Hochschule Rhein-Waal

Rhine Waal University of Applied Sciences

Faculty of Society and Economics

Term Paper
WS 14/15
Module APPLIED RESEARCH PROJECT

Dr. Oliver Serfling

Topic: 05

Effect of Debt Crises and Fiscal Sustainability on the Euro Zones Economy

by

Olakunle Solebo 16308

Farhana Kaniz 16363

Ami Matsutani 17881

Abu Sayed MD Sayem 16341

Submission Date: 27.02.2015

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Abstract

The recent debt crises of 2007/2008 made it imperative to revisit the concept of Fiscal
Sustainability as well as to examine the various element of fiscal sustainability from Debt to
GDP ratio to inflation, unemployment and the current issues of increasing ageing population
especially in the Euro zone areas. Many notable writers and keen observers of the world financial
crises have agreed that the crises evolved in America. Some blamed the crises on the
accumulated debt USA used to finance its budget deficit and the issue of housing boom which
eventually became a bubble that burst. The experience of the crises in the Euro zone is
enormous, from the challenges of rising debt to GDP, Balance of payment, Government Bond
value depreciation, to employment, inflation and the issues of aging population., A detailed
literature review is carried out in this research with particular reference to Portugal, Ireland,
Italy, Greece, Spain and other relevant European countries involved. We examine the various
economics strategies in place and more so review the effect of these strategies in the affected
countries as well as the Euro zone as a whole. This research work made unique and interesting
findings which show the great effect of aging population on the fiscal sustainability of a
government as well as the impact of unemployment and inflation in the Eurozone economy.

Keywords: fiscal sustainability, debt to GDP, balance of payment.

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Acknowledgement

We would like to express our profound appreciation and thanks to Professor Dr. Gernot Muller
and Dr. Oliver Serfling for their precious time, suggestions and comments during the process of
this research work. Their advice really gives us the required motivation as we got varieties of
idea and directions needed to deal with this topic. Special thanks also go to the entire members of
the group Olakunle Solebo, Fahrana Kaniz, Ami Matsutani and Abu Sayed MD Sayem for their
individual and collective contribution to the work. The contribution of the group members are
given below:

1. Introduction (16308, 16341, 16363, 17881)

2. Literature Review (16308, 16341, 16363, 17881)
3. Conceptual Frame work (16308, 16341, 16363, 17881)
4. Research Design and Methodology (16308, 16363, 17881)
5. Data Analyses, Findings and Conclusion (16308, 16363)
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Declaration of Authenticity

We, (Solebo, Olakunle T (16308), Farhana Kaniz (16363), Ami Matsutani (17881) and Abu
Sayed MD Sayem (16341) hereby declare that the work presented herein is our own work
completed without the use of any aids other than those listed. Any material from other sources or
works done by others has been given due acknowledgement and listed in the reference section.
Sentences or parts of sentences quoted literally are marked as quotations; identification of other
references with regard to the statement and scope of the work is quoted. The work presented
herein has not been published or submitted elsewhere for assessment in the same or a similar
form. We will retain a copy of this assignment until after the Board of Examiners has published
the results, which we will make available on request.
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TABLE OF CONTENTS

1 Introduction 1
1.1 Research Problem 2
1.2 Objectives of the study 2
1.3 Method of Data Analyses 3
2 Literature Review 4
2.1 Concept of Public Debt. 4
2.2 Brief history of Debt crises 4
2.3 Origin of the recent Financial Crises 6
2.4 Financial Crises in Europe 6
2.5 Fiscal Sustainability 7
2.6 Challenges of Fiscal Sustainability in Europe 7
2.6.1 Debt to GDP 8
2.6.2 Debt Security Risks 9
2.6.3 Ageing Population 10
2.6.4 Balance of payment imbalance (BOP) 11
2.6.5 Unemployment 12
2.6.6 Inflation 15
2.7 Sustainability strategies in the Euro Zone 17
2.7.1 Bail-out 17
2.7.2 Austerity Measure 21
3 Conceptual Frame work 25
3.1 Fiscal Sustainability Indicators 25
4 Research Design and Methodology 30
4.1 Econometric Model 30
4.2 Econometric Model 30
4.3 Sources of Data 31
4.4 Test of hypothesis 31

5 Data Analyses, Findings and Conclusion 32

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5.1 Data Analyses and findings 32

5.2 Regression for individual countries 34

5.3 Multicolinearity Test 44

5.4 Conclusion 45

References 47
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List of Figures
Figure 1: Debt to GDP Ratio of some Eurozone countries.. 09

Figure 2: Bail out against actual debt.......................... 21

List of Tables
Table 1 Bailout beneficiaries from 2010 to2012 19
Table 2: Model Summary and ANOVA (EU 18) . 33
Table 3: Model Summary (France) ... 34
Table 4: Coefficients (France) ... 35
Table 5: Model Summary and ANOVA (Germany) .. 36
Table 6: Coefficients (Germany) 37
Table 7: Model Summary and ANOVA (Greece) .. 37
Table 8: Coefficients (Greece) 38
Table 9: Model Summary and ANOVA (Italy) . 38
Table 10: Coefficient (Italy) .. 39
Table 11: Model Summary and ANOVA (Portugal) . 40
Table 12: Coefficients (Portugal) .. 40
Table 13: Model Summary and ANOVA (Spain) . 41
Table 14: Coefficients (Spain) .. 42
Table 15: Model Summary and ANOVA (Ireland) 43
Table 16: Coefficients (Ireland) . 43
Table 17: Multicollinearity Diagnostics 44
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List of Abbreviations

BLUE Best Linear Unbiased Estimator

BOP Balance Of Payment
ECB European Central Bank
EEC The European Economic Community
EMU Economic Monetary Union
EU European Union
FIRREA Financial Institutions Reform, Recovery, and Enforcement Act
GDP Gross Domestic Product
IIP International Investment Position
ILO International Labor Organization
IMF International Monetary Fund
LCH Life Cycle Hypothesis
MOU Memoranda of Understanding
OECD Organization for Economic Corporation and Development
OLS Ordinary Least Square
PIIGS Portugal, Ireland, Italy, Greece, and Spain
PPP Purchasing Power Parity
R&D Research and development
VAT Value Added Tax
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1 Introduction

Financial sustainability and the debt crises is a great national and international issue which has a
particular importance in public decision making. Bank of England in October 2011 referred to the
European debt crises of 2008/2009 as the most serious financial crisis at least since the 1930s.
Cukurcayir and Tezcan(2013). Observed that Macro-economic indicators such as Balance of
payment deficit, decline in rate of development, falling GDP and rising debt to GDP ratio,
reduced value of import and export, low rate of investments and increase in rate of unemployment
has been experienced since the beginning of the recession, especially by worst hit countries in the
Euro zone.

Sher and Iyanatul (2010) explained that the Global financial crisis of 2007/2008s effect on the
economic fortunes of important world economy including the European Union and Japan. They
revealed that this Crisis came largely as a shock to many policy makers, multinational agencies,
academics and investors. Nobody could have expected the global downturn. Thus, Glenn Stevens
(2008), Governor of the Reserve Bank of Australia noted that no one predicted the last financial
crises.

It has therefore become imperative to examine the emergence of this crisis in the Euro zone as
well as the impact of fiscal sustainability on macroeconomic variables such as unemployment,
inflation and the menace of ageing population in Europe. A detailed literature review is carried
out in this research with particular reference to Portugal, Ireland, Italy, Greece, Spain and other
relevant European countries involved. We also look at the role of Germany, France and the
economic unions in the crises and examine the various economics strategies in place and more so
review the effect of these strategies in the affected countries as well as the Euro zone as a whole.

Findings and conclussion is not only based on the review of literature but on a critical analyses of
the relevant data using a Multiple Regression Model as explained by Chris Brooks (2008). This
is because of the multiple natures of our variables.In computing the parameters we use the
Ordinary Least Square (OLS) approach.

This research study will be very significant to various governments, agencies and other policy
makers of countries. It will also be beneficial to scholars of economics and political science as
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reference to further research on issues of fiscal policy, unemployment as well as ageing

population problem.

1.1 Research Problem

Euro stat Jan. (2014) revealed the third quarter of 2013s government debt to GDP revealed that
the highest ratios of government debt to GDP within the European Union were recorded in Greece
(171.8%), Italy (132.9%), Portugal (128.7%) and Ireland (124.8%).Decline in the economic
performance of countries especially of the Euro Area in recent years has become more apparent
along with the financial crisis which also increased the concern about the future of the Economic
and Monetary Union.

According to the European commission report of 2013, Many EU Member States have
measures to maintain the level of public funding for health, but increasing unemployment and a
resultant decreasing revenue from payroll taxes made it difficult to meet expenditure
commitment.

Deterioration was experienced in employment and a risk of permanent job losses as a result of
weak economic activity. Unemployment increased to 11.4% in the euro area in 2012, it further
increased increase in 2013 to 12% in the euro area with the hope of stabilizing in 2014.

ECB report of 2009 identified that Populations are ageing rapidly in nearly all EU Member
States, due to increasing life expectancy. Population ageing poses important challenges for
policymakers in the coming decades. Increasing outlays for pension, health and elderly care
systems will weigh on government budgets while economic growth is projected to decline due to
the gradually decreasing population of working youth.

