
gives rise since mid-2008 to a high increase in the Spanish household
savings rates, peaking at 24.2 per cent in 2009 Q4, the highest rate since
2000.17 This increase, which as we will see later, takes place during a
context of increasing real wages, can be explained by two factors. The
first is the constraints suffered by households in gaining access to bank-
ing credit. The second is the rise in household precaution savings as a
result of the uncertainties and turbulences existing in the labour market.
The truth is that this pattern of behaviour is not exclusive of this period.
Actually, the rise in savings rates as a result of the combination of strong
employment destruction and a high rate of temporary employment
took place for the first time during the crisis of early 1990s, when the
higher savings propensity of Spanish households also contributed, as is
now also happening, to slowing down the incipient economic recovery

(Ferreiro and Serrano 2001). This behaviour of the household savings
rate is strongly related not only to the general dynamics of the figures of
employed and unemployed workers, but, more precisely, to the evolu-
tion of the absolute figures of salaried workers with permanent and with
fixed-term employment contracts and the subsequent evolution of the
share of temporary workers.18
As mentioned above, one of the main problems of the Spanish labour
market is the excessive use of fixed-term employment contracts. A par-
ticular and distinctive feature of the Spanish labour market is that, in
the presence of negative demand shocks, the adjustment of payrolls is
made at a first stage through the destruction of temporary employment,
and, in a later stage, through the adjustment of permanent employment.
This pattern of adjustment is explained by the combination of three
interrelated elements: the lower, nearly zero, firing costs of workers with
temporary contracts; the lower wage costs of temporary workers (which,
in turn, also explain the lower firing costs of these workers in compari-
son to those of the permanent workers since these costs are related to
the previous earnings of the workers fired);19 and the concentration of
high qualification and productivity jobs among workers with perma-
nent employment contracts.20 This process of adjustment means that
the rate of temporary employment falls in the slumps, as is currently
taking place: thus, the rate of temporary workers that was 30.9 per cent
in 2007 Q4 is 25.5 per cent in 2011 Q2.21
In fact, between 2007 Q4 and 2011 Q2, the figure of salaried employ-
ment destroyed in Spain amounted to 1,582,100 jobs, representing a
9.4 per cent fall. However, permanent salaried employment only fell in
268,600 workers (2.3 per cent), while the temporary salaried employ-
ment fell in 1,315,500 workers, representing a destruction of temporary
employment of 25.2 per cent. In other words, the destruction of tempo-
rary employment represented 83.1 per cent of employment destruction.
This means that in the presence of demand shocks, the adjustment
in the Spanish labour market, and in company payrolls, is not made
through the use of the wage22 or functional (or working time) flexibil-
ity, but through the changes in the total volume of employment, but
mainly via the adjustment of temporary employment.23
On the other hand, one of the problems resulting from the dys-
functional working of the Spanish labour market is the role played
by collective bargaining and the consequent behaviour of the wage-
setting process at the beginning of the crisis. The inefficient structure
of the Spanish collective bargaining is commonly blamed as part of the
250 The Euro Crisis
endemic problems of the labour market. The existence of an excessive

wage growth is explained as a result of an insufficient decentralization
of the collective bargaining and/or an excessive relevance of the prov-
ince-level sectorial collective bargaining agreements. However, and this
does not mean that such an argument may be wrong, since from the
late 1990s until the bust of the crisis, the Spanish economy registered
an outstanding wage moderation, which took place in a context defined
by high economic growth, unparalleled process of job creation and a
strong and sustained fall in unemployment rates.
The real wage growth (measured as the nominal wage growth minus
the inflation rate measured by the CPI) in the decade of the 2000s was
very low. Measured using data from the wage growth agreed in the col-
lective bargaining,24 real wages grew below 1 per cent in annual terms,
but if we measure wage growth as the growth of wage costs,25 the lat-
ter almost without exception fell systematically since 2006, and when
they began increasing in 2007 they did so very moderately, again below
1 per cent in annual terms.
In all cases, the practice of wage moderation is explained by the contin-
uous signature since 1997 of the subsequent Acuerdos Interconfederales
de Negociacin Colectiva [Interconfederal Collective Bargaining
Agreements] (AINC). These Agreements, signed by the employers asso-
ciations and the two main Spanish trade unions (Comisiones Obreras
and Union General de Trabajadores) mean the acceptance of an implicit
wage policy, where the parties involved agreed as a guideline for collec-
tive bargaining to bargain the wage growth to be passed in the collective
bargaining agreements on the basis of the inflation target for the period
and on the basis that only a part of the productivity increases would be
incorporated into the wage growth.26 Moreover, in these Agreements the
existence of opting out clauses was included: companies facing difficul-
ties could opt out of this wage growth guideline, setting wage growth
below that resulting from the guideline.27
What is relevant for our analysis is that this policy of wage mod-
eration, an implicit true wage policy, broke down in 2008, despite the
fact that trade unions had approved for that year the renewal of the
Agreement signed a year before, in 2007. Thus, the renewal of the AINC
for 2008 was not actually implemented, and even the trade unions
rejected a new wage moderation agreement in 2009.
The rejection of the wage policy meant that real wages in Spain started
to grow at the beginning of the crisis. The real wage agreed in the col-
lective bargaining increased by 2.2 per cent in 2008 and 1.4 per cent in
2009. In the case of real wage costs, these increased during the period
2008 Q12009 Q4 at an average rate of 2.65 per cent. This wage push
led to an increase in total costs and to a fall in the competitiveness of
Spanish firms, which partially explains the employment adjustment
registered in this period.
This process of wage increases only halted in 2010. Thus, since the
third quarter of 2010, the remarkable moderation in the growth of
nominal wage costs has led to a fall in total real wage costs in the last
three quarters.
6 The external debt of the Spanish economy
As we have already mentioned, the financial crisis was a global phe-

nomenon that affected all world and European economies. The crisis
in the international financial and banking markets collapsed the access
to credit and increased the price of credit (increasing the risk premium
of many financial assets) in all the economies. Why has it affected the
Spanish economy more than other European countries? The answer is
that Spain has been more exposed to financial turbulences because it
had a model of growth highly dependent on these markets.
The external imbalance of the Spanish economy (measured by the
trade balance, which is exports minus imports of goods and services)
only started to reach worrying dimensions since the year 2004. In the
period 1995 Q1 until 1998 Q3, Spain had a surplus in its trade balance
equivalent to 0.39 per cent of GDP. Since then, Spain entered a phase of
permanent deficits in the trade balance, but that trade only amounted
to 1.8 per cent of the Spanish GDP in 2003 Q2. It is then when trade
deficits increased reaching 7.5 per cent GDP in 2007 Q4.28
The worsening of the trade balance is often claimed to be generated
by the structural competitiveness problems of the Spanish economy,
mainly those of the manufacturing sector. It is obvious that the existence
of a trade deficit involves the existence of a problem created by the fact
that the part of the domestic demand satisfied via imports of goods and
services is not fully offset with an equivalent amount of exports of goods
and services. However, the accounting existence of this deficit does not
by itself explain the reasons of its generation. Actually, the consequences
of the trade deficit, mainly regarding those affecting the measure
required to correct such a deficit, are not the same when the deficit has a
structural or a cyclical nature; neither are they the same when the deficit
is the result of a rise in imports or a fall in exports.
We can see that the worsening of the trade balance is directly
related to the expansion since 2003, and how since 2008, with the
252 The Euro Crisis
beginning of the recession, there was an abrupt adjustment of the

