From a vicious to a virtuous circle in the Eurozone - the time is ripe

Marco Buti, Pier Carlo Padoan

27 March 2012



The economic and financial crisis in the Eurozone is in its fourth year. In late 2011, it had evolved dangerously into a vicious circle of sluggish growth, tensions in sovereign debt markets and banking sector fragility. Investor confidence in the Eurozone seemed on the verge of collapse, many sovereigns and banks struggled to access market funding and the future of the Eurozone was widely questioned in financial markets and the policy debate.

Need to focus on a strategic response to the crisis

While tensions have eased recently, the Eurozone is still in a situation in which multiple equilibria can materialise. In a vicious circle, confidence falls and financial market conditions deteriorate, jeopardising debt sustainability, more so in an environment of low growth. A bad equilibrium can establish itself (Padoan et al. 2012). To move from a vicious to a virtuous circle requires time, while markets tend to be impatient. By providing a confidence bridge, decisive and credible policy action can turn the economy around and bring it towards a good equilibrium of debt sustainability and sustainable growth. Securing a good equilibrium for the Eurozone is possible. Developments since the beginning of this year have surprised on the upside. The ECB’s provision of longer-term bank funding has had a powerful effect in boosting confidence. The fear of an imminent bank failure and the risk of a credit crunch have receded. Despite the downturn towards the end of 2011, there are signs of stabilisation and an increasingly likely recovery in the second half of 2012. Sovereign debt markets have improved, as reflected in successful bond auctions and declining yields.

These favourable trends cannot be a cause for relaxing Europe's efforts, but offer the opportunity to focus on a more strategic response. It is essential that this opportunity is not squandered. Further measures are required to address unfinished business and avoid the establishment of a bad equilibrium. In the near term, contagion must be blocked and reverted. This would create space for strengthening the banking system without engendering a credit crunch – implementing structural reforms to strengthen growth and to address competitiveness problems, fiscal consolidation to restore the sustainability of public finances, adequate firewalls to prevent contagion, and Eurozone governance reforms so as to prevent future crises. These policies need to be implemented as a coherent package – because of the systemic nature of the problem a partial solution is bound to be not effective and to lack credibility.

A five-point strategy to ensure a good equilibrium

A strategic response that will bring the Eurozone towards a good equilibrium is based on five mutually reinforcing points (European Commission 2011)1:

  • Undertake credible economic adjustment in vulnerable member states.
  • Establish an adequate firewall against contagion in sovereign-debt markets.
  • Ensure that EU banks are sufficiently capitalised.
  • Reform the framework for economic governance in the Eurozone.
  • Implement policies to boost growth and address imbalances.

Substantial progress is being made on all five elements, with a decisive breakthrough achieved in the past three months. However, the pace of implementation is not uniform and failure to make sufficient progress on any single element – possibly motivated by complacency over recent developments - would undermine the overall strategy. The possibility of falling back towards a bad equilibrium is still uncomfortably high and requires strong determination at the national level and high vigilance by EU institutions.

Weak economic growth remains the key challenge

Of the five components of the strategy, in this column we concentrate on the need to boost growth. The unsatisfactory growth performance of, and imbalances in, the Eurozone over the past decade originated in poor structural settings that discouraged productive investments in some sectors, contributed to the instability of the housing market, and failed to keep wage and price developments in line with productivity. A credible and ambitious strategy of structural reforms that can address these weaknesses would have a tangible impact on economic growth and debt sustainability, in particular in vulnerable countries.

Often the fruits of reform efforts are visible only over the medium term. However, a credible reform package can also generate positive effects in the short term in terms of confidence and performance, while short-term costs can be vastly overstated (OECD 2012).

Economic growth in the Eurozone remains subdued at best. The potential growth rate of the Eurozone is estimated to be around 1.25%, with markedly lower rates in some of the countries facing intense market pressure. Stronger growth would restore confidence, improve debt dynamics and facilitate an exit from the crisis, particularly in countries with high accumulated debts.

Growth-enhancing policies must go hand in hand with appropriately paced fiscal consolidation. There are obvious reasons for this:

  • The extraordinary pre-crisis build-up of debt to largely unsustainable levels has left most Eurozone economies with the task of redressing imbalances and embarking on an unavoidable deleveraging. High debt permanently weakens economic growth.
  • Risk aversion and, with it, risk premia, have spiked since the financial crisis in 2008 and ended a long period of high risk appetite and compressed premia. Current heightened risk aversion makes deleveraging even more necessary and, at the same time, more painful in the short term.
  • Low interest rates and the excessive lending and borrowing prior to the crisis had not only led to growing debt levels, but also to an allocation of resources that has proven unsustainable and that must be corrected.
  • In a situation of multiple equilibria, where confidence plays a crucial role, the distinction between short-term and long-term measures (suggesting the possibility of postponing action) is misleading and could be possibly dangerous. Short-term measures that weaken confidence would push the medium-term dynamics towards a bad equilibrium (Padoan et al. 2012).

This legacy defines and limits the role of active demand management and calls for sound fiscal policies. Clearly, the scope, pace and approach to fiscal consolidation should not be uniform across member states but, rather, reflect the specific features of each country, its fiscal position and the strength of its economic conditions. In all cases, fiscal adjustment should be growth-friendly.

The reinforced governance framework of the Eurozone will help member states stay on track towards these goals. Experience shows that fiscal discipline is especially at risk in countries where policies are more short-sighted, possibly driven by the electoral cycle. In such a setting, a strong external anchor, as provided by the recently reinforced fiscal governance rules in the Eurozone, can help keeping up necessary reforms (Buti et al. 2009). Available evidence points, remarkably, to the fact that structural reform efforts during the current crisis appear positively correlated with fiscal consolidation efforts. Moreover, reforms are taking place in countries which most require a boost in growth potential and adjustment within the Eurozone (OECD 2012).


Buti, M., and Padoan, P.C. (2012), "From a Vicious to a Virtuous Cycle: A Five-Points Strategy for the Eurozone", CEPR Policy Insight No. 61..
Buti, M., Röger, W., Turrini, A. (2009), "Is Lisbon Far From Maastricht? Trade-offs and Complementarities between Fiscal Discipline and Structural Reforms", CESifo Economic Studies 55(1).
European Commission (2011), "A roadmap to stability and growth", COM(2011) 669 final, 12 October.
European Council (2011), Euro summit statement, 26 October 2011,
OECD (2012), Going for Growth, Paris.
Padoan, P. C., Sila, U., van den Noord, P. (2012), A Dual Equilibrium Model for Public Debt and Growth, forthcoming.

1 Leaders of Eurozone States have committed to these last October (European Council 2011).



Topics:  Macroeconomic policy

Tags:  eurozone, growth, fiscal consolidation

Director General, DG Economic and Financial Affairs, European Commission

OECD Deputy Secretary-General and Chief Economist