CHAPTER 7
Figure 7.18: Markets have learned to look at fiscal vulnerabilities (five-year credit default swap spreads and public debt, mid2008 and August 2011)
Note: Dark blue dots represent EU15 countries, and light blue EU12 economies. Source: Eurostat; and Bloomberg.
Lithuania, Romania, and the Slovak Republic in the 2000s. These reforms moderated the impact of population aging on public finances. But eastern partnership countries lag their European peers in these reforms. In addition, they also expanded social transfers faster than increases in the dependency ratio, as they appear to have responded to the expectations of people to meet the social standards of Western Europe. Naturally, Western European countries can be more generous; they can mobilize resources for social programs more easily, possibly with smaller disincentive effects on work.
Getting the fiscal house in order With the economic recovery losing steam three years after the Lehman crisis broke, governments in Europe would like to focus on creating jobs and generating growth. Instead, they are confronted with a public debt crisis. In many countries, putting the fiscal house in order has become the main preoccupation of policymakers for five reasons: the size of government, fiscal deficits, and public debt have risen due to the economic crisis, boosting the scale of the fiscal challenge; learning from the crisis, financial markets have turned their attention to potential fiscal vulnerabilities; the postcrisis growth prospects look uncertain, making fiscal adjustment more difficult; population aging will accelerate in the coming decades; and restoring the ability of fiscal policy to respond will help prepare for future crises.
A bigger fiscal challenge Even without the crisis, governments in Europe already had large public sectors. During the crisis, government expenditures increased even further. In 2010, expenditures reached more than 50 percent of GDP in Western Europe and 42 percent of GDP in Eastern Europe, the highest in a decade and a half. The crisis also led to an unprecedented peacetime deterioration in fiscal balances as the revenue base collapsed, GDP contracted, and government spending rose to stabilize the economy and mitigate social impacts. The median general government deficit jumped from 0.5 percent of GDP in 2008 to 4.7 percent in 2010 for Western Europe and from 2 percent to 4.2 percent in Eastern Europe (figure 7.17).
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