trade balance, showing the high cyclical component of the external
imbalance. In this sense, in 2011 Q1 the trade deficit only amounted
2.1 per cent GDP.
Now, regarding the second question mentioned above, we note that
the worsening in the trade balance is not explained by a fall in the size
of the exports, whose size as a percentage of the Spanish GDP remains
very stable (both in the case of the exports of goods and in the exports
of services), but to the fast increase of imports, which amount to above
34 per cent of GDP in late 2007 and early 2008.
This particular behaviour of the Spanish external imbalance,
explained by the dominant pattern of growth in the last decade, is
corroborated by the analysis of the evolution of the gross national
savings and investment, both variables measured as percentage of
GDP. Gross national savings were very stable until the end of 2007,
with values in a range between 21 per cent and 23 per cent GDP. On
the contrary, investment has a rising tendency until mid-2008, when
the gross capital formation is above 32 per cent GDP. Therefore, more
than having merely a problem of low competitiveness or low savings,
Spain has had a problem of unsustainable growth, with an excessive
dependence on foreign capital to finance the process of domestic capi-
tal accumulation.
It is frequently stated that the increase in Spanish investment is due
to the development of the sector of residential construction, and that,
consequently, led to the Spanish housing bubble;29 this it has been
suggested would have been the main engine of capital formation, in
particular, and economic activity in general. However, this is not true.
It is true that capital formation in dwellings is the component of invest-
ment spending that grew faster during the boom phase. Thus, between
1997 Q4 and 2007 Q4 gross capital formation in dwellings increased its
size in Spanish GDP to 4.3 percentage points, but investment in equip-
ment also increased its size to 3.5 percentage points of GDP, and the
investment in infrastructure construction accounted for 1.9 percentage
points of the GDP.
In fact, spending on investment in equipment has always been the
main component of gross capital formation (GCF) in Spain. Investment
in dwellings has traditionally been the third component of gross capital
formation, behind investment in infrastructures. In the period 2000
Q1 to 2007 Q4, the average gross capital formation in equipment and
other amounted to 12.2 per cent GDP, the GCF in other building and
structures was 7.92 per cent GDP, and the GCF in dwellings was 7.91
per cent GDP. Despite the increase in residential construction, it only

exceeded investment in infrastructure by a narrow margin between
2003 and 2008.
The recource to external finance for the purposes of increasing capital
accumulation led to a skyrocketing increase of the volume of Spanish
external debt. At the end of 2006, Spanish external debt, excluding
direct investments in Spain, amounted 253,000 million euros, repre-
senting 53.4 per cent of the GDP. But at the end of 2009, the external
debt reached 1,806,564 millions euros, which was equivalent to 171.4
per cent of Spanish GDP. The exponential increase of the external debt
is due to the external debt contracted by the banking system and by the
non-financial companies. The external debt of both sectors amounted
in 2007, before the crisis, to 116 per cent of Spanish GDP.30 This exter-
nal borrowing is made with the aim to keep financing the investment
made by the Spanish companies and the purchase of dwellings through
mortgage credit, both the credit given directly to the Spanish house-
holds for the purchase of their (first or second) houses and the credit
given to the property promoters to finance the construction of the new
houses.
It is this high external debt, the very element that makes the Spanish
economy highly vulnerable to monetary and financial shocks, both
those coming from the normal management of monetary policy,
through the measures to control banking credit and the management of
the interest rate, and those shocks coming from unexpected situations,
such as those that generated the international financial crisis that began
in the summer of 2007.
With the burst of the international financial crisis, the collapse of
the international monetary market deprived the Spanish financial (and
non-financial) companies from the possibility of borrowing abroad at
the speed that they had been doing. Moreover, the hike in interest rates
made it much more expensive for households and firms with more
scarce funding. In this sense, the rise of interest rates passed in July 2008
by the European Central Bank, and the restrictive measures adopted in
2008 to reduce the funds lent to European banks, led to further deterio-
ration in the funding problems of the Spanish economy.
It is then more than evident that the model of economic growth
based on excessive internal and external borrowing was condemned
to collapse, affecting the financial and the real sectors. And this high
external debt is the element that explains the current vulnerability of
the Spanish financial markets in the face of the turbulence arising in the
European financial sector, mainly in the sovereign debt markets.
254 The Euro Crisis
7 The role played by fiscal policy
In this section, we will focus our analysis on the role played by the
Spanish fiscal policy in the generation of the current situation. We
argue that the bad management of fiscal policy before and during the
crisis contributed to the exacerbation of the disequilibria in the Spanish
economy, thereby amplifying the consequences of the financial tur-
moils generated, at first, in the international financial markets, and
later in certain EMU countries.
Thus, we will indentify and discuss four problems of the Spanish fiscal
policy implemented before and after the crisis:31
Fiscal policy should have adopted a more restrictive (anti-cyclical)

fiscal stance during the expansion phase.
Fiscal policy adopted a loose stance (pro-cyclical) in the last year of
expansion.
In 20078, Spanish authorities exhausted the leeway to implement
an expansionary fiscal policy.
Lack of coordination with local and regional governments.
The first problem of the fiscal policy mentioned above is that it should
have adopted a more restrictive (anti-cyclical) fiscal stance during the
expansion phase. As we explained in preceding sections, Spanish eco-
nomic growth was based on excessive recourse to external borrowing to
finance the increasing capital accumulation. This excessive growth led
to a huge trade deficit and to an enormous external debt. In this sense,
fiscal policy should have tried to avoid the overheating of the Spanish
economy, which could have led to lower trade deficits and external
debt, something that would have placed Spain in a better situation to
face the impact of the financial crisis.
During the first phase of the economic expansion, until the year
2003, the improvement in the fiscal balance is generated in view of a
significant fall in the expenditures side. Between 1995 and 2003, the
fiscal deficit fell from 6.5 per cent to 0.2 per cent GDP, with total expen-
ditures falling from 44.4 per cent GDP to 38.4 per cent GDP. However,
and despite the economic acceleration, the figure of revenues remains
almost unchanged, regardless of whether we measure these variables in
absolute values or in cyclical adjustment terms, that is, removing the
impact of the business cycle on the figures of revenues and expendi-
tures.32 In absolute values, total revenues increased from 38 per cent
GDP to 38.2 per cent GDP, while the cyclically adjusted total revenues
fell from 38.9 per cent to 37.9 per cent GDP. The reason has to do with
the continuous fiscal cuts, mainly in direct taxes, which prevented a
higher increase in the public revenues. This means that if these tax
cuts had not been adopted, Spain in 2003 would have enjoyed a fiscal
surplus of 0.8 per cent GDP (instead of the actual deficit of 0.2 per cent
GDP); also a cyclically adjusted surplus equivalent to 0.5 per cent GDP,
instead of the actual deficit of 0.5 per cent GDP.33 This fiscal tighten-
ing should have been more intense in the years 2006 to 2008. As we
analysed above, it is in this period when the external imbalance of the
Spanish economy reached its bigger dimension. The external debt and
the trade deficits register unparalleled values in a context defined by an
extraordinary level of investment that comes with declining national
savings.
If we focus on the period 20047, excluding the year 2008 for reasons
that will become apparent later, the improvement in the fiscal balance
was not too high; hardly two percentage points of the GDP. Contrary to
what happened in earlier years, public revenues increased significantly
in this period, but this took place with an increase in public expendi-
tures. Thus, cyclically adjusted expenditures increased by 0.8 percentage
points of the GDP between 2003 and 2007.
In sum, and mainly since 2003, Spain should have adopted a tighter
fiscal stance. Fiscal cuts, mostly concentrated in direct taxation, and
the increase in public expenditures should have been avoided.34 Higher
fiscal surpluses, that is, a more intense use of a counter-cyclical fiscal
policy, would have slowed down the rate of economic growth, reduced
the internal and external borrowing of the households and the (finan-
cial and non-financial) companies, and would have placed the eco-
nomic growth of Spain on a more sustainable path. This would have
reduced the consequences generated by the collapse of the international
financial and monetary markets in 2007 and 2008, and the contagion
effect coming from the fiscal crises in Greece, Ireland and Portugal.
But even more worrying than the absence of a deep counter-cyclical
fiscal policy during the boom period, is the fact that Spain wasted and
ruined all the available leeway to develop an effective counter-cyclical
fiscal policy during the recession before it entered recession. Again, it
is important to note that when Spain joined the club of countries in
recession in the last quarter of 2008, it is in this quarter that Spanish
GDP registers its first negative record of year-to-year growth.35 That is
to say, it is in the second half of 2008 when Spain starts to suffer the
world recession.36 However, as a consequence of the measures adopted
in 2006 and, mainly in 2007, the fiscal situation had suffered a strong
256 The Euro Crisis
deterioration in 2008, before the beginning of the recession in Spain:

