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Issue 31/12 January 2011

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1)Happy 2011? By Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva. Director of the International Centre for Money and Banking Studies.

Charles Wyplosz

Is the worst of Europe’s crisis behind us? Or yet to come? This column looks at 2011 and argues that the Eurozone crisis offers a unique chance to correct the “dreadful mismanagement” of the past year.

2010 was a dreadful year for Europe. Yet no one expected it to be quite so dreadful. Exactly one year ago, there were good reasons to be worried about Greece and what a Greek sovereign debt crisis would mean for the Eurozone. Indeed, contagion to other Eurozone countries in difficult fiscal situations was a distinct possibility. So, where was the surprise? The real surprise has been the woeful mismanagement of the crisis. The Eurozone architecture is a shambles. The many plans that have been mooted, in fact pre-announced but not carefully worked out, have collapsed one after another, and the end is not in sight. The unthinkable breakup of the euro is no longer contemplated just by those who never believed that it could work, it is becoming a credible scenario – though it must be said not the most likely one. The Commission has been sidelined. Recovery is on hold.

In a way, the European debt crisis is just bringing to the fore well-identified cracks in the Eurozone construction. These cracks were hidden by policymakers. We knew all along that fiscal discipline was left in the careless hands of national governments, that banking regulation and supervision was delegated to national authorities more interested in promoting national champions than in completing the Single Market, and that crisis management would be masterminded not by the Commission but by national governments with poor analytical support. We thought that, at least, the staunchly independent ECB would remain a beacon of careful and precise thinking, only to discover that monetary policy dominance – the ability of a central bank to reject responsibility for enforcing the budget constraint – is extraordinarily fragile1.

What about 2011, then? The pessimists consider that the dominos will fall one after the other because the absence of a responsible European government is a fatal flaw. The optimists still look forward to a change of direction that will correct for past mistakes, those in the design of the Eurozone and those accumulated over 2010. With every day that passes it is harder to remain in the optimist camp. As always the situation is made worse because economists disagree on everything, from diagnosis to policy recommendations, leaving panicked policymakers with the firm view that economics is largely useless and that anything can be done if it makes good political sense. Here is a partial list of clouded but vital economic and political issues.

Who should enforce fiscal discipline in the Eurozone?

The Treaty gives two mutually incompatible answers: member states are sovereign in fiscal matters; and the Stability and Growth Pact imposes limits on national fiscal policies. We know from the experience of federal states that sub-federal units cannot enjoy full sovereignty. This is the deep reason for the existence of the Pact and the intuition behind calls for a toughening of its operation. The creation of the €440 billion European Financial Stability Fund, and the moral hazard implied by its rescue operations, is a federalist step that pushes us in this direction. Yet, no matter how tough the pact can be made, at the end of the day it clashes with national sovereignty. Either we will have the collective will to roll back national sovereignty, or current plans will founder.

Those who defend the tough-Pact option note that, already, Greece and Ireland have experienced such a roll-back. They are right, but… the conditions imposed upon Greece and Ireland are part of a standard IMF programme, even if the programmes have been jointly mooted with the Commission. In addition, it is one thing to impose on national sovereignty exceptionally in the midst of a crisis; it is something else to do so routinely as part of on-going surveillance.

Even though most people think that it is more reasonable to paper over the Treaty’s cracks, the crisis has shown that it is very costly, and possibly lethal. There are two clean options; explicitly limit sovereignty whenever fiscal discipline is in jeopardy or recognise that fiscal discipline can only be achieved at the national level. The first option clearly requires a new treaty; it is the approach under consideration but defining precisely how this is to be done will prove to be very tricky and ratification by all member states is far from guaranteed. The second approach requires that each Eurozone member country adopts formal procedures or rules that are known to deliver fiscal discipline, the most obvious being a German-style balanced-budget rule2. Whether this can be achieved voluntarily without a new treaty is an open question, but there should be little objection to such a rule that relies purely on domestic agreements.