1.2 Objective of the study

The main objective of this study is to review the challenges of financial crises and the various
economics strategies that have been adopted to ensure fiscal sustainability, improve employment,
and manage the challenges of ageing population in the Euro zone area and more so, to examine
the effectiveness of strategies such as austerity measure, bail out and inflation control in the
countries where they have been applied. This is necessary to verify if the strategies will guarantee
long term financial sustainability of the euro zones economy.
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Therefore, we examined the level of unemployment and resultant effect on revenue from payroll
taxes and its effect of the general level of government spending in the Euro zone area.

We also do a critical analysis of the challenges of ageing populations in EU Member States and
the effect of the ageing population on the fiscal sustainability of the countries.

1.3 Methods of data analyses

In order to establish a cause and effect relationship, we used a Multiple Regression Model to
analyzing the available data. This is because of the multiple natures of our explanatory variables.
Variables x2it, x2it and x3it are a set of k 1 explanatory variables which are thought to influence
y, and the coefficient estimates 1 and 2 are the parameters which quantify the effect of each of
these explanatory variables on y. Chris Brooks (2008).

1.4 Test of Multicolinearity

To have BLUE properties and avoid a wrong decision making; we conducted a test of
Multicolinearity for a Possible Multicolinearity search such as, Near Multicolinearity or very high
Multicollinearity or Perfect Multicollinearity. This was done to identify if a clear relationship
exist between the variables, if for instance variable x1 = x2 = x3 with high coefficients of u where
change in x variables leads to large changes in coefficients; at end we discovered that there was
no Multicolinearity.

Chris Brooks (2008) and Professor Muller Econometric Lecture slides presentation (Part4 slide
14)
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2 Literature Review
2.1 Concept of Public Debt

Government debt can be viewed from two major dimensions either from a gross or net debt
perspective. Jean-Claude et al. (1986) Gross debt: Public debt of a government can be referred to
as gross debt of that country. That is, the total financial liabilities of the government considering
government assets, which includes funds borrowed by government from other countries in order
to create risk asset to individuals and other institutions for the purpose of national development. It
also includes accumulated funds from public pension plan and social insurance schemes which
represent buffers for year-to-year fluctuations of premiums and expenditures for unemployment
or medical insurance schemes.

Net debt: Government debt can also refer to the net debt of a government, identified as the gross
financial liabilities less the financial assets of that country. This reflects the cumulative total of
past budget deficits, which represent the net borrowing by government in each period.

According to the United States Treasury Department, the national debts is described as:
...the accumulated debt the government owes from... years of borrowing... money owed to
individuals, corporations, state or local governments, foreign governments, and other entities
outside the United States Government.(Joan Reinbold)

American Economic Review101 (August 2011), revealed that External debt crises involve as a
result of outright default on payment of debt obligations incurred under foreign legal jurisdiction,
including nonpayment, reputation, or the restructuring of debt into terms less favorable to the
lender than in the original contract.
From the various definitions of public debt earlier highlighted, it is obvious that the concept of
public debt does not only relate to Cross country loans, it also includes debt to individuals,
corporations, state or local government. This is in form of pension, bonds and social security
scheme and other entities.

2.2 Brief History of Debt Crises

Carmen Reinhart and Kenneth Rogoff (2008) counted 250 government debt defaults from 1800s
to mid -2000s, As it is obvious now that the history of government debt is characterized by
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default as noted by Winkler in his The history of government loans is really a history of
government defaults. The fourth era of debt begins in the Great Depression of the 1930s which
further extended through the early 1950s, when about half of all countries were in default. The
most recent default crises cycle is a follow up of the emerging market debt crises of the 1980s and
1990s.

European sovereign debt crisis of the 1920s destabilized the finances and political system of that
time before ending in the usual defaults. David Lloyd George, the former British prime minister
blamed it on the prolonged and intense World War II. The destructive scale which was never
previously conceived possible had left belligerent nations deeply impoverished with immense
burden of debt. After the War, no asset was left for the service of the nations debt. Lloyd
George observed the lessons in war finance and suggested that lenders should not lend to the
likely losing side in war. But even the winners of 1918, the governments of France and Britain,
had massive debts they could not pay.

There was a Treaty of Versailles which was that Germany would be forced to pay reparations so
that France would be able to pay its debt to Britain and United States, therefore Britain could also
pay its debt to United States. The problem was that Germany could not pay the reparation debt as
decreed by the treaty; therefore no one could pay off their debt. This was the famous economic
consequence of the peace as predicted by J.M Keynes. But there were also political
consequences, since government cannot perpetually remain in power especially when broke. A
new government may take over and refuse to pay the obligations of previous regimes, as in the
case of Germany in 1934 and Russia in 1917.

In the 1980s governments of countries continues to default on their debt, now the US banking
system suffered enormous economic losses. Citibank had been a leader in availing big loans to
these borrowers, and other competing banks had joined in. adopting various strategies to entice
investors and governments to obtain one loan or the other at that time. Alex J. Pollock (2012)
recalled that loans were at that time widely patronized and was so-called Petrodollar-recycling
until the dramatic era of defaults began. The former chairman of Citibank Walter Wriston, was
mocked by critics for having pronounced a provocative statement at that time saying that
Countries dont go bankrupt. this was an ignorant statement going by the financial experience
like the 1929 predictions of a permanently high stock prices and the most recent perception that
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house prices would never fall. Recent economists, financial actors, and economic regulators
carelessly talked of the risk-free debt of governments bonds and the risk-free interest rate.

2.3 Origin of the Recent Debt Crises

Many notable writers and keen observers of the world financial crises of 2007/2008 agreed that
the crises evolved in America. Some blamed the crises of the United States on the accumulated
debt crisis of between 2001 and 2007. Chinn and Frieden (2009) noted that America had
borrowed trillions of dollars from abroad which was used to finance its budget deficit. While
some spending went for physical commodities, such as including imports, most of the expenditure
was for local goods and services, like financial services and real estate. The result was a large and
unsustainable economic expansion which drove up the relative price of goods and services not
involved in foreign trade. Examples are in domestic consumptions such as haircuts, taxi rides, and
most housing. The key non-tradable good was housing; that boom eventually became a bubble.
And, when that bubble burst, assessments of assets and liabilities across the board became
unbalanced.

(Cukurcayi and Tezcan, (2013) and others believe that the crisis actually erupted following the
US government failure to bailout Lehman Brothers which is the fourth largest investment bank in
the United States from bankruptcy in 2008. This immediately affected the US economy which
quickly spread to the entire world and since become a global financial and real sector crisis.

2.4 Financial Crises in Europe

Global financial crisis has influenced many Countries of the world, and caused various economic,
political and social problems among the European Union countries especially in Portugal, Italy,
Ireland, Greece, and Spain (PIIGS) including Cyprus. The decline in the financial Performance of
the Euro Area countries in recent years has become more disturbing along with the economic
crisis; this situation increased the anxiety about the future of the Economic and Monetary Union.
Public debt for the aggregate euro area did not appear to be a looming problem in the mid-2000s.
During the previous decade, the euro area and the United States shared broadly similar debt
dynamics. Though, the fiscal crisis so far has been most severe in Portugal, Ireland, Italy Greece
and Spain. The boarding of these crises has been on other European members like Germany and
France who were the main rescue team in the Euro Zone crises.
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2.5 Fiscal Sustainability

There is no consensus among economists on a precise operational definition for fiscal

sustainability. Rather different studies use their own, often similar definitions. According to
European Central Bank, fiscal sustainability is defined as a governments capacity to service its
debt obligations in the long term. A government that has debt outstanding has to run primary
surpluses in the future, and these have to be large enough to accommodate the cost of servicing
the governments (current and future) debt obligations. In other words, fiscal sustainability
requires a government to be solvent, i.e. it has to be able to repay its debt at some point in the
future. ECB monthly bulletin (April 2011)

According to European commission report (2012) Fiscal policy is not sustainable if it implies
an excessive accumulation of government debt over time and ever increasing debt service.
Sustainability means avoiding an excessive increase in government liabilities a burden on future
generations while ensuring that the government is able to deliver the necessary public services,
including the necessary safety net during of hardship, and to adjust the policies in response to new
challenges. Limits to sustainability differ across countries and over time. The capacity to run high
debts depends on the degree of development of financial markets, perceived risks, and trust in the
capacity of a government to implement structural reforms and consolidate government deficits. It
also depends on the degree of global risk aversion and the attractiveness of investments
alternative to government bonds. However, countries with high debt ratios as well as large
external imbalances or contingent liabilities are particularly exposed to market turbulences, such
as changes in interest rates during times of large changes in economic prospects.

2.6 Challenges of Fiscal Sustainability in Europe

European Commission Report (2012) revealed that there is a specific requirements of the EU
fiscal framework enshrined in the treaty on the functioning of the EU; The idea that government
debt shall not exceed 60% of GDP which has not been given due attention. Specific attention need
to be paid to the current level of debt in the EU countries. For this reason, several different
indicators are used to assess risks to the sustainability of the public finances. Issue of issuing debt
securities to finance the economic deficit, unemployment, BOP, ageing population and inflation
are some of the issues which kept coming up during this crises period.
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2.6.1 Debt to GDP Ratio

GDP data is a veritable tool in evaluating the performance of an economy including the
determination of its fiscal sustainability by measuring the ratio of debt relative to the GDP of that
country. Tim Callen (2008), It has become widely used as a reference point to determine the
health of national and global economic performance.GDP is referred to as the income earned by
factors of production in the country within a specific time period. In order words, it measures the
monetary value of all finished goods and services produced in a country within the defined period
of time. The calculation of GDP is usually done on quarterly or annual basis. It includes both
private and public consumption in the country within the defined period of time.