thus, between 2007 and 2008, Spain changed its fiscal surplus of 1.9
per cent GDP to a fiscal deficit of 4.2 per cent GDP, and the cyclically
adjusted fiscal balance moved from a 1.3 per cent GDP in 2007 to
4.1 per cent GDP in 2008.
What are the reasons behind this strong deterioration of public
finances in 2008? In 2008, the size of public expenditure increased 2.1
percentage points of the GDP, while public revenues fell by 4 percentage
points of the GDP. As a result, the fiscal balance moved from a surplus
of 1.9 per cent GDP to a deficit of 4.2 per cent GDP, representing a dete-
rioration of the fiscal balance of 6.1 percentage points of the GDP. If we
analyse the fiscal variables, but now measured in cyclical adjustment
terms, public revenues fall by 3.3 percentage points of the GDP, and
public expenditure rises by 2.1 percentage points of the GDP.
As a consequence, the cyclical response of the public revenues to the
slowdown in the economic activity in 2008 was a decline in the rev-
enues equivalent to 0.7 percentage points of the GDP, while the expen-
ditures remain unchanged. In another words, the slowdown in Spanish
economic growth registered in the year 2008 was only responsible for
the deterioration in the Spanish fiscal balance, representing 0.7 per-
centage points of the GDP. However, the discretionary fiscal measures
adopted by the public authorities in 2007 and 2008 were responsible
for the deterioration in the fiscal balance equivalent to 5.4 percentage
points of the GDP. This means that if the public authorities had not
adopted expansionary fiscal measures in 2007 and 2008, either cutting
direct taxes or increasing expenditures, Spain would have entered the
recession with a fiscal surplus amounting to 1.2 per cent of GDP.
This fiscal space could, and should, have been used at the right time,
that is, at the time Spain fully entered into recession, in 2009, reduc-
ing the impact of the crisis on the Spanish economic activity. What it
is even more important and considering the speculative attacks against
the Spanish public debt that have been unleashed since 2010, this
would have contributed to reducing the current levels of fiscal deficit
and public debt.
This unnecessary fiscal impulse explained by electoral reasons deeply
conditioned the working of Spanish fiscal policy during the recession.
In 2009, when the output gap was 4.5 per cent, the public expendi-
tures rose 4.5 percentage points of GDP, and public revenues fell 2.4
percentage points of GDP, with the fiscal deficit increasing 6.9 percent-
age points of the GDP. The cyclically adjusted expenditures increased
4.3 percentage points of GDP, and the cyclically adjusted revenues fell
1.2 percentage points of GDP, and, thus, the cyclically adjusted deficit
rose 5.5 percentage points of the GDP.
In 2009, when the output gap was 5.2 per cent, the public expendi-
tures fell by 0.8 percentage points of GDP, and public revenues rose by
1 percentage point of GDP, with the fiscal deficit falling 1.8 percentage
points of GDP. The cyclically adjusted expenditures fell 0.9 percent-
age points of GDP, and the cyclically adjusted revenues increased 1.3
percentage points of GDP, and, therefore, the cyclically adjusted deficit
fell 2.2 percentage points of GDP.
In sum, the Spanish authorities introduced a big fiscal impulse at a
time when it was not necessary, and even when it was counterproduc-
tive, that is, during an expansion phase. As far as the crisis was getting
worse, the fiscal impulse lost weight, and when it became more neces-
sary, in the year 2010, the public authorities were forced to adopt a
discretionary tight fiscal stance in order to improve the bad situation of
the public finances. The only aim was to reduce the fiscal deficit, since
then the main priority of the Spanish government.
However, the implementation of these fiscal stimuli does not mean
that they had a significant impact on the economic growth, which
could have contributed to offsetting the decline in private expendi-
ture (both consumption and investment). Indeed, as we next analyse,
another problem of the Spanish fiscal policy is due to the low multiplier
effect of the tax cuts and the rising expenditures. The small impact on
economic activity is explained by the combination of the use of fiscal
tools with low multipliers (tax cuts, transfers, investment with low
potential of lasting employment creation), and the implementation of
a loose fiscal policy in a context of a tight monetary policy and rising
interest rates implemented by the European Central Bank in 2007 and
2008. The final outcome of these measures was the generation of a huge
fiscal deficit that did not have the needed positive impact on economic
activity.37 This working of the Spanish fiscal policy is different from that
implemented in other European economies, where lower fiscal impulses
led to a smaller deterioration of the public finances, but with a more
positive effect on the economic activity.
Let us analyse more deeply these elements, comparing the fiscal impulse
implemented in Spain with those implemented in other European coun-
tries. In this sense, we identify the fiscal impulse as the impact on public
finances of the discretionary fiscal measures adopted by European eco-
nomic authorities, both on the sides of revenues and expenditure. The
fiscal impulse is identified by the change in the cyclically adjusted fiscal
balance (measured as a percentage of the GDP). That is, we measure the
258 The Euro Crisis
fiscal impulse as the difference between the cyclically adjusted fiscal bal-
ances of the years 2009 and 2007. Thus a () sign represents a worsening
in the corresponding cyclically adjusted fiscal balance, and a (+) sign an
improvement in that balance. Consequently, a () represents an expan-
sionary discretionary fiscal policy, and a () represents a restrictive discre-
tionary fiscal policy. That fiscal impulse is divided into two components:
the change in the revenues and in the expenditures.38
In Spain the change in the cyclically adjusted total revenue of general
government amounted to 4.2 per cent GDP, while the change in the
cyclically adjusted total expenditures of general government amounted
+6.3 per cent GDP. As a result, the total fiscal impulse was equivalent to
10.5 points of Spanish GDP.
If we compare the Spanish impulse with those implemented in the
rest of Europe, it is worth noting two elements. The first is that the
Spanish fiscal impulse was the highest impulse in the European Union,
nearly twice the average fiscal impulse in the European Union (EU-27
countries) (+2.8 per cent GDP) or the euro area (2.6 per cent GDP), 26
times larger than the German one (0.4 per cent GDP), or six times larger
than the French (1.8 per cent GDP). In fact, only Ireland implemented
a similar fiscal impulse amounting to 10.2 per cent GDP. The higher fis-
cal impulses, excluding Spain and Ireland, were implemented in Cyprus
(+8.2 per cent GDP), Greece (+7.5 per cent GDP), Portugal (+5.6 per cent
GDP), and United Kingdom (+5.3 per cent GDP). The second remark-
able element is the high share in that fiscal impulse of the measures
adopted to cut taxes. In fact, an expansionary fiscal policy via tax cuts
was implemented only in seven countries (Bulgaria, Greece, Spain,
Cyprus, Malta, Poland, and Portugal), and in Spain this discretionary
cut in taxation had the largest impact on public finances. Thus, in Spain
the size of cyclically adjusted total revenues of the general government
fell by 4.2 per cent of GDP. In Cyprus, they fell in 3.7 per cent GDP, but
in Bulgaria and Portugal they only fell 2.1 per cent GDP.
This particular pattern of the discretionary Spanish fiscal policy had
two negative consequences. The first consequence was that by cutting
taxes, the fiscal deficit increased more than in other countries, reducing
the leeway to adopt further fiscal expansionary measures in the form
of increasing public expenditures. This led to the implementation of
restrictive measures to reduce the fiscal deficit once it reached excessive
and unsustainable levels, regardless of the negative cyclical situation of
the economy.
The second consequence was that the fiscal impulse was concentrated
on those items of the public budget with the lowest multipliers. The
analysis made before the crisis in Spain concluded that the multipliers
of revenues were much lower than those of public expenditures; and
that among the latter, gross capital formation was the item of expendi-
ture with the higher positive multiplier. Compensation of employees
expenditure had also a positive, but lower, multiplier, and that the
expenditure on compensation of employees had a negative multiplier
(De Castro 2005).
The main body of fiscal stimulus that the Spanish government devel-
oped in 2008 was through direct tax decreases. A part of that stimulus
was designed and implemented during that year with the aim of curbing
the plummeting of demand. However, the most important part of that
stimulus comes from the corporation tax reform and from the income
tax changes which had come into force during 2007. When these
reforms were designed they had a clear pro-cyclical bias, since they were
oriented to increase the disposable income of families and companies.
The change of cycle, though, turned them anti-cyclical at the moment
they became operative. The same can be said about the stimulus through
public expenditure (1.6 per cent of the GDP). The increase in wages and
salaries of public servants is the component which best explains this
expansion.
The fiscal impact of those tax cuts with permanent effects on public
finances is estimated to be 2 percent of GDP. The impact of the rest of
the tax cuts with temporary effects on public finance would be equiva-
lent to 0.8 percent of GDP.39
If we assess these measures bearing in mind the values of the
coefficients mentioned above, the conclusion is obvious: the fiscal stim-
ulus the Spanish economy received in 2008 is the one with lower mul-
tipliers and, therefore, its effects on the economy were minimal. There
are partial indicators that reinforce this assessment, the most significant
being the household saving behaviour. As a result of the tax decrease a
3.8 per cent increase of their disposable income was observed in 2008.
However, their consumption grew only 0.1 per cent. The result was an
increase in the saving rate of almost 3 points, rising from 10.3 per cent
in 2007 to 13 per cent in 2008. In conclusion, fiscal stimulus moved
towards saving in a context of great uncertainty and high interest rates.
The ECB kept a rising interest rate policy, which was not relieved until
the last quarter of 2008.
In 2009 fiscal policies were reoriented towards expenditure and, espe-
cially, towards public investment and the increase of transfers to unem-
ployed workers. Nowadays, it is not possible to estimate the fiscal costs
of all the fiscal measures implemented. The programmes supporting
260 The Euro Crisis
certain productive sectors, and a wide range of subsidies, were approved