How should a sovereign debt restructuring be handled?

The crisis has also brought home the fact that sovereign debt defaults cannot be ruled out, even in today’s Europe. When the discipline problem is solved, in one of two ways suggested above, the issue will be moot, but this is bound to take some time and we have to go through 2011 better equipped than in 2010.

Again, the question here is the same: Should any debt restructuring be left to the discretion of each country? Or should there be a collective constraint because it is “a matter of common concern”, to paraphrase the Treaty? In fact, here too, we face a contradiction between two logics of the Treaty: collective interest and national sovereignty.

There are two valid arguments for making debt restructuring a collective issue: an externality and conditionality. The externality arises if one country’s restructuring raises alarm in the markets and adversely affects other Eurozone member countries. This argument must be made more precise, however. What exactly would be the channel(s) of contagion? No one believes, it seems, that a debt restructuring of California would trigger contagion within the US dollar area, so this is not a common currency effect. Several assumptions can be entertained, all of which rest on multiple equilibria. It could be that markets expect some collective support from other countries, leading them to seek a clarification. In this case, the first best response is to offer such clarification ex ante. It could be that markets fear that some Eurozone banks would suffer large losses, which could be socialised thus weakening the corresponding governments. Here the first best response is to strengthen the exposed banks through adequate recapitalisation and, failing that, to design bank resolution processes that would protect the depositors with limited costs to taxpayers. Alternatively, it could be that markets panic as they realise that Eurozone sovereign debts are riskier than hitherto believed. This is not really convincing when we look at the spreads, which can only correspond to default risk. At any rate, the first best solution is for all countries to come up with credible debt stabilisation plans, precisely the alternative envisioned in the previous section.

The other argument, conditionality, is the basis of current “bail-in” discussions: if and when a country needs to be supported by Eurozone taxpayers, it would make sense that creditors also be asked to chip in. In the future, therefore, any bail-out operation financed by the successor to the European Financial Stability Fund would involve an obligation to restructure the debt. This is a powerful argument, so powerful in fact that it is surprising that it is not being applied to current and forthcoming bail-outs. The rumour is that the IMF would have favoured debt restructuring but that the Eurozone countries vetoed such a move. Since this is but a rumour, we cannot know for sure why a solution that makes sense “later” is not being used “now”. It could be legal considerations – the lack of instrument – or the need to protect some banks that are currently weak, or a fear of contagion in the absence of a worked-out plan.

This is all very fine, but do we really need to expand considerable intellectual efforts and political capital to organise debt restructurings? Surely it would be much better to establish fiscal discipline and dispense with painful situations. In a way, these discussions and policy proposals accept that fiscal discipline will not be established. Yet, instead of building an inherently controversial European Monetary Fund, it would seem natural to directly aim at national rules that are in the clear interest of each Eurozone member country.

Is this a competitiveness issue?

It is often asserted that the crisis is rooted in the emergence of European current-account imbalances. Indeed, a striking aspect of the first ten years under the euro is deepening current deficits in some countries, matched by growing surpluses in others (see Mongelli and Wyplosz 2009). As with the global imbalances issue, many observers have concluded that the problem lies with real exchange rate misalignments. With a common currency, it is claimed that many years of high, respectively low, inflation rates have led to significant competitiveness losses, respectively gains. This is an ominous development for it can only be corrected either through higher inflation in the previously virtuous countries or through years of painfully inflation-reducing restrictive policies and sub-par growth in the deficit countries, most likely the latter.

Such a development has always been thought as the monetary union’s nightmare scenario. It lies behind the Commission proposals for enhanced surveillance and for the potential use of sanctions to be imposed on Eurozone countries that do not take remedial action. If accepted, this proposal would impinge upon national sovereignty in the very deep areas of price and wage setting. It would therefore be justified if the market mechanism were failing. Of course, we all know that labour markets do not follow easily the market logic and that governments may provoke misalignments in many ways, including the setting of wages in the public sector and labour market policies that shield large segments of the labour force from market discipline. If there is one place in the world where we would expect grave distortions, it is Europe.