Keynesian model: GDP = C + I + G + (NX)

Debt to GDP ratio is therefore the ration of a country's national debt to its gross domestic
product (GDP) (Investopedia).. By comparing what a country owes to what itsfactor of production
produces, the debt to GDP ratio is an indicator of a country's ability to pay back its debt. This
ability is often expressed as a percentage; the ratio can also be interpreted as the number of years
needed by a country to pay back its debt if GDP is dedicated entirely to debt repayment
(Investopedia).

Debt to GDP ratio = Total annual debt / total annual GDP x 100

A common starting point for the assessment of sustainability risks in the Euro zone is to examine
a countrys (explicit) gross debt-to-GDP ratio because high and rising government debt ratios
indicate potential sustainability problems

Figure.1 below shows the Debt to GDP ratio from 2002 to 2013. Which show a rising figure for
the most affected countries in the euro zone with Greece at the peak of the crises?
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Figure 1 Debt to GDP Ratio of some EU countries

200
Greece
180
160 Portugal
140 Ireland
120 Cyprus
100
Belgium
80
60 Italy
40 Spain
20 Germany
0
France
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Eurostat 19:05:2014

From the above figure, there a general rise in the Debt to GDP ratio of the EU countries. There is
a specific requirements of the EU fiscal framework enshrined in the Treaty on the functioning of
the EU, one of which is that government debt shall not exceed 60% of GDP which has not been
given due attention. European Commission Report (2012).

2.6.2 Debt Security Risk

While debt has positive implications for growth up to a certain degree, as it helps investors to
finance growth via taking up loans or issuing debt securities, it becomes harmful for growth when
it becomes too high. The financial crisis, which started in mid-2007 and intensified in September
2008, brought about a rethink of what constitutes a sustainable level of debt, as well as a
rediscovery of credit risks. ECB monthly bulletin Feb (2012)

Andritzky (2012) observed there has been a growing concern of public insolvency since the debt
crises resulted in stress in the European banking sector loaded with Euro-area debt. Gennaioli et.
al. (2014) particularly banks in the countries where the crises has been severe have entered the
crisis with a large share of their assets in their government bonds. With 5 percent bond holding in
Portugal, Spain 7 percent in Italy and 16 percent in Greece as reported by the EU Stress Test, of
2010. As sovereign spreads rose, these banks greatly expanded their exposure to the bonds of
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their distressed governments, leading to even greater challenges. It was then obvious that
Europes troubled banks and their broke governments are in a dangerous situation

Maturity structure of the outstanding stock of government debt securities constitutes an important
factor to be considered when assessing short-run fiscal risks. Indeed, higher shares of outstanding
short-term government debt may raise refinancing risks. All other things being equal, the
government will need to roll over more maturing debt in the short run. Hence, the interest paid on
the debt would be more sensitive to changes in current market interest rates and refinancing
conditions would be more affected by deteriorations in the liquidity of sovereign bond markets.
Countries may also become more vulnerable when a significant share of government debt is held
by non-residents of the country concerned. These may be more sensitive to negative economic
developments because they generally receive information later or have less precise information
than residents.

2.6.3 Ageing Population

According to European commission Ageing Report 2012 population ageing is expected to have
a significant impact on growth and to lead to significant pressures to increase public spending. It
will be challenging for European Member States to maintain sound and sustainable public
finances in the medium and long term. Ensuring fiscal sustainability requires time-consistent
policies, which involves addressing budgetary imbalances before the budgetary impact of ageing
sets in. The cost of ageing, which is the other key element of the sustainability indicators, covers a
longer time horizon and its impact comes from the projected changes in age-related expenditure,
such as pension, health care, long-term care, education and unemployment benefits. The fiscal
costs of the crisis and of projected demographic development compound each other and make
fiscal sustainability a significant challenge. In the coming decades, Europe's population will
undergo dramatic demographic changes due to low fertility rates, increases in life expectancy and
the retirement of the baby-boom generation.

Kelley and Schmidt (2001) and Bloom et. al. (2001) reported the relationship between aging
and economic growth and found statistically significant positive relationship that per capital GDP
growth is positively associated with the share of working-age population and negatively with that
of the youth and the elderly. They concluded that Ageing weakens the growth potential of the
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economy due to smaller labor force on the supply side and lower investment demand in the
economy on the demand side due to slow-down of the market growth.

Koskela and Viren, (1992) and David (1999), also found a positive statistical relationship
between aging and per capita GDP growth which is the impact of aging on savings. People have
stable income during their working-age while they have no labor income after retired. As per the
life cycle hypothesis (LCH), individual behavior as an attempt to smooth out consumption
patterns over ones lifetime of current levels of income. This model defines that if the working
age population increases savings increase which accelerates capital accumulation and leads to a
higher growth. On the other hand, if elderly people increase which lead to a fall in savings and
therefore economic growth slows down. On the basis of this adverse relation in aging and its
impact in savings, a lot of econometric studies using cross-sectional data of OECD countries find
statistically significant correlation between savings rate and aging.

Castro et al. (2013), suggests that the impact of population can be significant, depending on the
level and pace of the aging dynamics, the existing rules for social benefit and the policy response.
They include a stylish pension system in an open economy New-Keynesian general equilibrium
model with non-Ricardian agents. The result deduced that supranational policy coordination at
euro area level is crucial to foster economy and financial stability.

2.6.4 Balance of payment imbalance (BOP)

Investopedia defines BOP as a statement that summarizes an economys transactions with the
rest of the world for a specified time period. The balance of payments, also referred to as balance
of international payments, includes all transactions between a countrys residents and its
nonresidents. This involves goods, services and income; financial claims on and liabilities to the
rest of the world; and transfers such as gifts. Balance of payments account can be classifies in to
two accounts, the current account and the capital account. Current account encompasses all the
goods and services transactions, investment income and current transfers, while the capital
accounts refer to transactions in financial instruments usually in the financial market. An
economys balance of payments transactions and international investment position (IIP) together
constitute its set of international accounts. (Investopedia)
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According to David Guerreiro (2013), a country which belong to a monetary union usually faces
external disequilibrium against its main partner, this is because corresponding interest rate
differential increases. Moreover, the persistence of these imbalances may trigger a balance of
payments crisis as experienced by Greece, Ireland and Portugal. Before the euro crisis of
2007/2008 EU officials tended to ignore the imbalance of current accounts among EMU member
countries with the perception that BOP figures were not relevant. As long as financial markets
were buoyant and credit was easily accessible at low cost for borrowers, the flaw in this argument
was not laid bare. This changed abruptly when the appetite for credit risk markets plunged in the
course of the financial crisis and EMU member countries with high debt and a bleak economic
outlook experienced a sudden shuck of capital inflows and even net capital outflows.

Guerreiro and Mignon (2011) and Guerreiro et al. (2012), made a critical analyses of how to
identify external imbalance and linking them to differentials of interest rates. They consider
purchasing power parity (PPP) theory developed by Cassel (1922) being a fair concept to identify
external imbalances.

PPP concept shows that there are some restoring forces driving the nominal exchange rate
between two countries to a ratio that ensures the balancing of their real exchange rate equation.
The ratio allows the same purchasing power of the two currencies when these last are converted
into the same measure unit.

Absolute form of PPP: Et pt pt *

Where

Et = log of the spot exchange rate,

pt = log of the domestic
pt* log of foreign price levels

2.6.5 Unemployment

Paolo Guerrieri (2013) emphasized that the relentless rise in the rate of unemployment
particularly of the youths in Eurozone countries over the last three years is one of the most drastic
consequences of the crisis in the euro area. A quarter of youths in Europe have no job and
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overwhelming prospects with the possibility of finding employment. Finding measures to mitigate
this problem and prevent the deepening of the unemployment crisis has become a major challenge
in Europe.

Davos-Klosters(2014) in the world economic forum, it was reiterated that countrys economic
performance and employment varies considerably; many people are experiencing deeper crisis.
According to the International Labor Organization (ILO), global unemployment is set to rise in
2014, with over 200 million people jobless across the world.

(Eurostat, 31st October) Unemployment rate increased dramatically after last financial crisis.
This increasing rate of unemployment collapsed those countries real economy. As a result GDP
growth has been decreased which has interconnected with sustainable development. On the other
side, Germany, Netherland and Austria unemployment is around 5%. Those countries have no
effect that so much on their job sector likes other EU countries.

Manos Matsaganis (2013) noted that In 2009 Greece made the headlines because when its fiscal
crisis turned swiftly into a sovereign debt crisis, which finally metamorphosed into a full blown
recession. He observed that a sharp rise in unemployment among the primary earners has
continued to increase the risk of poverty. Because of gaps in the social safety net and the fear that
long term unemployment will probably remain high until a foreseeable future, the dilemma of
jobless adults and children in the households has now become a recurrent social question.

There are obvious arguments that even the austerity measure introduced was wrongly timed as
Greece was already in recession. There was a fall in demand for goods and services, lots of
businesses went bankrupt, some relocated, while most of those struggling to survive had to lay off
staffs. This resulted in deeper unemployment crises as unemployment the rate rose from 6.6% in
May 2008 to 27.6% in April 2013. Minimum wage was reduced by 22% and 32% for workers
aged below 25).