without a precise budget. Nonetheless, the two special investment
funds approved and specifically designed and implemented to support
aggregate demand (Fondo Estatal de Inversin Local, and the Fondo
Especial para la Dinamizacin de la Economa y el Empleo) amounted
to 1 per cent of GDP. New tax cuts were adopted, though they were
less important. On the other hand, during the same year some of the
above-mentioned tax cuts continued exerting effects. At the time of
writing, there is not enough information to assess the impact of these
new measures. Nevertheless, and regarding the effects of tax reductions,
they are very likely to have been moved towards saving. Partial indica-
tors of the household saving behaviour during the first quarter of 2009
seem to confirm this fact.
Finally, the last problem of fiscal policy in Spain is related to the prob-
lems of coordination among the different levels of the public admin-
istration. Approximately, central government and the social security
system manage 52 per cent of total public expenditure in Spain, with
the other 48 per cent being spent by the sub-national administrations
(regional and local governments).
The social security system has had surpluses in its balances for more
than a decade, even in the current situation. Thus, fiscal deficits have
been generated by the rest of the public administrations; it is at the
central government level of administration where fiscal deficits were
generated. Total fiscal deficits of the regional governments were low
and stable, below 0.6 per cent GDP, and the situation of the local gov-
ernments had always been quite balanced. In fact, the improvement in
the public finances in Spain before the crisis can be explained by the
improvement of the fiscal balance of the Spanish central government:
between 1995 and 2007, the fiscal balance of the whole regional gov-
ernments changed from 0.64 per cent GDP to 0.22 per cent GDP, the
fiscal balance of the local governments changed from 0.03 per cent
GDP to 0.31 per cent GDP, and, finally the fiscal balance of the cen-
tral government fell from a deficit of 5.48 per cent GDP to a surplus of
1.13 per cent GDP.40
This situation changed with the crisis; the generation of high fiscal
imbalances took place in all levels of administration, not only in cen-
tral government. In 2010, the fiscal deficit of the central government
is 4.98 per cent GDP, the fiscal deficit of the regional governments is
3.38 per cent GDP, and that of the local governments is 0.64 per cent
GDP. The reason of the increasing deficits of the regional and local
administrations is directly related to the fall in the revenues of these
administrations, highly dependent on the fiscal revenues linked to the