But what is the evidence? Figure 1 shows the real effective exchange rates – the ratio of domestic to foreign unit labour costs – of the presumably-guilty countries since 1999, along with the evolution in Germany. It is easy to spot the gradual depreciation of Germany’s real exchange rate and the real appreciation in Greece and Italy. Magnitudes also matter, however. In all but one case, the index remains within the 95-105 range. Given the precision of these numbers and given trade elasticities, the “ominous” evolution is really mundane. The only exception is Ireland, which underwent a large real depreciation followed by an equally large real appreciation and where a correction is already under way. Simply put, this is a non-existent problem.

Figure 1. Relative unit labour costs (Index: 100 = period average)

chart 4

Source: AMECO database, European Commission.

Should the Commission be in the driving seat?

Another striking feature of the crisis is the sidelining of the Commission. The debates on possible remedies take place among governments, in fact a couple of governments. The Commission simply puts words on the ideas mooted in Berlin and Paris, merely trying to put itself in charge of the policies that could follow. This is a strange evolution.

Along with the ECB, the Commission is unique in its technical capacities on the monetary union. One would normally expect the Commission to come up with solid proposals, not just at crisis time but also in quiet periods when flaws can be quietly identified and reforms proposals assessed. Unfortunately, the Commission has boxed itself in an impossible position. It has interpreted its role as Guardian of the Treaty as rigorously implementing the Stability and Growth Pact. As a result, it has become associated with all the bad aspects of the pact, including so-far unsuccessful efforts at rolling back sovereignty, and it has endorsed the role of bad cop.

In fact the Commission seems unwilling to disagree with powerful governments on matters of governance. Along with endorsing what governments had previously announced, its September report on the Pact includes interesting but toned-down proposals that governments have ignored (see Wyplosz 2010). This means that ministers and officials are not provided with critical views and innovative alternatives. Much of the current morass is due to groupthink.

It is of course perfectly understandable that the Commission needs to tread carefully on central issues. Yet it is an independent body. At this dangerous juncture, it would help a lot if it were using its important intellectual resources to produce original analyses, especially as governments are driven by domestic considerations.

The crisis as a life-time opportunity to deepen integration

One interpretation of recent policy responses is that crises offer unique opportunities to transform existing arrangements. In this view, the unprecedented bailouts offer a unique chance to take a definitive step to some form of fiscal federalism as a way of making what the late Padoa-Schioppa called “a currency without a State” less of an oddity. This is an audacious bet. As any bet, it holds great potential rewards but it also carries risk.

The rosy scenario sees the European Financial Stability Fund being transformed into a sort of European Monetary Fund. This fund would have its own resources and the ability to lend to governments, subject to conditions that inevitably restrict sovereignty at crisis time. In order to limit incentives to require external help, a strengthened Pact would see to it that governments behave in a responsible way at all times, another step that would strengthen the “centre” – whoever that is, possibly the Commission – and limit the room for misbehaviour by national governments. The European Monetary Fund would issue European bonds, guaranteed by member states, a sort of “federal” debt. The euro would finally have the germs of a State.

The less rosy scenario is that discussions over this historic evolution will drag on and prove to be divisive. Markets will conclude that these discussions are leading nowhere and that the Eurozone still does not have a plan to deal with the more pressing situation in several countries. Bailout Greece and Ireland, possibly Portugal too, is one thing. Bailing out Spain and Italy requires amounts of a different order of magnitude. An emergency request to increase the size of the European Financial Stability Fund will trigger strong negative reactions from wary German taxpayers. The only remaining support will have to be provided by the ECB, leading to a large-scale sell-off of euros. Acrimony will rise and the end of the euro will be in sight.

