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EUROPEAN ECONOMY 7|2009EUROPEAN COMMISSION Economic Crisis in Europe: Causes, Consequences and Responses ISSN 0379-0991... The European Economy series contains important reports and com

EUROPEAN ECONOMY 7|2009

EUROPEAN COMMISSION

Economic Crisis in Europe:

Causes, Consequences

and Responses

ISSN 0379-0991

The European Economy series contains important reports and communications from the Commission

to the Council and the Parliament on the economic situation and developments, such as the Economic

forecasts, the annual EU economy review and the Public fi nances in EMU report

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ISBN 978-92-79-11368-0

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Reproduction is authorised provided the source is acknowledged

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European Commission

Directorate-General for Economic and Financial Affairs

Economic Crisis in Europe:

Causes, Consequences and Responses

FOREWORD

The European economy is in the midst of the deepest recession since the 1930s, with real GDP projected

to shrink by some 4% in 2009, the sharpest contraction in the history of the European Union Although signs of improvement have appeared recently, recovery remains uncertain and fragile The EU’s response

to the downturn has been swift and decisive Aside from intervention to stabilise, restore and reform the banking sector, the European Economic Recovery Plan (EERP) was launched in December 2008 The objective of the EERP is to restore confidence and bolster demand through a coordinated injection of purchasing power into the economy complemented by strategic investments and measures to shore up business and labour markets The overall fiscal stimulus, including the effects of automatic stabilisers, amounts to 5% of GDP in the EU

According to the Commission's analysis, unless policies take up the new challenges, potential GDP in the

EU could fall to a permanently lower trajectory, due to several factors First, protracted spells of unemployment in the workforce tend to lead to a permanent loss of skills Second, the stock of equipment and infrastructure will decrease and become obsolete due to lower investment Third, innovation may be hampered as spending on research and development is one of the first outlays that businesses cut back on during a recession Member States have implemented a range of measures to provide temporary support

to labour markets, boost investment in public infrastructure and support companies To ensure that the recovery takes hold and to maintain the EU’s growth potential in the long-run, the focus must increasingly shift from short-term demand management to supply-side structural measures Failing to do

so could impede the restructuring process or create harmful distortions to the Internal Market Moreover, while clearly necessary, the bold fiscal stimulus comes at a cost On the current course, public debt in the euro area is projected to reach 100% of GDP by 2014 The Stability and Growth Pact provides the flexibility for the necessary fiscal stimulus in this severe downturn, but consolidation is inevitable once the recovery takes hold and the risk of an economic relapse has diminished sufficiently While respecting obligations under the Treaty and the Stability and Growth Pact, a differentiated approach across countries

is appropriate, taking into account the pace of recovery, fiscal positions and debt levels, as well as the projected costs of ageing, external imbalances and risks in the financial sector

Preparing exit strategies now, not only for fiscal stimulus, but also for government support for the financial sector and hard-hit industries, will enhance the effectiveness of these measures in the short term,

as this depends upon clarity regarding the pace with which such measures will be withdrawn Since financial markets, businesses and consumers are forward-looking, expectations are factored into decision making today The precise timing of exit strategies will depend on the strength of the recovery, the exposure of Member States to the crisis and prevailing internal and external imbalances Part of the fiscal stimulus stemming from the EERP will taper off in 2011, but needs to be followed up by sizeable fiscal consolidation in following years to reverse the unsustainable debt build-up In the financial sector, government guarantees and holdings in financial institutions will need to be gradually unwound as the private sector gains strength, while carefully balancing financial stability with competitiveness considerations Close coordination will be important ‘Vertical’ coordination between the various strands

of economic policy (fiscal, structural, financial) will ensure that the withdrawal of government measures

is properly sequenced an important consideration as turning points may differ across policy areas

‘Horizontal’ coordination between Member States will help them to avoid or manage cross-border economic spillover effects, to benefit from shared learning and to leverage relationships with the outside world Moreover, within the euro area, close coordination will ensure that Member States’ growth trajectories do not diverge as the economy recovers Addressing the underlying causes of diverging competitiveness must be an integral part of any exit strategy The exit strategy should also ensure that Europe maintains its place at the frontier of the low-carbon revolution by investing in renewable energies, low carbon technologies and "green" infrastructure The aim of this study is to provide the analytical underpinning of such a coordinated exit strategy

Marco Buti Director-General, DG Economic and Financial Affairs, European Commission

ABBREVIATIONS AND SYMBOLS USED

Member States

IT Italy

SI Slovenia

Currencies

iv

v

Other abbreviations

ACKNOWLEDGEMENTS

This special edition of the EU Economy: 2009 Review "Economic Crisis in Europe: Causes, Consequences and Responses" was prepared under the responsibility of Marco Buti, Director-General for Economic and Financial Affairs, and István P Székely, Director for Economic Studies and Research Paul van den Noord, Adviser in the Directorate for Economic Studies and Research, served as the global editor of the report

The report has drawn on substantive contributions by Ronald Albers, Alfonso Arpaia, Uwe Böwer, Declan Costello, Jan in 't Veld, Lars Jonung, Gabor Koltay, Willem Kooi, Gert-Jan Koopman,

Moisés Orellana Peña, Dario Paternoster, Lucio Pench, Stéphanie Riso, Werner Röger, Eric Ruscher, Alessandra Tucci, Alessandro Turrini, Lukas Vogel and Guntram Wolff

The report benefited from extensive comments by John Berrigan, Daniel Daco, Oliver Dieckmann, Reinhard Felke, Vitor Gaspar, Lars Jonung, Sven Langedijk, Mary McCarthy, Matthias Mors, André Sapir, Massimo Suardi, István P Székely, Alessandro Turrini, Michael Thiel and David Vergara Statistical assistance was provided by Adam Kowalski, Daniela Porubska and Christopher Smyth Adam Kowalski and Greta Haems were responsible for the lay-out of the report

Comments on the report would be gratefully received and should be sent, by mail or e-mail, to:

Paul van den Noord

European Commission

Directorate-General for Economic and Financial Affairs

Directorate for Economic Studies and Research

Office BU-1 05-189

B-1049 Brussels

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CONTENTS

2 The crisis from a historical perspective 14

1 Impact on actual and potential growth 24

2 Impact on labour market and employment 35

3 Impact on budgetary positions 41

1 A primer on financial crisis policies 56

2 Crisis control and mitigation 62

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2.1 Introduction 62

3 Crisis resolution and prevention 78

References 87

LIST OF TABLES

LIST OF GRAPHS

viii

II.1.8 Potential growth 2007-2013, euro outs 31

LIST OF BOXES

ix