construction activity.
The problem for the management of fiscal policy, and for the required
adjustment in the public finances, is that although the central adminis-
tration has been able to significantly reduce its deficit by 4.4 percentage
points of the GDP in the year 2010, sub-national governments have
increased their deficits. This is mainly in the case of regional govern-
ments, whose deficit has risen in 2010 to 1.4 percentage points of the
GDP, thus partially offsetting the efforts of central government to cut
its fiscal imbalance.
This situation of the fiscal deficits of the different public administra-
tions has its reflection in the evolution of the public debt in Spain.
Since the first years of the decade of the 1990s, the dynamics of the
public debt in Spain is explained by the changes in the debt of central
government. In December 1990 the size of the public debt issued by the
Spanish central government was 37.6 per cent GDP. After that the debt
began a rising trend, reaching a peak in March 1998, when it amounted
to 56.6 per cent of Spanish GDP. Since then it started a declining ten-
dency, and in March 2008 it only amounted to 26.8 per cent. However,
during these years, the shares of the debt of local and regional govern-
ments remained stable at shares of 3 per cent GDP and 6 per cent GDP,
respectively. However, since 2008, the size of regional government
debt shows a rising trend, peaking at 11.4 per cent of GDP in March
2011.41
This puts an additional pressure on the situation of the overall public
finances. This is the case not only in terms of the current situation,
but mainly in the form of short and medium-term prospects, and in
the effective capacity of regional administrations to implement the
requested fiscal adjustments; those agreed between the 17 regional gov-
ernments and central government.42
The financial crisis that began in the summer of 2007 has caused the
Spanish economy to move in a couple of years from being one of the
most dynamic European economies to one of the most deeply affected
by the crises. Not only has this materialized because of the financial
turbulences that took place at a worldwide level in the years 2007 and
2008, but also because of its direct involvement in the turbulences
affecting the sovereign debt markets in the euro area as a result of the
crises of Greece, Ireland and Portugal. Also, because of the differences
262 The Euro Crisis
existing among the euro area countries about the rescue of these three
economies, mainly in the case of Greece.
The greatest depth of the Spains problems, in comparison with other
European countries, is explained by the existence of long-lasting struc-
tural problems in the Spanish economy. We argue in the introduction
that these problems were the high levels of external indebtedness, the
inefficient design of the Spanish labour market, and the inappropriate
management of the fiscal policy. All these causes are relevant before
and during the crisis and the consequent problems of economic policy
that burden the credibility of the economic authorities and the imple-
mented measures.
In this sense, the analysis of these elements allows us to learn some
lessons from the Spanish strategy of economic growth and economic
policy. The first lesson is that the strategies of growth based on perma-
nent recourse to external borrowing are unsustainable and can lead to
financial problems, although the accumulation of external debt does
not lead to a currency crisis, as in the case of the members of a currency
union. These problems can take place although, as in the case of Spain,
the external funds do not finance the spending in consumption but the
spending on investment.
The second lesson is the need to have in the economy institutions
that can play a counter-cyclical role. In the Spanish case, the design
and working of the labour market, characterized by the excessive use
of temporary employment contracts, has generated direct and indirect
consequences, from the supply and the demand sides, that have con-
tributed to the increase in the negative impact of the (external) shocks
and to the delay the exit of the crisis.
The third lesson is the relevance of the fiscal policy. In the case of
Spain the bad management of fiscal policy before and during the crisis,
a fiscal policy that, besides not offsetting the negative impact from the
financial turbulences, has contributed to generating some fiscal imbal-
ances that have put Spain on the spot in terms of the strains on the
financial markets. Thus, learning from the experience of the bad fiscal
policy in Spain, a good fiscal policy must consider the following aspects:
the need to adopt a solid counter-cyclical stance during booms and
busts; the need to consider multipliers of the different items of public
expenditure and revenues at the time of implementing an expansionary
fiscal policy; the importance of the timing of fiscal policy; and, finally,
the importance of political economy aspects: namely, the existence of
parliamentary majorities, the coordination with sub-regional govern-
ments, and finally the credibility-reputation of the public authorities.
Notes
1. Previous versions of this chapter were presented at the European Association
for Evolutionary Political Economy, EAEPE 2010 Conference (Bordeaux,
2830 October 2010), at the Conference entitled The Greek and the Euro Area
Crises (Bilbao, 17 December 2010), and at the 8th International Conference
entitled Developments in Economic Theory and Policy (Bilbao, 29 July1
July 2011). Comments from participants at these conferences and the edi-
tors of this volume are acknowledged. The usual disclaimer applies. We also
thank the support of the Basque Government (Consolidated Research Group
GIC10/153).
2. According to the most recent available data of the Quarterly Spanish National
Accounts corresponding to the second quarter of 2011 elaborated by the Spanish
National Institute of Statistics (data available at the Institutes website: www.
ine.es), the exports of goods are the only dynamic component of the aggregate
demand since 2010 Q1. Actually, in the second quarter of 2011, exports of
goods are growing at a year-to-year rate of 8.5%. Household final consumption
expenditure is falling at the rate of 0.2%, and the final consumption expendi-
ture by the government is falling at a rate of 1.0%. Meanwhile, gross capital
formation expenditure is falling at a rate of 6.7%. From the perspective of the
aggregate supply, the industrial sector is growing at a rate of 3.2%. Since the
GDP on the whole is growing at a rate of only 0.7%, it is clear, that the external
sector is the only one pulling the economic activity, and that it is the recovery
of Spains main trade partners, France and Germany, that is maintaining the
level of economic activity, avoiding an even worse situation than the current
one. Actually, the slow-down in the economic growth of France and Germany,
registered in 2011 Q2, has led to a lower rate of economic growth in Spain in
2011 Q2 compared to the figures registered in the previous quarter.
3. AMECO database, European Commissions Directorate General for Economic
and Financial Affairs (DG ECFIN), July 2011
4. Real GDP per capita rose +24.1% in the EU-27, +19.7% in the euro area
(17 countries), +17.1% in Germany, +18.9% in France, +10.7% in Italy,
and +27.1% in the United Kingdom (all data obtained in Eurostat, Annual
National Accounts, August 2011).
5. Nominal GDP in PPS per capita rose +54.3% in the EU-27, +48.6% in the
euro area (17 countries), +43.1% in Germany, +44.6% in France, +34.2% in
Italy, and +51% in the United Kingdom (all data obtained in Eurostat, Annual
National Accounts, August 2011).
6. Measured in PPS the Spanish GDP per capita increased in that period from
93.2% to 101.2 % of that of the European Union (EU-27), from the 82.5% to
96.3% of that of the euro area (17 countries), from 74.8% to 90.7% of that
of Germany, from 81.2% to 97.4% of that of France, from 78.6% to 90.3% of
that of the United Kingdom, and from 78.2% to 101.2% of that of Italy.
7. Much of the increase in the Spanish population is explained by the intense
immigration process registered in these years. Thus, between 1998 and 2007,
the foreign population living in Spain increased by 3.9 million people, rising
from 637,000 people in 1998 to 4,520,000 people in 2007. As a result, the
rate of foreign population in Spain increased from 1.6% of total population
in 1998 to 10% ten years later.
264 The Euro Crisis
8. Data based on Eurostat Annual National Accounts, and Eurostat National

Accounts by 6 Branches, August 2011.
9. Data from the Spanish National Institute of Statistics, Labour Force Survey,
2nd quarter 2011.
10. Data based on Eurostat Annual National Accounts, and Eurostat National
Accounts by 6 Branches, August 2011.
11. Data from the European Commission, European Economic Forecast, Spring
2011.
12. Data from Bank of Spain, Summary Indicators, Financial Indicators Daily
Series, September 2011 (available at http://www.bde.es/webbde/en/estadis/
infoest/sindi.html)
13. http://www.tesoro.es/en/home/estadistica.asp
14. http://www.meh.es/Documentacion/Publico/GabineteMinistro/Varios/Infor
mePosicionCiclica2011.pdf
15. Despite the turbulences in the public debt markets, the average cost of the
outstanding public debt has not significantly increased in 2011: in the
period JanuaryJuly 2011, the average nominal interest of the public debt of
the central government was 3.83%, while in the period JanuaryJuly 2010 it
was 3.53% (http://www.tesoro.es/sp/home/estadistica.asp)
16. Among other studies, see European Commission (2010), Ferreiro (2004),
Ferreiro and Gomez (2006a, 2006b, and 2008), Ferreiro et al. (2007), Ferreiro
and Serrano (2001 and 2004), International Monetary Fund (2009, 2010, and
2011), or Jaumotte (2011).
17. Own calculations based on Spanish National Institute of Statistics, INEbase /
Quarterly non-financial accounts for the Institutional Sectors / Detailed
accounts for the institutional sectors, June 2011.
18. Another related problem is the short length of the fixed-term employment
contracts. In 2010, according to the data of the Ministry of Labour and
Migration, 14,417,150 employment contracts were signed in Spain, with
only 1,228,124 contracts being permanent employment contracts. The aver-
age length of the fixed-term employment contracts in 2010 was 64 days.
This short-term length contributes to putting additional pressure on the
precautionary savings of Spanish households.
19. According to the data from the Encuesta Anual de Estructura Salarial (Wage
Structure Survey) of the Spanish National Institute of Statistics, in 2009 the
annual average earnings of a temporary worker were only 69.6% of those of
a permanent worker.
20. According to the Encuesta de Coyuntura Laboral (Labour Situation Survey)
of the Ministry of Labour and Immigration, in 2011 Q1 the rate of tempo-
rary workers was 39.9% in the construction sector, 25.3% in the services
sector, and 16.6% in the manufacturing sector.
21. Source: Spanish National Institute of Statistics, Labour Force Survey,
September 2011.
22. It is true, as is often argued, that Spanish real wages are downwards rigid
in periods of recession. However, this wage rigidity also takes place in
expansion periods, when the growth of real wages is very small, and even
negative.
23. This is not the only problem generated by the excessive use of fixed-term
employment contracts. Another problem is related to the negative impact
generated on the firms innovation activities. An excessive rate of temporary