Social Impact of recession on jobs and Wages was no doubt a dominant feature of Greek
socioeconomic characteristics, with a continuous rise in the rate of unemployment figures
reaching the lowest level for over a decade with over 325,000 workers in 2008. As at 2013 level
of unemployment has escalated 1.4 million with an unemployment rate at 27.5 per cent
 14

compared to 26.3 per cent in Spain and 17.2% in Portugal, 13.5% in Ireland and 12.1% in Italy.
Manos Matsaganis(2013)

Types of unemployment
Traditional economist usually distinguishes between structural, frictional, and cyclical
unemployment. Assar Lindbeck (1999)

Structural unemployment is seen as a result of institutional set up of an economy, That is, private
and government organizations, the types of market arrangements as well as demography, laws and
regulations of the land. According to Hall & Lieberman (2009, 155), before the recession of 2007,
USAs unemployment rate stood at 4.7 percent, jobs were available for different categories of the
labor market, nurses, science and math teachers including language translators. Many were laid
off at the depth of the crises, most of which could not get jobs as a result of lack of skills to fill
the available jobs due to skill mis-match. The importance of institutional features for structural
unemployment is tied to their implications for demand for and supply of labor, The formation of
price and wages, as well as the efficacy of search and matching processes in the labor market.

Frictional unemployment; This is a subset of structural unemployment, it basically reflect the

spell of temporary unemployment as a result of difficulties of job search and matching in the
connection with quits, it is seen as a normal turnover on the labor market. It includes people
temporarily between jobs or because they are changing or moving occupation, and those who are
just new entries to the labor market, and job separation because of the employers dissatisfaction
with some individual workers.

Cyclical unemployment differs from structural and frictional unemployment because it is

basically by basically caused by short term economic fluctuations. The average cyclical
unemployment rate in Western Europe has moved from about 3% in the mid1960s to 6% in the
mid1970s and to 10 percent from the mid1980s to the late 1990s. Layard et al. (1991) But various
unemployment persistence mechanisms shadow the distinction between cyclical and structural
unemployment.
 15

Seasonal unemployment arises due to a short term changes in economic patterns as a result of
weather or other seasonal factors and usually. Seasonal factors sometime cause complication in
unemployment data since unemployment rate increase in certain months and declines in another
month despite the unchanged economic condition. Hall & Lieberman (2009, 154), to prevent a
monthly complications in unemployment rate, an adjustment process is introduced to removes any
changes in the rate that occurs in that month is made.

2.6.6 Inflation

Marc Labonte(2011) defined Inflation as a sustained or continuous rise in the general price level
or alternatively, as a sustained or continuous fall in the value of money. However, Aguiar (et
al)(October 2013)Noted, that Inflation is costly, but reduces the real value of outstanding debt
without the full punishment of default. With high inflation credibility, which can be interpreted as
joining a monetary union or issuing foreign currency debt, debt is effectively real. By contrast,
with low inflation credibility, sovereign debt is nominal and in a debt crisis a government may opt
to inflate away a fraction of the debt burden rather than explicitly default.

Pradhan el al (2014) argues that there is a strong sense of caution for low inflation problem on the
background of the ECB has made the competitive devaluation. Low inflation problem of Euro
zone is caused by the strength of weakness and exchange of domestic demand. Domestic demand
will last weak movement foreseeable future because the Southern Europe heavy debt countries
which deep-rooted structural adjustment pressure to center. So ECB lead competitive devaluation
for trying to increase the inflation pressure. They further identified reasons for decreasing the rate
of inflation as the weakened rise of core prices and Energy prices stability.

History of Inflation Management

Carmen Reinhart and Kenneth Rogoff (2008) noted that no emerging market economy in history,
has managed to escape the session of high inflation, the challenges of external debt default,
domestic debt default and inflation are all integrally related. They assert that a government that
chooses to default on its debts can barely be relied upon to preserve the value of its countrys
currency. Both money creation and interest costs on debt enter the governments budget
constraint. During a funding crisis, a sovereign government will typically grab from any sources.
In this section,
 16

.One could easily assume that inflation became a problem with the advent of paper currency in the
1800s. History shows that governments found ways to manipulate inflation before this era. The
major device was through debasing the content of the coins, either by mixing in cheaper metals or
by reducing the size of the coins and reissuing in the same denomination. Modern approach of
inflation and currency management are just a more technologically advanced and more efficient
approach in achieving same end.

Inflation Policy in Europe

The weakened rise of core prices reflects the weakness of domestic demand. Economy in the euro
area is slowly picking up, but the driving force is the export. In other words, downturn of
domestic demand has continued in Euro area since European Debt crisis was happened. During
the process of the European debt problem is serious (2010-2012 years), value-added tax is raised
around the heavily indebted countries, and it has led to the push-up of core inflation. Inflation of
core prices has weakened because domestic demand has continued to be downturn.

Energy prices stability can be said that commodity prices are getting calm, but increasing the
exchange is bigger element. When we estimate the energy price function, it can be seen that the
exchange is working toward pushing down the price since the end of 2012.

Because of the policy response by the ECB, the movement of the repurchase the euro has been
stronger since the end of 2012. Therefore, the exchange policy by ECB is really important. If
they raise a pressure of imported inflation by competitive devaluation, it is possible to relieve a
low inflation problem. International Labor Organization ILO, Research Department (2014)
examined that the first quarter of 2014. Greece unemployment rate was 27.9%, which up from
7.2%in the third quarter of 2008. During the recession, their labor market and social condition
had been collapsed. Moreover, income inequality have also expanded, which is lead to
sustainable development

According to European Central Bank report (June 2014)Governing Council took the decision
to cut the interest rate on the deposit facility to -0.10%, which was the first trial for such the major
central banks to adopt a negative interest rate policy.
 17

And furthermore, on 4th September, the Governing Council decided to decrease the rate of deposit
facility even more, -0.20%. And also, they decided to lower the Interest rate on main refinancing
operations of Euro system from 0.15% to 0.05%, and the rate on the marginal lending facility by
10 basis points to 0.30%.

2.7 Sustainability strategies in the Euro zone

Since the beginning of this recent crises, various strategies has been adopted in form of Bail-out
Funds, Debt forgiveness , Austerity measure etc. it is in the interest of this paper to review these
strategies in order to see the effect so far on the affected countries as well as the Euro zone as a
whole.

2.7.1 Bail-out

A Bailout can be referred to as a situation in which a business, individual or angovernment offers

financial aid to a failing institution in order to prevent the consequences that arise from a business
bankruptcy or failure. Bail outs can be benefited as loans, bonds, stocks or cash aid. While some
requires reimbursement others may not (Investopedia). Greece had various bailout amounting to
240 Billion, Ireland, 161 billion, Portugal 78billion, Spain 100billion and Italy 4.7 Trillion

Bailouts of countries in financial crises have been a phenomenon of since the 1990s. Before the
existence of bailouts, loans have been granted for countries in financial crises to rescue them from
distress.

The bailout history in European countries emerged from the government debt crisiswhich erupted
in the Euro zone during the 2007/2008 financial crises which led to the near-collapse of European
monetary union.

In early 2010, the worlds focus shifted from the global economic recession to the growing
problem of the European debt financial crisis. In May 2010 after being completely shut out of the
international credit markets

Classification of Bail out

Block Cheryl D (2010) classified the various types of bail out into the following ways;
 18

Profitable Bailouts: widely used in the late 1980s is government bailouts program that provide
genuine assistance to troubled enterprises which do not necessarily involve expenditures from
general tax revenue. Government might something profit from these kinds of bailout programs,
where most federal administrative costs are covered by interest and fees.

Low or No Cost Bailouts: several government bailout or interventions involve little or no

expenditure from general revenue. Government can simply facilitate private-market solutions
without involving federal resources at risky venture. This can be done by bringing private lenders
as well as investors together to work out strategic measures and long term plan to rescue the
economy.

No general Revenue or Special Fund Bailouts: Most interventions do imposes real costs on the
taxpayers who are usually concerned about the burdens of such costs on them despite many
bailout-type programs being funded through general revenues. Authors argue that Bailout
intervention does not necessarily have to impose a direct burden upon taxpayers It is how ever
better to impose to impose bailout costs on some narrower subset of taxpayers. Benefit theory of
taxation is an equitable tax system where taxpayer contributes proportionately with the benefits
receives from public services. However, the benefit approach is seen as inappropriate.
General Revenue Bailouts: This term is used to refer to bailouts for which costs are broadly
spread among the general taxpaying public. Funds for such general revenue bailouts come from
general Treasury Department. General revenue expenditures are usually from the federal budget
and government financial statements.
Combination Bailouts: Bailouts which are funded through a combination of both special funds
and general revenues. For example, FIRREA established a rather complex mechanism to provide
funding for the 1980s savings and loan bailout. Funds for the bailout were to come from the sale
of banks assets receivership, the sale of non-voting capital stock to Federal mortgage Loan Banks,
assessments against certain savings and loan banks and the issuance of obligations.
 19

I. Bail Out Beneficiaries

During the most recent financial crises of 2007/2008 various Bail out benefits was extended to
most of the affected countries especially in the Eurozone. Details of the bailout in Greece,
Portugal, Spain and Italy are follows

Table 1 above shows the total amount of various Bail out received by some of the EU countries
between 2010 and 2012 with Italy having over 2 trillion dollars in bailout from 2010 to 2012 and
Portugal receiving a moderate bailout from the EU and IMF..

