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EU (before) EU (after) US (before) US (after)

The global crisis hit Europe twice. The first strike came from abroad in 2007. In the United
States, markets had ignored credit risk in subprime mortgage markets. A lack of financial
supervision allowed opaque financial instruments to flourish, aggravating the problem. As a
result, the U.S. banking system underwent a dramatic bail-out in September 2008. European
banks suffered in the fallout. Two years later, a second crisis erupted in the euro area. Years of
unsustainable government policies had caused deficits and debt burdens to mushroom and
bloated pre-crisis wages and housing prices. As the situation worsened, Europe took
courageous decisions to put the continent back on firm footing.

The budgetary support or fiscal impulse that the government can provide to the economy refl ects the
initial momentum from public fi nances, as broadly captured by the year-on-year change in the general
government budget balance as a share of GDP. The fi scal impulse can be broadly decomposed into
three categories, comprising the operation of automatic fi scal stabilisers associated with the business
cycle equivalent to the change in the cyclical component of the budget; 2) the fi scal stance, consisting
of discretionary fi scal policy measures and a number of non-policy factors as captured by changes in
the cyclically adjusted (or structural) primary balance; and 3) interest payments, which represent a fi
nancial fl ow between the government and other sectors in the economy, and therefore may also be
seen as part of the fi scal impulse (see Chart 1). In a cyclical downturn, the operation of automatic fi scal
stabilisers provides an automatic buffer to private demand through built-in features of the government
budget. These refl ect above all rising unemployment and other social security benefi ts on the
expenditure side and falling income from corporate, personal and indirect taxes on the revenue side.
Conversely, in a cyclical upturn, the automatic features of the budget work in the opposite direction,
thereby putting a brake on private demand. The fi scal stance is commonly used to measure the impact
of discretionary fi scal policies on government fi nances. The fi scal stimulus packages, adopted by
governments as a direct response to the economic crisis, form a subset of discretionary fi scal policies.
The fi scal stance is, however, also affected by non-policy factors outside the control of government.
Notably, diffi culties in estimating the output gap in real time complicate the separation of cyclical and
policy-related budget changes and could distort a proper measurement of the fi scal stance (see e.g.
Cimadomo, 2008). As shown by Morris et al. (2009), in the boom years before the crisis several euro
area countries recorded large increases in tax revenues that could neither be explained by discretionary
measures, nor by the development of typical tax base proxies. These windfall revenues are nevertheless
registered as improving the cyclically adjusted primary balance. Similarly, the reversal of these windfall
revenues after the boom (leading to revenue shortfalls) is recorded as a deterioration in the cyclically
adjusted primary balance. Revenue windfalls/shortfalls may be caused, for example, by changes in asset
prices, in the price of oil, or in households spending habits. On the expenditure side, such non-policy
factors refer to government spending trends in excess of trend output growth. This could refl ect the in-
built momentum of expenditures (e.g. public wages) or an unanticipated drop in trend growth.

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