workers reduces the innovation activities and negatively affects the pro-
ductivity and competitiveness of the companies (see Altuzarra and Serrano
2010). This may be one of the structural causes of the low external competi-
tiveness and the trade deficit of the Spanish economy.
24. Own calculations based on data on collective bargaining from the Ministry
of Labour and Immigration, Boletn de Estadsticas Laborales, and the
National Statistics Institute (series on Consumer Price Index and Spanish
National Accounts), June 2011.
25. Source: Own calculations based on the National Statistics Institute (series on
Consumer Price Index, Quarterly Labour Cost Survey and Quarterly Spanish
National Accounts), June 2011.
26. This means, in practice, that the real wage growth passed in the collective
bargaining is compatible with a fall in the real unit labour costs.
27. For instance, accepting a wage freeze or a negative growth of real wages.
28. Own calculations based on Spanish National Institute of Statistics (Quarterly
Spanish National Accounts), June 2011.
29. The increase in housing prices and the rise in the number of new houses
built have been often presented as the proof of the existence of a housing
bubble in Spain a bubble that would have been fuelled by the existence
of favourable financial conditions in terms of easy access to banking credit
and very low, even negative, real interest rates for mortgages. Thus, the
real interest rates of the mortgages in Spain was negative between 2004
and 2006 (Ferreiro et al., 2007). However, some authors modify this argu-
ment, arguing that housing demand in Spain was not (only) fueled by the
expectations of higher housing prices, but, mainly, by economic fundamen-
tals, such as population growth, employment generation, and increase in
per capita income; also by favourable financial conditions (Altuzarra and
Esteban 2008).
30. Our calculations based on Bank of Spain, Boletn Estadstico, Balance of
payments and international investment position vis--vis other euro area
countries and the rest of the world, June 2011 (available at www.bde.es)
31. Another problem regarding the working of the fiscal policy in Spain is
the small size of the Spanish government. According to the data of the
AMECO database, in the period 20057 the size of the public expenditures
in Spain was 38.7% GDP, a share below the average size of 46.3% for the
whole European Union (EU-27). Only five EU countries (Estonia, Ireland,
Lithuania, Romania and Slovakia) had a smaller government size than Spain.
In as much that the government size can play a stabilizing role (Debrun et al.
2008), the small size of the Spanish government may well have played a role
in the greater depth and length of the Spanish recession.
32. The estimation of public balances adjusted for the cycle, and especially the
estimation of public revenues, shows some methodological problems, which
cause an overvaluation of the structural component and, as a corollary, an
undervaluing of the cyclical element (Larch and Turrini 2009). In the case
of public revenues there are two kinds of problems. The first has to do with
the estimation of the economic cycle and the corresponding output gap,
since this is not an observable variable. Besides this source of uncertainty, we
have to add the one linked to the response of the fiscal income to the cycle.
266 The Euro Crisis
For example, in the Spanish case, it has been observed that the structural
component of fiscal revenues is lower than the estimated one (De Castro
et al. 2008), since the estimation method of the balance attributes a part
of the extra incomes generated as a consequence of the housing boom as
structural income. The fiscal boost of 5.4 percentage points of GDP for 2008
is very likely to be lower than the one that has actually taken place. The loss
of tax collection caused by the bursting housing bubble may be imputed
to that value. In the case of expenditures, the only cyclical component
is that of unemployment benefits. The information currently available at
the time of writing does not permit marking out the structural component
of the expenditure from the cyclical component. For this reason, in the
information provided by the EU on cyclical adjusted balances, the cyclical
component takes a value of zero in most countries. Therefore, the structural
component of the expenditure is likely to be upwardly biased. In conclusion,
the intensities of the fiscal impulse must be interpreted cautiously (Serrano
2010).
33. Own calculations based on AMECO database, European Commissions
Directorate General for Economic and Financial Affairs (DG ECFIN), July
2011.
34. Given the low size of public expenditures in Spain, a tighter fiscal stance
should have been reached through the revenues side. This tighter fiscal
policy would have led to a lower size of public debt and to a lower debt bur-
den, increasing the fiscal surplus thanks to a lower spending on public debt
interests.
35. In terms of the quarter-to-quarter growth, the first quarter with negative
records is 2008 Q3.
36. The year-to-year rate of growth of the GDP in 2008 Q1 and 2008 Q2 were,
respectively, 2.7% and 1.9%.
37. For a deeper analysis of the different measures in the public expenditure and
revenues side, and the budgetary impact of these measures, see Bank of Spain
2009, 2010, and 2011.
38. The source of the data is AMECO database, European Commissions
Directorate General for Economic and Financial Affairs (DG ECFIN), July
2011.
39. These estimations have been made considering all the tax reforms (including
both direct and indirect taxes) implemented in 2008 and 2009, according
to the information provided by the Spanish Central Bank (Spanish Central
Bank 2009).
40. Source: Bank of Spain, Boletn Estadstico, General Government, June 2011
(available at www.bde.es).
41. Source: Bank of Spain, Boletn Estadstico, General Government, June 2011
(available at www.bde.es).
42. According to the most recent data available (8 September 2011), the accumu-
lated deficit of the regional governments in the period JanuarySeptember
2011 amounted to 1.2% of Spanish GDP. The objective of the fiscal deficit
of the regional governments for the whole year 2011 (JanuaryDecember)
agreed between central government and the regional governments is 1.3%
of Spanish GDP. This situation reflects the problems existing for a proper
control of the fiscal imbalances of the regional administrations.
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Index
adjustment convergence criteria 4

constrained growth 67 credit control 52
macroeconomic 58 decision-making 18
mechanisms 569 ECB see European Central Bank
prices 14 European System of Central Banks
processes 13, 66, 67 (ESCB) 4, 8, 18
Arestis, Philip xi, 130 Federal Reserve System 8
Austria, euro area 2 inflation rates 53
interest rates 60
balance of payments, constrained Ireland 169, 176, 182
growth 67, 76 lender of last resort 601
banks monetary policy 89
Committee of European Banking see also banks
Supervisors 27, 28 Central and Eastern European
European Banking Authority 28 countries (CEECs), EU
Germany 175 expansion 2
Irish see underr Ireland Committee of European Banking
stress testing 278 Supervisors (CEBS) 27, 28
see also central banks competitiveness
Belgium, euro area 2 current account imbalances 11, 23
bond yields economic performance 1, 10
euro area 38 euro-plus pact 27, 56
Spain 246 Greece 12730, 1323
budget constraints Ireland 174
fiscal sustainability 84 labour costs 45, 48
present value 84 national currencies 22
budget deficits Portugal 200
contagion 171 contagion
convergence criteria 5, 7 budget deficits 171
current account imbalances 22 financial and economic crisis 30,
Germany 39, 40 23568
Greece 3, 36, 39, 42 convergence criteria
Ireland 3, 36, 1756 budget deficits 5, 7
Portugal 3, 36, 39, 40, 42 fiscal responsibility 4
public investment 62 nominal terms 4
rescue packages 223 Treaty of Maastricht (1992) 1, 3,
Stability and Growth Pact (SGP) 3, 4, 7, 90
39, 54 credit crunch 12, 217
Spain 40 current account imbalances
treaty obligations 54 borrowing 14
budget deficits 22
central banks competitiveness 11, 23
clearing operations 66 domestic demand 445
269
270 Index
current account imbalances continued primary gap indicators 948,

economic performance 1, 10 11618
Economic and Monetary Union standard methodology 92104
(EMU) 23, 197201, 21720 summary of indicators 1046
financial and economic crisis synthetic-recursive indicator of
3749 fiscal sustainability (IFS)
financial integration 196 1024
growth contributions 445 tax gap indicators 1012, 11618
intra-EMU imbalances 197201, tax ratios 99100
21720 theoretical considerations 817
Ireland 44, 62 deficits, budget see budget deficits
limits imposed 2205 deflation
macroeconomic indicators 467 euro-plus pact 37
net foreign assets/liabilities 778 SGP 1
Portugal 20410 Denmark, opt-outs 4
solutions 669 Desli, Evangelia xi, 11958
Cyprus, euro area 2 devaluation, effectiveness 23
debt economic crisis see financial and

decomposition 1446 economic crisis
gross consolidated debt 40 Economic and Monetary Union
monetization of debt 9, 51, (EMU)
2257 current account imbalances 23,
sovereign see sovereign debt 197201, 21720
debt dynamics debt sustainability 79118
analysis 11315 exchange rates 5
fiscal sustainability 82 fiscal policy 1, 39
Greece 1479 Greece 146
policies 80 inflation rates 20
debt sustainability interest rates 5, 175
analysis (DSA) 856 intra-EMU imbalances 197201,
approaches 817 21720
assessment 857, 92104 launch 2
background 801 monetary policy 1, 39
base case scenario 935 political integration 1745
conservative scenario 934, 97 Portugal 217
debt stabilization primary reform proposals 21727
balance 115 sovereign debt 256, 30
debt target analysis 11516 systemic risk 12
evaluation 79118 vulnerability 12
fiscal experience 8790 economic performance
fiscal policy 81 competitiveness 1, 10
Greece 14451 current account imbalances 1, 10
impossibility principle 86 euro area 23, 913
indicators 902 Greece 11958
insolvency 823 growth rates 10
Millennium Development incomplete financial
Goals 82 integration 12
optimistic scenario 934, 96 Ireland 15994
Index 271
Portugal 20110 Portugal 2, 195234