Table 1 Bailout beneficiaries 2010 to2012

2010/12 Bail out Beneficiary Total Bail out Amount Total Debt 2013 $ Billions
$ (Billion)

Greece 240 317

Ireland 161 205
Portugal 78 211
Spain 100 955
Italy 2,000 2,076
Others 4,774

by Olakunle Solebo 2014

Sources; OECD and Eurostart. 2012

Greece: As observed in figure 2 and 3 above, Greece accepted a massive bailout package from
the EU and the IMF in order to avert a default. EU leaders finalized the bailout package for
Greece. Greece as a result has received two bailout packages from its euro zone partners and
International Monetary Fund. That is a bailout package of 110-billion Euros worthUS$142-billion
in May 2010. When it became clear that bailout was not enough because the economy continue to
weaken, there was a second bailout received in February 2012 for another 130 billion Euros and a
further write-down of government bonds value was reduce the burden

Ireland: In late November of 2010, Germany continued its contributions to bailing out EU
nations. This time, it was Ireland that cried for help. The bubble eventually burst and the Irish
 20

government bailed out those banks, which is what ruined the Irish government (Washington Post).
Moreover, the package that was prepared by the euro zone finance ministers included 10 billion
Euros for immediate recapitalization measures, 25 billion Euros on a contingency basis for
banking system supports and 50 billion Euros covering budget-financing needs (Cheng).
Germany, once again, was the major contributor of all the European nations with approximately 9
billion Euros. However, Germanys perspective on the two bailouts brings up a great point.

Portugal: After the Ireland rescue, investors focused on the next weakest country in the
crises. The economy and public finance of Portugal was weak and unstable. There was rising
government borrowing rate in the bond market. In May 2011, the country agreed to a rescue loan
of 78billion Euros.

Spain: The next weakest country considered among European investors is Spain because the
countrys economy is much larger than those of Greece, Ireland or Portugal. The rescue loans
strongly tested the euro zones financial capabilities. The main concern was that Spanish banks
had experienced huge losses on the collapsed real estate market, which could force the
government into rescue efforts it could not afford. The Spanish government therefore agreed on a
bail out deal in July 2012 with the euro zone officials to get about 100 billion Euros of rescue
loans for the banks. Though the borrowing rates of the bond markets fell back down, Since the
ECB wanted to go all out to save the euro it created a new program to buy a countrys bonds if
needed, there was a drastic boost of confidence in the euro zone states public finances.

Italy: Italy is the third largest economy of the Eurozone after Germany and France, holds the
largest public debt of over 2 trillion, which has been growing at an interesting pace, even in
more recent times and particularly as a ratio to GDP (130%), since the latter is contracting fast
(Orsi. Roberto 2013).
 21

Figure2: Bail out against actual debt

100%
80%
Total Debt 2013 $ Billions
60%
40% Total Bail out Amount $
(Billion)
20%
0%
Greece Ireland Portugal Spain Italy

By Olakunle Solebo (Data source: OECD and Euro state2013)

2.7.2 Austerity Measure

Austerity measures generally refer to the measures taken by governments to reduce expenditures
in an attempt to shrink their growing budget deficits (Investopedia). Since the beginning of the
debt crisis, the crises the most affected countries in Europe have been pushed to take drastic steps
in order consolidate their finances so as to reduce their budget deficits. Despite strong public
opposition and the painful short run effects, the countries have undertaken many of the
internationally recommended reforms and budget control.

The Revenue expansion and Expenditure Reduction strategies in some of the affected countries
includes;

Fiscal Consolidation (budget control)

Pension Reform (e.g. increased retirement age)
Public sector recruitment freeze and salary cut
Increase in VAT rate and income taxes
Bank Re-capitalization

Greece experience

Intereconomics (2013) revealed that In the three years since the beginning of the crisis, Greece
implemented a fiscal tightening of about 20% of GDP and reduced its budget deficit by an
 22

impressive nine percentage points, even after they lost a fifth of the GDP since the crises. The
following controls were made;

10% reduction in salaried bonuses and the freezing of recruitment in some public sector
Increases in VAT rates from 19% to 21% and in taxes on some luxury items
Reduction in expenditure on central government operating cost and public investment.
income tax adjustment

Ireland experience

The ex-ante fiscal strategy undertaken by the government of Ireland between 2008 and 2012
amounted to about 16 percent of GDP in 2011.

Irelands budget deficit control focused on expenditure cuts for about two-thirds of the adjustment
and tax increases for one-third

Ireland also reduced public sector employment in 2008 especially in the health and education
departments from 320,000 to 291,000 employees.
In 2009 and 2010, the government reduced public sector pay by about 15%.
Reduction in social welfare payment and services, despite the increase in demand as a result of
rising unemployment. Introduction of universal social charge
Indirect tax increases was implemented through VAT and others.
A high yielding property tax base on value of house which was formerly low and flexible has
been set
A voluntary redundancies and early retirement was introduced to reduce the pay bill by a further
3bn by 2014

Italy experience

Since the introduction of the euro with its fiscal rules, Italy has engaged in a rigorous process with
a multilateral surveillance has resulted in building a more disciplined environment of public
policies. OECD and other international organizations have several recommendations for a
stronger regulation, more competition and more flexibility in the labor market.
 23

Membership in the EMU and rapid globalization also increased the costs of inflexibility, the
burden of which has materialized over time. The union launched some structural reforms such as
the simplification of administrative procedures and the improvement of the apprenticeship system
which was resisted.

In December 2011, more fiscal consolidation measures was introduced, pension reforms were
made with a commensurate effort to enhance economic growth with emphasis on business and
liberalization. This was christened Operation Save Italy law.
Further development decrees were made to reduce spending and reform the labor market as well
as anti-corruption law.
In 2008-2009, the consolidation strategy called for both an increase revenues and the reduction of
tax system distortion. A general shift in taxation from labor and income to consumption and real
estate property with emphasis in fight tax evasion was made. And an intensive fight against tax
evasion and avoidance was reinforced
New tax frameworks were designed to aid economic growth by reducing the tax burden on capital
investment and encourage businesses and firms located in disadvantaged regions. Income tax
was reduced for female employees and workers under 35 years old.
Some sectors, such as education and health care, are required to contribute to rationalization
efforts in public spending mainly through efficiency gains, while spending (e.g. on pensions) has
been reformed and reduced. Such measures involve important reorganization.
In 2010, the retirement age for women in the public sector was reviewed to improve the long-term
sustainability of the system. The statutory retirement age was increase from 60 to 65) as well as
reduction in the pension benefits.
In December 2011, a new set of strict measures were adopted by the new government aiming at
curbing pension expenditure in the short term while improving the long-term sustainability of the
system at the same time

Portugal experience:

In May 2011 the Portuguese government signed Memoranda of Understanding (MOU) with the
EU and the IMF for 78bn (approximately 45% of GDP) of loans under strict conditionality,
following negotiations with the troika of EC, ECB and IMF staff.
 24

Banking sector policy measures saw the MOU opted for state-funded bank recapitalization up to
27.2% of GDP and guarantees on bank-issued debt
The initial MOU austerity measures included, inter alia, increases
in some VAT rates; increases in property taxes; increases in personal income taxes;
increases in fees to access public services such as hospitals, the court system and public highways
A public sector hiring freeze; and a freeze on any promotions in the public sector.
There were nearly ten thousand fewer school teachers in 2012/2013 than in 2010/2011, as school
curricula were trimmed, school class sizes increased and the number of schools in the network
reduced.
Additional (post-MOU) austerity measures have included, for example, permanent public
employee and pensioner wage cuts of 14%

Spain experience:

The imbalances in the Spanish budget arise partly from the increase in public sector expenditure
but mainly from the reduction in public revenues. Following the recommendations of
international institutions such as the IMF which affirmed in the World Economic Outlook of
October 2009:

However, beginning in 2010, as a result of the severe deterioration of public finances, the main
strategy has been to pursue fiscal consolidation
Tax cuts amounted to 1.8% of GDP in 2008 and 2009. These cuts included income and corporate
tax reforms in 2007, a personal income tax rebate of 400,
Elimination of the wealth tax in 2007 and the introduction of child benefits (2,500) payable at
birth.
Introduction of liquidity support measures to households and companies that reduced revenues by
1.2% of GDP in 2008 and 2009 (advances on the income tax deduction for house purchases and
monthly VAT returns for companies).
On the expenditure side, the government introduced was the Plan E which was endowed with
8 billion euro (0.7% of GDP) and a special fund to improve the prospects of certain strategic
sectors (e.g. the automotive industry or R&D) and public consumption projects (0.3% of GDP)
 25

3 Conceptual Framework

Financial sustainability has been expressed as a major concern by different academicians and
others stake holder in economic and financial circles. Extensive Literature on fiscal sustainability
continue to evolve year in year out as new economic experience and behavior continues to
contribute to the definition of the subject matter, There is therefore no consensus among
economists on a precise operational definition for fiscal sustainability. However different authors
use their own, often similar definitions; Enormous burden of debt servicing on some countries
budgets and the secular pressures on expenditure has made fiscal adjustments based on political
discretionary actions extremely difficult, resulting to public debt and interest payment to develop
a structural problem in countries with regular deficits. We look at the following models developed
over time;

I. Fiscal Sustainability Indicators

INTOSAI Professional Standard Committee Denmark (2010) identified various fiscal

sustainability indicators which provide information on the magnitude of the fiscal adjustment
because they have direct influence on the debt to GDP ratio. They emphasized the need to use
these indicators in controlling and analyzing countries capacity to accept new debts before
sustainability problem could arise. They acknowledged that the development of sustainability
indicators has traditionally been influenced by models that explicitly take into consideration these
the link between fiscal stocks and flows. The inter-temporal relationship that exists between fiscal
balances, public debt as well as interest payment as expressed below;

Dt+1 = Dt (1 + rt)+ BPt

Where;
Dt = public debt at time t
R = interest rate and
BPt = fiscal balance at time t

II. Sustainable fiscal position indicator

Croce and Juan Ramn (2003) identified fiscal sustainability indicator by evaluating tax authority
reaction when some relevant variables of debt sustainability over time. A sustainability indicator
was therefore created for this purpose.
 26

The sustainable fiscal position indicator explicitly adds a reaction function of fiscal authority and
whose variation over time allows for the evaluation of the reaction of the fiscal policy when the
conditions have changes. They defined the reaction function of the fiscal authority as the ratio of
the primary effective balance gap to the primary sustainable or goal and the debt to GDP ratio.