Continuing to raise the ante in 2011 may fulfil the dreams of those who have seen the euro as a step towards deeper integration. It could as well trigger a disintegration of the patiently achieved construction that started in 1958 with the Treaty of Rome.

At least we started the New Year with good news as Estonia finally became the Eurozone’s 17th member. It is reassuring that the euro still appeals to those outside.


Begg, David, Paul de Grauwe, Francesco Giavazzi, Harald Uhlig and Charles Wyplosz (1998) “The ECB. Safe at Any Speed?”, Monitoring the European Central Bank 1, CEPR.

Mongelli, Francesco Paolo and Charles Wyplosz (2009) “The Euro at Ten: Unfulfilled Threats and Unexpected Challenges”, in Bartosz Mackowiak, Francesco Paolo Mongelli, Gilles Noblet and Frank Smets (eds), The Euro at Ten – Lessons and Challenges, European Central Bank.

Wyplosz, Charles (2010), “Eurozone reform: Not yet fiscal discipline, but a good start”,, 4 October.

1 The first CEPR Monitoring the ECB Report included a Chapter entitled “The A-Class Test” in reference to the disastrous revelation that Mercedes’ new A-class car had capsised when journalists submitted it to an unexpected obstacle. We wanted the picture to appear on the report’s front page, but Mercedes threatened us with legal action if we did. More importantly, we were chided by the forthcoming ECB leadership for raising questions that, they argued, would put the new currency in an unfavorable perspective. The questions are those listed in this paragraph, see Begg et al. (1998).

2 In June 2009, Germany adopted a constitutional rule – due to be phased in gradually up to 2016 – that establishes that deficits should not exceed 0.75% of GDP, with an intelligent provision that in effect requires that the rule applies over the business cycle.



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2) Fiscal Policy: an Evaluation. By Maziar Homayounnejad, Queen Elizabeth's School, Barnet.

As a tool of macroeconomic adjustment, fiscal policy (FP) was first discussed by the English economist John Maynard Keynes during the Great Depression of the 1930s. At the time, his advice to governments that they should increase spending and cut taxes to boost their economies was considered heretical: the prevailing view of the 1930s was that a market economy would recover on its own, without government action. By contrast, Keynes argued that an economy could suffer indefinitely with high unemployment if consumer confidence remained stubbornly low. In such a case, the interest elasticity of demand for loans would be very low, meaning that even a loose monetary policy (i.e. low interest rates) would do little to boost aggregate demand.

However, government spending, according to Keynes, would do two things.

  • Firstly, it would boost aggregate demand directly, without having to rely on any third parties to alter their behaviour.
  • Secondly, the increased government spending would boost the incomes of workers and suppliers and therefore trigger multiple rounds of repeat consumer spending in the economy.
  • Such was his belief in government spending as a way to force an economy into recovery that Keynes even advised governments to hire workers to “dig holes in the roads then fill them up again”. Indeed anything to secure an income for workers, which would boost their consumer confidence and therefore the amount being spent in the economy.

    Similarly, a tax cut would leave more disposable income in the pockets of consumers, thereby raising the value of the multiplier as more money was available to buy goods and services at each round of repeat spending. (Note: this can also be seen as a fall in the marginal propensity to withdraw (MPW), which increases the size of the multiplier (K), since K = 1 / MPW).

    Therefore, Keynes argued that the appropriate FP during times of high unemployment was to run a budget deficit (i.e. an expansionary FP). Yet conventional wisdom asserted that budget deficits were always bad, so Britain and the US chose to ignore the policies advocated by Keynes, and continued to balance their budgets until the outbreak of World War II.

    After the war, however, these theories gained a lot of ground. By the 1960s, the idea of managing government spending and taxation in order to achieve full employment became the centrepiece of macroeconomics – both in universities and in central government departments. Such was the belief in Keynesian economics that national governments claimed to have mastered the art of ‘fine-tuning’ the economy. That is, to rapidly alter their spending and taxation plans before an upturn or downswing in the business cycle, thereby keeping the economy humming along at full employment and relatively stable prices.