Spain 23568 sectoral financial balances 414,
unemployment 11 48
unit labour costs 10 withdrawal 21617
economic policies Euro-bonds 2256
adjustment mechanisms 569 euro-plus pact
capital mobility 569 competitiveness 27, 56
European Union (EU) deflationary pressures 37
framework 4950 reforms 28
flawed theoretical European Banking Authority
underpinnings 4959 (EBA) 28
Germany 175 European Central Bank (ECB)
intended interaction 50 Enhanced Credit Support (ECS) 9
Ireland 545, 16173, 17782 euro launch 2
macroeconomic imbalances 569 Greek debt 3
Portugal 195234 Harmonized Index of Consumer
post-Keynesian see post-Keynesian Prices (HICP) 51
perspective inflation targeting 503
soft coordination 50 interest rates 5, 89, 64
Spain 54 neo-liberalism 45
structural reforms 569 reform 20, 64
wage/price flexibility 569 sound financial assets 9
Enhanced Credit Support (ECS) 9 strategy 64
Estonia, euro area 2 European Financial Stability Facility
euro area (EFSF), establishment 245,
adjustable asset-based reserve 28, 36
requirements 2245 European Financial Stability
bailout mechanism 256 Mechanism (EFSM)
bond yields 38 Ireland 389
budget deficits see budget deficits role 25, 367
design flaws 171, 1745, 178, 185 European System of Central Banks
distressed peripheral countries 12, (ESCB) 4, 8, 18
196 European Union (EU)
economic crisis see financial and expansion (2004) 2
economic crisis expansion (2007) 2
economic performance 23, 913 finance ministry proposed 29
financial balances 39 eurozone see euro area
fiscal distress 87, 88 exchange rates
fiscal experience 8790 devaluation see devaluation
fiscal prudence 87, 88, 89 economic shock 13
future prospects 15 Economic and Monetary Union
gross consolidated debt 40 (EMU) 5
heterogeneity 20110 Portugal 201, 205, 2078, 210,
inflation rates 8, 201, 2234 219, 2289
institutional reform 195234
Mediterranean countries 196 Ferreiro, Jess xii, 23568
membership 2 financial and economic crisis
net foreign asset position 489 alternative solutions 3578
political integration 249 background 24, 367
272 Index
financial and economic crisis great recession 1, 3, 8, 10, 18, 22,

continued 245, 27, 2930, 33, 160,
contagion 30, 23568 176, 190
current account imbalances Greece
3749 background 120
euro area 130, 3578 budget deficit 3, 36, 39, 42
great recession 1, 3, 8, 10, 18, 22, competitiveness 12730, 1323
245, 27, 2930, 33, 160, 176, credit expansion/private
190 consumption 123
Ireland 1737 debt
post-Keynesian perspective 3578 decomposition 1446
Spain 23568 dynamics 1479
financial markets GDP ratio 89, 137, 1449
deregulation 513 scenarios 14951
stability 64 sustainability 14451
Finland demand injections 122
euro area 2 economic performance 11958
inflation rates 8 Economic and Monetary Union
fiscal policy (EMU) 146
balanced budgets 50 engines of growth 1224
convergence/consistency 118 euro area 2
coordination 65 fiscal prospects 137
debt sustainability 81 foreign direct investment
discipline/responsibility 46 (FDI) 12931
Economic and Monetary Union foreign inflows 129
(EMU) 1, 39 goods trade balance 1279
one size fits all 536 growth/macroeconomic
Stability and Growth Pact stability 12033
(SGP) 50, 535, 65 inflation rates 21, 1278
Spain 25463 infrastructure investment 1234
stabilization 536, 612, 65 institutional weakness 1302
fiscal sustainability interest
budget constraints 84 cover 135, 136
liquidity 834 payments 90
meaning 825 rate spreads 148
foreign direct investment (FDI) low efficiency 1247
Greece 12931 macroeconomic indicators 135
Ireland 160, 1623, 166 Medium Term Fiscal Strategy
France, euro area 2 (MTFS) 143, 144
Memorandum of Understanding,
Germany initial provisions 1401
banks 175 policy recommendations 1523
budget deficit 39, 40 poor governance 1302
debt/GDP ratio 89 primary budget 1478
economic policies 175 product market reform 1434
euro area 2 productivity 121, 1323
inflation rates 8, 21 public finances
neo-mercantilist strategy 489 history 13344
sectoral financial balances 44 parameters 1339
GIPS countries 38, 43, 160 recent developments 13940
Index 273
sectoral financial balances 42, 43 investment

social security 137, 139, 143 budget deficits 62
sovereign debt 3, 38, 197 Greece 1234, 12931
Stability and Growth Programme Ireland 160, 1623, 166
(SGP) 119, 137 Spain 2523
stock flow adjustments 1489 Ireland
strong growth/high background 1601
productivity 121 bail-out 1767
warning signs 12730 banking and financial services
crisis 159, 1745, 178, 184
Hein, Eckhard xii, 3578 Financial Measures Programme
(FMP) 182
incomes moral hazard 179, 180
income/wage policies 61 property boom 159, 168, 170,
nominal wages 64, 21416 1734, 1789
Portugal 21416 Prudential Capital assessment
Spain 2501 Review (PCAR) 183
wage/price flexibility 569 recapitalization 176, 1824
inflation, ECB targeting 503 reform measures 1834
inflation rates supervision 169, 179, 184
Economic and Monetary Union systemic risk 169, 170
(EMU) 20 big government 164, 165, 177
euro area 8, 201, 2234 bond yields 38
Finland 8 budget deficit 3, 36, 1756
Germany 8, 21 capital flow bonanza 178
Greece 21, 1278 capital stock 172
Portugal 21 Celtic Tiger 16173
Spain 21 central bank 169, 176, 182
temporary rise 2234 competitiveness 174
insolvency, debt sustainability construction sector 168, 1714,
823 1789, 18990
institutions current account imbalances 44,
euro area reform 195234 62
Greek weakness 1302 debt/GDP ratio 89
interest payments European Central Bank (ECB) 176
economic output 8990 economic miracle 16173
Greece 90 economic performance 15994
interest rates economic policies 545, 16173,
European Central Bank (ECB) 5, 17782
89, 64 economic stagnation 162
Economic and Monetary Union European Financial Stability
(EMU) 5, 175 Mechanism (EFSM) 389
interest rate rule 50 euro area 2
Ireland 1701, 181 financial and economic crisis
post-Keynesian perspective 1737
601 fiscal crisis 1756, 184
short-term policies 513 inequality 1723
Spain 2467 interest rates 1701, 181
International Monetary Fund (IMF), irrational exuberance 1778
debt sustainability 823 libertarian right 181
274 Index
Ireland continued New Consensus Macroeconomics