With a statistical analyses of the indicators, it may be seen as complementary to the indicators
above, it explains how income and expenditure policies which

Is the determinant of the primary balance, are pointed to create a convergence of the debt to GDP
ratio. Therefore the effect on the primary balance level required to stabilize the debt to GDP ratio
produced as a result of variations in the long term macroeconomic conditions, we compare the
reaction function to the evolution of the conditions determining the stability of the debt to GDP
ratio.

That is regarded as the relationship between the long term interest rate and the GDPs long term
growth rate.

1 r BP BP
I tPFS t t
1 gt bt 1 b*

Where,
= relationship between the real interest rate (r) and
GDP growth rate (g)
= Reaction function of fiscal policy
BP*= primary sustainable balance
BP = primary effective balance gap
b = the ratio of debt to sustainable GDP from the lasp period
It= ratio of debt to sustainable GDP

if the ratio of debt to GDP in previous period is higher than the goal, then it will converge to b*

only if t t 1

III. Short term primary gap indicator

Short term primary gap is commonly used sustainability indicator, which gives the primary
balance level required to stabilize debt as a proportion of GDP. BP* represents the primary
balance
 27

needed to stabilize debt while BP corresponds to the current primary balance.

BP* - BP = (rt- nt)b- BP

Where,
BP* = primary balance needed for debt stabilization
BP = prevailing primary balance
r = real interest rate trend
n = population growth rate
b = ratio of debt to GDP.

If the permanent primary balance exceeds the current primary balance, it indicates a positive
primary path, which means that the fiscal policy is not sustainable; this is because it tends to
increase the debt to GDP ratio. But when there is a lower permanent primary balance than the
current primary balance, the fiscal policy reduces the debt to GDP ratio.

IV. Comprehensive sustainability indicator of William Butter

William Buiter (1985) identified the indicator requires to determine the gap between the
sustainable primary balance and primary effective balance where the sustainability condition was
defined from a wider net wealth concept over the one in the debt to GDP ratio.

b * bt (r q)wt bt

Where,

b*= ratio debt to sustainable GDP

b= ratio debt to GDP
wt= net over real government wealth value a proportion of GDP
r= interest rate
q= product increase rate.
The accurate measurement of net government wealth should not be a simplistic measurement.
Asset elements such as financial and real capital, lands and minerals, current value of future taxes,
social security contributions, among several others should be included in the calculation.
Liabilities includes direct public debt, current value of future expenses for social security
 28

expenses and other benefits, and the adjusted value based on risk of all contingent liabilities of
difficult quantification

V. Fiscal Consistency Indicator

According to Blanchard et al (1990), Fiscal sustainability indicator takes into account the
consistency of tax policy, while keeping the debt-to-GDP ratio constant over time. This indicator
measures taxation gap by looking at the difference between the existing and sustainable fiscal
burden. The indicator shows the tax level required to stabilize the ratio of debt to GDP at an
expense level. GDP path of increase and the initial debt balance. If there is a negative
relationship, it indicates that the economys taxation pressure is too low to stabilize the debt to
GDP ratio.

n
t n t g r q d t
n
Where,
tn= Constant fiscal burden at period n years
d= debt-to-GDP ratio
g= expenditure
r= interest rate
q= GDP growth rate

VI. Macro-adjusted Primary Deficit

Talvi and Vgh (2000) observe that due to the high volatility of macroeconomic variables and the
challenges deficit varying around the expected value under normal macroeconomic conditions.
Calculating the primary balance adjusted by observing the fluctuations in macroeconomic
variables. We estimate a long term potential value. The basic idea is to compare the macro
adjusted balance with the estimations of current values.

I tm
r g b d tm
t 1
1 g
Where,

r= real interest rate

g= real growth
dm= primary macro adjusted balance
 29

VII. Currency Availability Indicators

Calvo et. al. (2003) the initial assumption is that volatility of capital flows variables is higher than
the volatility of macroeconomic variables. Thus, a critical element of debt

Sustainability is its composition compared to that of the industrial production that is, tradable and
non-tradable goods. This indicator compares the external debt to internal debt ratio with the
proportion of tradable goods related to the non-tradable goods in economy

b= B + eB* (a)
y + ey*

Where
b= debt to GDP ratio
B= debt in terms of non-tradable goods
e= the type of real exchange
B*= the debt in terms of tradable goods
y= GDP of non-tradable goods
y*= GDP of tradable goods.

A relevant case to the use of this indicator occurs when debt composition and production are
perfectly consistent under this condition; the variations in the exchange rate have no effects on
fiscal sustainability implying a constant debt to GDP ratio

B/ eB*
y/ ey* = 1 (b),
 30

4 Research Design and Methodology

We have carried out this research to further explain the indicators fiscal sustainability going by
the experience of the recent financial crises. To organize this study we use secondary source of
data which was analyzed using econometrics model so as to have a valid conclusion at the end of
the research.

4.1 Economic Model

In this research we study the relationship between fiscal sustainability and Macroeconomic
variables such as life expectancy, inflation and unemployment in determination of the fiscal
sustainability of a government. Having studied various economic literatures on this issue, we
observe that not enough literatures have been extended to accommodate the magnitude and
interrelationship that exist between these variable in determining how fiscally sustainable a
government is.

We therefore postulate that the fiscal sustainability is influenced by Debtor to GDP which is also
influenced by life expectancy, inflation and unemployment,

4.2 Econometric Model

The model below is used to for the bases of our findings and conclusion in this study

yt 0 1 X1 2 X 2 3 X 3 U t

Where;

Y=Fiscal sustainability

0= Constant, 1=Unemployment, 2=Ageing population, 3= Inflation, T=time (18 countries in

15 years)=270

Debt to GDP Data is the value of the dependent variable since it commonly accepted and widely
used as a coefficient of sustainability, 0 is the constant, 1 is the beta coefficient or slope for
Life expectancy, 2 is the beta coefficient or slope for inflation and 3 is the beta coefficient or
slope for Unemployment and U is the error term.
 31

In computing the parameters we use the Ordinary Least Square (OLS) approach to minimize the
residual sum of square with respect to .

Data from 18 countries was collated from 1997 to 2013.

4.3 Sources of Data

To have a well-informed report given the scope of this research paper, we concentrate on
secondary sources of data from Organization for Economic Corporation and Development
(OECD) and Euro stat. and World Bank.

Numerous published information and reports from international agencies such as International
Monetary Fund (IMF), European Monetary Union (EMU), and The European Economic
Community (EEC) was reviewed

We will also review works of notable authors, renowned Journals and the various official reports
on the subject matter.

4.4 Test of Hypothesis

The following Null hypotheses were tested and valid conclusions were made from the test of
hypothesis:

Null Hypothesis 1

H0: There is no significant relationship between unemployment and fiscal sustainability in the
euro zone economy
Hypothesis 2
H0: There is no significant relationship between aging population and fiscal sustainability in the
euro zone countries
Hypothesis 3
H0: There is no significant relationship between inflation and fiscal sustainability in the euro zone
countries
 32

5 Data Analyses of Findings and Conclusion

Having criticaly reviewed this study we make some imperative undermentioned findings upon
which our conclussion is based. Our findings are not only based on the review of literatures but
largely on a critical analyses of the relevant result of theMultiple Regression Model as explained
by Chris Brooks (2008) and the various lecture slides of professor Dr. Gernot Muller. We
estimated the developed multiple linear regression through statistical software SPSS. In
computing the parameters we use the Ordinary Least Square (OLS) approach.

5.1 Data Analyses and Findings

Here we demonstrated the relationship between our Y-dependent variable and the X-independent
variables, for which multiple regression analysis is assumed to be proper way to verify the
relationship between these variables and dependent variable in this paper. To run the multiple
regressions in SPSS, we use inflation, unemployment, life expectancy, and Debt to GDP as
variables of Euro zone for 18 years and we run the test for 7 (seven) major countries (France,
Germany, Greece, Ireland, Italy, Portugal and Spain) of Europe separately for 17 years

5.1.1 Regression test for EU 18 countries

We conducted our regression analyses on the 18 Euro zone members using the available data; we
find the correlation coefficient, R-square, P-value and the coefficients of the model.