    But FP fell strongly out of favour during the 1970s and 1980s, when it proved incapable of managing the economy to the exact standards that governments required.

    The following scenarios offer a few explanations as to why fiscal policy is no longer used as a tool for ‘fine-tuning’ the economy.

    The Elasticity of the AS Curve

    Firstly, during the 1970s there were several incidents where government misjudged the UK’s position on the business cycle, and therefore where the AD curve crossed AS. Thinking that we were in a demand-deficient slump, the Labour government undertook an expansionary FP with the aim of stimulating AD and restoring full employment. However, there were times (especially during the infamous oil price shocks) when the cause of recession was an upward / leftward shift of the AS curve rather than a leftward shift of AD. Thus the UK economy was not as far away from full employment output as the government thought. So the increased spending saw AD racing ahead of AS with inflation as an inevitable consequence, while any rises in real GDP were barely noticeable (this can be seen in the diagram below, where government thought it would be shifting AD1 to the right, but was actually shifting AD3 to AD4). These incidents highlighted the acute importance of government having accurate data on the current state of the economy – in particular the size of the output gap – or else they risk undermining the price stability objective.

    graph 1

    Time Lags

    In addition, time lags always seemed to compromise the effectiveness of FP. Firstly, governments took time to even recognise that there was a problem or an impending recession (i.e. the ‘recognition lag’). This is never a quick and easy process, given the inaccuracies inherent in macroeconomic data and the time it takes to correct them. Secondly, it always took time for government to decide what to do (e.g. do we cut taxes or boost spending? Which first, and by how much? Etc). This was the so-called ‘decision lag’. Finally, even once decisions had been made, governments would then have to put their fiscal policy into practice. But of course changes to government spending and taxation only occur once a year in the Annual Budget. So there is also an ‘action lag’. All this means that by the time FP transmits into AD, it may be too late as the threat of recession may have disappeared.

    For example, during the height of FP’s popularity, President Kennedy enacted a series of tax cuts to combat the US recession of 1959-60. However, indecisions and political wranglings meant the cuts only came into effect after the US economy was showing signs of recovery, thus making them largely redundant.

    Crowding Out

    Another problem of FP which was seen during the 1970s concerns the allocation of resources. Essentially, when government ran a budget deficit in the mid-1970s it had to borrow heavily. However, with a fixed supply of loanable funds, the debt markets were overwhelmed by the excess demand for finance, mainly driven by government demand. Inevitably, this put an upward pressure on interest rates and meant that the cost of borrowing rose too high for many parts of the private sector. The rightward shift of aggregate demand was therefore subdued to some extent and this clearly limited the effectiveness of the expansionary FP.

    graph 2

    The effect of this crowding out can be seen in the above diagram. The rise in government spending shifted the AD curve from AD1 to AD2, but the consequent rise in interest rates reduced both consumption and investment demand, thereby shifting the AD curve left, from AD2 to AD3. This lessens the impact of an 2 – Y3.

    Impact of an Expansionary FP on Future Taxation and Spending Plans

    Essentially, a budget deficit can only happen if government borrows from the debt markets, thereby adding to the UK’s national debt. In the long-run, however, the money has to be paid back with interest. Hence we may see a rise in future taxation and / or cuts in public spending to fund the repayments. If this is the case, the rightward shift of AD may slow down or may even be reversed altogether in the long-run. This would compromise economic growth, employment and therefore living standards in the future.

    The current situation in the UK illustrates this point very well. With national debt approaching £1 trillion from the vast public spending of previous years, the current government has had to raise VAT to 20% and impose controversial cuts in areas such as higher education. Despite fears of a ‘double-dip’ recession, these contractionary measures are seen as vital for bringing the national debt down to a manageable level and for safeguarding the future creditworthiness of the country.

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