moral hazard 179 (NCM) 35, 37, 51, 53, 55,
multi-national corporations 5860
(MNCs) 167, 172 stability 12033
neo-liberalism 177, 1801 Malta, euro area 2
post bail-out 1829 monetary policy
property boom 159, 16872 central banks 89
public expenditure 1656 EMU 1, 39
regulatory imprudence 179 financial market deregulation
sectoral financial balances 42 513
small government 164, 166, 177, inflation targeting 513
180, 189 interest rate rule 50
Social Partnership Agreement monetization of debt 9, 51
(1987) 164, 165 real interest rates 64
solvency/liquidity 185 short-term interest rate
sovereign debt 184 policies 513
stagflation 163, 189 Monogios, Yannis A. xiii, 79118
systemic risk 169, 170, 179
Tiger 2 period 168, 172, 173, 181, neo-liberalism
189 ECB 45
Italy, sectoral financial balances 43 Ireland 177, 1801
Treaty of Lisbon 4, 15
Keynesian economics The Netherlands, euro area 2
international Clearing Union New Consensus Macroeconomics
proposal 656 (NCM), economic policies 35,
macroeconomic adjustment 37, 51, 53, 55, 5890
58 New Keynesianism
see also post-Keynesian macroeconomic adjustment 58
perspective see also post-Keynesian perspective
Kitromilides, Yiannis xii, 15994
Korliras, Panagiotis xii, 79118 Optimal Currency Area (OCA)
considerations 1314
labour markets, reorganization 64 economic policies 57
Leao, Pedro xiixiii, 195234 price flexibility 21
liquidity
fiscal sustainability 834 Palacio-Vera, Alfonso xiii, 195234
Ireland 185 Pelagidis, Theodore xiiixiv,
Lisbon Strategy (2000) 50 11958
Luxembourg, euro area 2 pension reform 267
policies
Macroeconomic Dialogue debt dynamics 80
(Cologne-Process) 65 economic see economic policies
macroeconomics ex ante coordination 65
adjustment 58 fiscal see fiscal policy
current account indicators 467 monetary see monetary policy
Greece 12033, 135 post-Keynesian perspective 5969
imbalances 569 political integration
indicators 12033 euro area 249
intra-EMU imbalances 197201 Treaty of Lisbon 1
Index 275
Portugal Slovenia, euro area 2

background 1967 solvency
budget deficit 3, 36, 39, 40, 42 illiquidity distinguished 83
competitive disinflation 21314 Ireland 185
competitiveness 200 sovereign debt
composition 199200, 215, 225 EMU 256, 30
current account imbalances 20410 Greece 3, 38, 197
debt/GDP ratio 89 guarantees 65
economic growth 21017 Ireland 184
economic performance 20110 monetization 9, 51, 65
economic policies 195234 Spain 2513
EMU 217 see also budget deficits
euro area 2, 195234 Spain
inflation rates 21 aggregate demand 23940, 2434
macroeconomic indicators 202 background 2367
net exports 21216 bond yields 246
nominal wages 21416 budget deficit 40
private savings 21011 crisis elements 2458
public savings 21112 crisis years 2415
real effective exchange rate economic performance 23568
(REER) 201, 205, 2078, 210, economic policies 54
219, 2289 employment contracts 249
post-Keynesian perspective euro area 2
basic principles 602 external debt 2513
euro area 626 financial and economic crisis
financial and economic crisis 23568
3578 fiscal policy 25463
interest rates 601 inflation rates 21
macroeconomic adjustment 58 interest rates 2467
policies 5969 investment 2523
prices labour market 2402, 24851
adjustment 14 sectoral financial balances 41
flexibility 21, 569 wages 2501
Harmonized Index of Consumer wonderful decade 23741
Prices (HICP) 51, 88 stabilization
Optimal Currency Area (OCA) 21 fiscal policy 536, 612, 65
nominal stabilization 61
quantitative easing (QE) 9, 26 real stabilization 612
Stability and Growth Pact (SGP)
Sawyer, Malcolm xiv, 130 budget deficits 3, 39, 54
sectoral financial balances deflation 1
euro area 414, 48 fiscal policy 50, 535, 65
Germany 44 key features 5
Greece 42, 43 reform 26, 37
Ireland 42 sustainability, debts see debt
Italy 43 sustainability
Spain 41 systemic risk
Serrano, Felipe xiv, 23568 EMU 12
Slovakia, euro area 2 Ireland 169, 170, 179
276 Index
Treaty of Lisbon unemployment

monetization of debt 9 currency union 14
neo-liberalism 4, 15 economic performance 11
political integration 1 United Kingdom, opt-outs 4
Treaty of Maastricht (1992) United States, Federal Reserve
budget deficits 54, 90 System 8
convergence see convergence
criteria van Treeck, Till xiv, 3578
fiscal discipline 56
Truger, Achim xivxv, 3578 World Bank, fiscal sustainability 82

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The Euro Crisis

International Papers in Political Economy Series

THE EURO CRISIS

NEW ECONOMICS AS MAINSTREAM ECONOMICS

21st CENTURY KEYNESIAN ECONOMICS

PATH DEPENDENCY AND MACROECONOMICS

CRITICAL ESSAYS ON THE PRIVATISATION EXPERIENCE

POLITICAL ECONOMY OF LATIN AMERICA

ALTERNATIVE PERSPECTIVES ON ECONOMIC POLICIES IN THE EUROPEAN

International Papers in Political Economy

1 Can the Euro Survive after the European Crisis? 1

1.1 Budget/GDP and debt/GDP 6

6.2 Portugal, current account, per cent of GDP, 19962009 204

2.1 10-year government bond yields, selected countries,

4.4 Technical efficiency, 19952008 125

This is the eighth volume of the series of International Papers in Political

PHILIP ARESTIS is Director of Research, Cambridge Centre for Economics

EVANGELIA DESLI is Assistant Professor of Economics at the Aristotle

JESS FERREIRO is Associate Professor in Economics at the University

ECKHARD HEIN is Professor of Economics at the Berlin School of

YIANNIS KITROMILIDES is Visiting Research Fellow at the Centre

PANAGIOTIS KORLIRAS is Professor of Economics at the Athens

PEDRO LEO is Aggregated Professor of Economics at the School of

His research focuses on money, macroeconomic policy, business cycle

YANNIS MONOGIOS is Research Fellow and Head of Fiscal Policy and

ALFONSO PALACIO-VERA is Lecturer in Economics at Universidad

THEODORE PELAGIDIS is Professor of Economics at the University

Resources Development International, etc. He is co-editor of the Welfare State

FELIPE SERRANO is Professor in Economics at the University of the

TILL VAN TREECK is Senior Researcher for Economic Policy at the

Dsseldorf, Germany. He is a member of the coordination committee of

Abstract: The great recession has highlighted a range of problems

Keywords: Economic and monetary union, euro, stability and growth

are highly significant as measures of economic well-being, and the

2 The convergence criteria

European Central Bank at its apex, signalled the adoption of a neo-

3 Fiscal and monetary policy in the EMU4

for other countries. Moreover, the loss of exchange rate instrument

Table 1.1 Budget/GDP and debt/GDP

Budget Budget Budget Budget Debt/ Debt/

Source: Calculated from OECD, Economic Outlook (various issues).

Table 1.2 Inflation rates

Annual inflation Annual inflation Annual

Source: Calculated from OECD, Economic Outlook (various issues).

of a balanced budget over the cycle represented a significant tightening

economic slowdown. Subsequently, the ECB was slow to push interest

4 Economic performance in the euro area

The economic performance of the euro area countries are briefly

the changes in competitiveness and the current account deficits, and

(i) there were large and continuing current account imbalances

Table 1.3 Current account positions and competitiveness

Current Current Current Current Change in

Source: Calculated from OECD, Economic Outlook (various issues).

Table 1.4 GDP growth and unemployment

GDP GDP GDP Unemploy- Unemploy-

Source: Calculated from OECD, Economic Outlook (various issues).

The protracted weak performance of the euro area can be attributed

precise institutional changes that could potentially save the euro. We

5 Adjustment processes and Optimal Currency Area

6 Can the euro be saved?

insufficient economic integration to support a single currency, but that

8 European Central Bank: Monetary and financial policies

There is a need to make some fundamental changes to the operation