The results of R square help us to understand how well data fit our statistical model. R-squared
values show the percentage of movement in the dependent variable that is explained by the
regression model. A high R-squared value of 0.99 would means that, all the movements of Y-
dependent variable are largely explained by 99% movements in the X independent variable. And
P value is used for testing our statistical hypothesis. If P value is less than or equal to the
significance level then null hypothesis must be rejected.
 33

Table 2: Model Summary and ANOVA (EU 18)

Model Summary ANOVA

R R Square Adjusted R Square F Sig.
0.528(a) 0.279 0.112 1.675 0.221

In this research R2=0.279 explains that 27.90% of the movement in Debt to GDP in Euro zone is
explained by the movement in inflation, unemployment and the life expectancy ratio of Euro zone
members. Adjusted R2 tends to be more realistic because it takes account of the size of our
observation used to carry out this research (that is 18 countries). Our adjusted R2 of 0.1124 shows
that 11.24% variability in Debt to GDP ratio is explained by this regression model.

ANOVA

The ANOVA table shows the significance of the model. Significance value in this table indicates
whether to reject the null hypothesis or not. I.e. the p value in here is 0.221 which is way more
than 0.05. So this indicates that the independent variable is insignificant and cannot explain the
model i.e. the model has no explanatory power. Hence the model is insignificant; so we need not
to look for the coefficients table of the independent variables as the coefficient cannot be
interpreted. .

Test of Hypothesis

Therefore from the bases of 18 Euro zone data, the entire Null hypotheses are not rejected
because it is not significant.

For the purpose of analyses, we take a critical look at the difference between R-Square (0,279)
and adjusted R-Square (0.112) and found a reasonable gap. Which implies that one of the
variables may be significant? More so, the coefficient results in the regression equation indicate
that unemployment has a much higher coefficient. Mores, the level of significance for
Unemployment is 0.51.
 34

y 37.734 0.105 X 1 0.146 X 2 4.53 X 3

Where = X 1 life expectancy, X 2 = Inflation and X 3 = Unemployment

5.2 Regression Test for individual countries

We selected relevant countries within the Euro zone and ran the regression test to the significance
of the test.

5.2.1 France:

Table 3: Model Summary (France)

Model Summary ANOVA

R R Square Adjusted R Square F Sig.
.884 .781 .726 14.260 .000

The above table shows a positive correlation coefficient i.e. R value, which explains strong
relationship between the dependent variable and independent variables. Here the R is 0.884 which
explains strong relationship between the independent variables and dependent variable. Here, the
Adj. R square is 0.726 which implies that 72.6% of total variability in Debt to GDP is explained
by the model.

ANOVA

The ANOVA table shows a highly significant level of the model for France. The P-value here is
0.000 which is way less than 0.05, even it is less than 0.01. By which we can conclude that there
is very strong evidence to reject the null hypothesis.

Test of Hypothesis:

The following decision is made on the bases of the above result of the regression analyses of
France;

1. H0: There is no significant relationship between fiscal sustainability and Aging population
We reject this hypothesis on the basis of the above regression result.
 35

2. H0: There is no significant relationship between Fiscal sustainability and Inflation

We do not reject this hypothesis on the basis of the regression result.
3. H0: There is no significant relationship between Fiscal sustainability and Unemployment
We also reject this hypothesis on the basis of the regression result.

The table below explains the relationship between independent variables and dependent variable
for the coefficient. The regression model we can write from the table;

Table 4: Coefficients (France)

Unstandardized Standardized
Coefficients Coefficients t Sig.
Mo Std.
del B Error Beta B Std. Error
1 (Constant) -620.495 110.242 -5.628 .000
Life_expectancy 8.331 1.390 .854 5.995 .000
Inflation -.161 2.433 -.010 -.066 .948
Unemployment 7.959 3.564 .318 2.233 .045

Dependent Variable: Debt_to_GDP

y = - 620.495 + 8.331 X1 - 0.161X2 +0.959 X3

The above table shows the significance levels of the independent variables. Hence independent
variables such as inflation and life expectancy are significance at 95% confidence level, which
confirms the reason that the null hypothesisis rejected. This proves that, there is a strong
relationship between the independent variables(life expectancy and unemployment) and fiscal
sustainability in the case of France. On the other hand, for inflation we observe a 95% standard
error and realized that inflation does not have a significant relationship with fiscal sustainability at
95% confidence interval. However, if we consider a confidence level of 90% then inflation will
also be significant in this model.

Hence, the model explains that 1(one) unit increase/decrease of the independent variable
increase/decrease the dependent variable by the amount of coefficient, holding other variables
constant. And the sign before the coefficient is very important. In our model we see that there is a
positive relationship between life expectancy and Unemployment with debt to GDP ratio.
 36

5.2.2 Germany:

The table below shows a positive correlation coefficient i.e. R value. Here, R value is .870 which
explains a strong relationship between the dependent variable and independent variables. The
coefficient of determination R2of 0.758 indicates that 75.8% of the total variability in Debt to
GDP is explained by the model.

Table 5: Model Summary and ANOVA (Germany)

Model Summary ANOVA

R R Square Adjusted R Square F Sig.

.870 .758 .697 12.513 .001

ANOVA
The ANOVA shows that the P value is 0.001 which is less than 0.005. This implies that the model
has significance. Hence the model has the significance; we need to look for the coefficients of this
model.

Null hypothesis

1. H0: There is no significant relationship between fiscal sustainability and Aging population.
We reject this hypothesis on the basis of the above regression result.
2. H0: There is no significant relationship between Fiscal sustainability and Inflation.
We do not reject this hypothesis on the basis of the regression result.
3. H0: There is no significant relationship between Fiscal sustainability and Unemployment.
We also do not reject this hypothesis on the basis of the regression result.

Here, we have two variables i.e. inflation and unemployment have negative relation with the Debt
to GDP. And the P value for these two variables is insignificant for this model. Only life
expectancy variable is significant for this model for Germany and has a positive relationship with
Debt to GDP which explains that, as the life expectancy of the people of Germany increases, there
is a significant increase in the government expenditure, especially in the public health care sector.
 37

Table 6: Coefficients (Germany)

Unstandardized Standardized
t Sig.
Mod Coefficients Coefficients
el Std. Std.
B Beta B
Error Error
(Constant) -272.966 79.672 -3.426 .005
Life_expectanc
4.140 1.000 .748 4.141 .001
1 y
Inflation -1.355 1.358 -.161 -.998 .338
Unemployment -1.753 .960 -.295 -1.825 .093

Dependent Variable: Debt_to_GDP

From the following table we can write the regression model,

y 272.966 4.14 x1 1.355x2 1.753x3

5.2.3 Greece:

The following table shows a positive correlation coefficient i.e. R value. Here, R value is 0.777
which explains reasonable relationship between the dependent variable and independent variables.
The coefficient of determination R2 of 0.604 indicates60.4% variability in Debt to GDP is
explained by the model.

ANOVA

ANOVA shows that the P value is 0.009 which is less than 0.05. So this implies that the model is
significant.

Table 7: Model Summary and ANOVA (Greece)

Model Summary ANOVA

R R Square Adjusted R F Sig.

Square
0.777 0.604 0.505 6.110 .009

Test of Hypothesis

1. H0: There is no significant relationship between fiscal sustainability and Aging population
We do not reject this hypothesis on the basis of the above regression result
 38

2. H0: There is no significant relationship between Fiscal sustainability and Inflation

We do not reject this hypothesis on the basis of the regression result
3. H0: There is no significant relationship between Fiscal sustainability and Unemployment
We also do not reject this hypothesis on the basis of the regression result

Table 8: Coefficients (Greece)

Mod Unstandardized Standardized t Sig.

el Coefficients Coefficients
B Std. Error Beta B Std. Error

1 (Constant) -407.612 245.136 -1.663 .122

Life expectancy 6.758 3.099 .424 2.181 .050
inflation -4.110 2.673 -.324 -1.538 .150
unemployment 1.609 1.206 .278 1.334 .207

Dependent Variable: Debt to GDP

From the above table we can write the regression model,

y 4007.612 6.758 X 1 4.11X 2 1.609 X 3

5.2.4 Italy

The table below shows a positive correlation coefficient i.e. R value. Here, R value is 0.923 which
explains strong relationship between the dependent variable and independent variables. The
coefficient of determination R2 of 0.853 or 85.3% indicates the total variability in Debt to GDP is
explained by the model.

Table 9: Model Summary and ANOVA (Italy)

Model Summary ANOVA

R R Square Adjusted R Square F Sig.
0.923 0.853 0.816 23.174 .000
 39

ANOVA

The ANOVA shows that the p value is 0.000 which is less than 0.005. This implies that the model
is significant. Hence the model has the significance; we need to look for the coefficients of this
model.

Test of Hypothesis

1. H0: There is no significant relationship between fiscal sustainability and Aging population
We reject this hypothesis on the basis of the above regression result
2. H0: There is no significant relationship between Fiscal sustainability and Inflation
We reject this hypothesis on the basis of the regression result
3. H0: There is no significant relationship between Fiscal sustainability and Unemployment
We also reject this hypothesis on the basis of the regression result

Table 10: Coefficient (Italy)

Mod Unstandardized Standardized T Sig.

el Coefficients Coefficients
B Std. Beta B Std.
Error Error
1 (Constant) -226.198 102.875 -2.199 .048
Life_expectancy 3.942 1.242 .519 3.175 .008
Inflation -4.111 1.464 -.312 -2.808 .016
Unemployment 6.715 .941 1.167 7.138 .000
Dependent Variable: Debt_to_GDP

From the following table we can write the regression model,

y 226.198 3.3942 X 1 1.355 X 2 6.715 X 3

Though, life expectancy inflation and unemployment shows a very significant relationship with
Debt to GDP in this case. However, inflation shows a negative relationship with the Debt to GDP.
 40

5.2.5 Portugal:

The following table shows a positive correlation coefficient i.e. R value. Here, R value is 0.919
which explains strong relationship between the dependent variable and independent variables.
The coefficient of determination R2 of 0.845 or 84.5% indicates the total variability in Debt to
GDP is explained by the model.

