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There’s a paper published from the OECD which tries to calculate the sensitivity of government accounts to changes in the output gap using regression analysis, in order to determine the ability of Euro countries to adhere to the Maastricht 3% deficit rule. The authors include a table containing coefficients for the main Eurozone countries:

Using OECD output gap estimates for the period between 2005 – 2013 i will use the above coefficients to make a rough analysis of Euro periphery fiscal stance during the expansion of 2005 – 2007, the fiscal stimulus response in the depths of the Great Recession as well as deficit and debt dynamics for the immediate future:

What is immediately clear from the above table is the depth of defficient demand (evident by output gaps) in recent years. Output gaps have quickly reached double digits, pushing the corresponding economies into severe recessions (or depressions as is the case of Greece). Calculating the difference between the actual primary surplus (deficit) and the one projected based on OECD coefficients (assuming that zero output gap corresponds to a zero primary deficit) can help in drawing some basic conclusions about each country:

  • In Greece, fiscal policy was quite expansionary during the boom years but ever since 2010 the output gap has grown so large that real stimulus is required. Unfortunately, although fiscal deficits are quite impressive, they are mainly used to pay interest on government debt, while actual primary deficits are recessionary.
  • Ireland had a balanced fiscal stance but quickly reversed course to very large primary deficits as a result of the house market meltdown and the national banking sector capital needs.
  • Italy has actually been highly restrictive during the whole period, with the government sector most probably contributing to slow growth and the current recession.
  • Portugal seems like a Greek replica.
  • Spain had the most restrictive policy of all periphery countries during 2005 – 2007 (a total of 8,5% of GDP) with a completely opposite course since 2008.

One can now look at debt interest payments (based on ECB data) for the above countries and try to project fiscal deficits for 2012 and 2013 using the OECD coefficients to calculate primary surplus (deficit). In the table below, interest payments of 2011 have been kept the same for 2012/2013 (so this is an unrealistic, optimistic scenario), 2% for Ireland (no recent data is available) and lowered to 4% for Greece:

It is quite evident that, even with this very rough estimate, the projected fiscal deficits for 2012 and 2013 are considerable. Given the current GDP growth projections and low inflation environment (apart from Italy probably), debt sustainability is questionable, due to a clear inability to achieve primary surpluses without pushing the economy into recession (IMF projections for Greek primary supluses of 4% are more of a dream than realistic goals). Based on the current yield curve for both Italy and Spain and the interest burden which that creates (Italy will probably face interest payments larger than 5% of GDP, while Spanish average interest rate on its debt is already over 4%) one could probably already argue in favor of a restructuring in terms of NPV with a significant reduction in interest rate paid.

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Kostas Kalevras

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