ANOVA
ANOVA shows that the p value is 0.000 which is less than 0.005. So this implies that the model is
significant.

Table 11: Model Summary and ANOVA (Portugal)

Model Summary ANOVA
R
R Adjusted R Square F Sig.
Square
0.919 0.845 0.806 21.732 .000

Test of Hypothesis

1. H0: There is no significant relationship between fiscal sustainability and Aging population
We do not reject this hypothesis on the basis of the above regression result
2. H0: There is no significant relationship between Fiscal sustainability and Inflation
We do not reject this hypothesis on the basis of the regression result
3. H0: There is no significant relationship between Fiscal sustainability and Unemployment
We reject this hypothesis on the basis of the regression result

Table12: Coefficients (Portugal)

Mo Unstandardized Standardized t Sig.

del Coefficients Coefficients
B Std. Beta B Std.
Error Error
1 (Constant) -16.902 190.318 -.089 .931
Life_expectanc .704 2.559 .061 .275 .788
y
Inflation -.131 1.773 -.009 -.074 .942
Unemployment 8.935 2.347 .864 3.807 .002

Dependent Variable: Debt_to_GDP

 41

From the following table we can write the regression model

y 16.902 0.704 X 1 0.131X 2 8.935 X 3

Though life expectancy and inflation has no significant relationship in this case, Life expectancy
shows a positive value in the model. We also observe strong positive relationship between
unemployment and Debt to GDP ratio in Portugal. For this reason, we do not reject the null
hypothesis that says unemployment has no significant relationship with Debt to GDP. While
Life expectancy shows a positive relation with Debt to GDP, Inflation shows a negative
relationship for this model in Portugal

5.2.6 Spain:

The following table shows a positive correlation coefficient i.e. R value. Here, R Square value is
0.912 which explains strong relationship between the dependent variable and independent
variables. The Adjusted R Square is 0.89which means that 89% of the total variability in Debt to
GDP is explained by the model.

ANOVA

ANOVA shows that the p value is 0.000 which is less than 0.005. This implies that the model has
significant.

Table 13: Model Summary and ANOVA (Spain)

Model Summary ANOVA

R
R Adjusted R Square F Sig.
Square

0.955 0.912 0.890 41. 629 .000

 42

Test of Hypothesis

H0: There is no significant relationship between fiscal sustainability and Aging population
We reject this hypothesis on the basis of the above regression result
H0: There is no significant relationship between Fiscal sustainability and Inflation
We do not reject this hypothesis on the basis of the regression result
H0: There is no significant relationship between Fiscal sustainability and Unemployment
We reject this hypothesis on the basis of the regression result

Table 14: Coefficients (Spain)

Model Unstandardized Standardized t Sig.

Coefficients Coefficients

B Std. Beta B Std.

Error Error
1 (Constant) 211.855 56.614 3.742 .003

Life_expect -2.262 .707 -.275 -3.201 .008

ancy
Inflation -.393 .978 -.038 -.402 .695
Unemploym 3.314 .337 .920 9.831 .000
ent
Dependent Variable: Debt_to_GDP

From the table above, we can write the regression model as,

y 211.855 2.262 X 1 0.393 X 2 3.314 X 3

Here, we have two variables i.e. life expectancy and unemployment being very significant to
determine the debt to GDP. Life expectancy and inflation has negative relation with the Debt to
GDP. However, inflation is not significant for this model but the other two variables are
significant.

5.2.7 Ireland

The table below shows a positive correlation coefficient i.e. R value. Here, R Square value is
0.923 which explains strong relationship between the dependent variable and independent
variables. The Adjusted R Square is 0.904 which means that 90.40 % of the total variability in
Debt to GDP is explained by the model
 43

Table 15: Model Summary and ANOVA (Ireland)

Model Summary ANOVA

R R Adjusted R Square F Sig.
Square
0.961 0.923 0.904 47.948 .000

Test of Hypothesis
1. H0: There is no significant relationship between fiscal sustainability and Aging population
We do not reject this hypothesis on the basis of the above regression result
2. H0: There is no significant relationship between Fiscal sustainability and Inflation
We do not reject this hypothesis on the basis of the regression result
3. H0: There is no significant relationship between Fiscal sustainability and Unemployment
We reject this hypothesis on the basis of the regression result.

Table 16: Coefficients (Ireland)

Mo Unstandardized Standardized t Sig.

Coefficients Coefficients
del
B Std. Beta B Std.
Error Error
1 (Constant) -81.423 116.978 -.696 .500
Life 1.314 1.493 .082 .880 .396
expectancy
Inflation .270 1.466 .019 .184 .857
Unemploymen 9.365 .997 .934 9.397 .000
t
Dependent Variable: Debt to GDP

From the table above, we can write the regression model as,

y 81.423 1.314 X 1 0.27 X 2 9.365 X 3

 44

The above table shows that only unemployment is significant in measuring the volatility of fiscal
sustainability in the model. The two other variables are not significant in this model. However,
coefficients for all the variables are positive.

5.3 Multicollinearity Test:

We measure the possibility of Multicollinearity to see the accuracy and correlation or high level
relevance between two or more explanatory variables in the multiple regressions. And we can
identify by the use of SPSS whether there is any Multicollinearity among the explanatory
variables or not. Here we use one independent variable as dependent and others variables are as it
is and run the Collinearity test and continue the test by swapping each independent variable as
dependent variable. And for result, we consider the VIF factor; if it is above 5 then we can
conclude that there is significant Multicollinearity among the independent variables. Now in the
following table, we see that in each cases our VIF are less than 2, so from this we can conclude
that in our model the explanatory variables do not have Multicollinearity problem.

Table17: Collinearity Diagnostics

Independent Collinearity Collinearity Collinearity
Variables Statistics Statistics Statistics
Tolerance VIF Tolerance VIF Tolerance VIF
Inflation (dependent) .913 1.095 .926 1.079

Life .689 1.450 (dependent) .926 1.079

Expectancy
Unemployment .689 1.450 .913 1.095 (dependent)
 45

5.4 Conclusion

Having completed this study, it is interesting to know that the challenges of fiscal sustainability
and debt are an age long dilemma. Since the 1930s countries has accumulated enticing
international debts usually meant for the development of internal economy. However, when the
economy is not well managed their debt becomes unsustainable; the unsustainability sometime
becomes a bubble and when it burst it snowballs into severe fiscal and financial crises.

Looking further into the strategies that have been adopted so far to sustain the Euro zone
economy, considering the resolve of the European central bank and other agencies like IMF and
EU to do what it take to manage the crises; The several bailout programs had been followed up
with some interesting Austerity measure which was bid to effectively consolidate the government
budget. Though these measures are being vehemently opposed by the citizenry as they have direct
negative impact on their welfare, the approach of the government and policy maker has been
characterized by No pain, Po gain ideology, they believe that, it will eventually result into a
favorable economic situation in the near future.

We carried out comprehensive analyses of the significance of inflation, unemployment and life
expectancy to the fiscal sustainability of an economy using the Eurozone area. Several renowned
scholars have used different model to identify the fiscal sustainability of the government of a
country. After studying those models we developed a new model to further explain the component
of fiscal sustainability taking into account the inflation, unemployment and life expectancy.

From our findings; we understand that using our model to analyze the fiscal sustainability for all
18 euro zone countries will be difficult, not only because some of the countries do not have the
complete data for all variables, more so because the size and performance of the individual
countries are completely different. We there for conclude that our model is not relevant to
measure fiscal sustainability for the Eurozone as a group giving the data available to us.

Therefore, from our findings of the 7 (seven) major countries we think are relevant in the current
fiscal crises, Portugal, Ireland, Italy, Greece, Spain as well as France and Germany, we believe
that. In France, Italy and Spain life expectancy are significantly related to the measurement of
debt to GDP ratio, while inflation accounted for a significant movement in Dept to GDP of Italy.
We also conclude that in Italy, Portugal, Spain and Ireland the unemployment level accounted for
 46

the volatility of the Debt to GDP ratio which implies that there is a great impact of unemployment
on the fiscal sustainability of the governments.

The regression we carried as well as the various literatures reviewed on Greece made us to
conclude that there may be some inconsistency between real data and the reality of what is on
ground in Greece as the model shows that life expectancy, inflation and unemployment has no
significance with the sustainability issues in Greece. Hellenic Observatory European institute in
July 2011 observes that since 2010, Greece has been the worst hit of fiscal crises in living
memory. After only a decade of fast growth, the weakness of the economy was made evident in
2009, when the new government announced that earlier fiscal data had been misreported.

5.5 Possible Extensions and Limitations of Study

There are several limitations during the process of analyzing in this research project. Since we
could not obtain our data from primary sources, we consulted secondary sources, such as
Eurostat, World Bank, and OECD.

The secondary sources was also characterized by several limitations in area of consistency and
data availability, we were therefore only able to secure quality and reliable data of 18 Euro zone
countries from 1997 to 2012. This excluded Slovenia from the data scope.

We believe strongly that if sufficient data was available the result of our data analyses will be
greatly improved. We would also like to take part in an empirical analysis of the real effect of
strategies like Austerity measure on the Eurozones fiscal sustainability as well as the economy as
a whole.
 47

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