Market Monetarists have stressed it again and again – the European crisis is primarily a monetary crisis rather than a financial crisis and a debt crisis. Tight monetary conditions is reason for the so-called debt crisis. Said in another way it is the collapse in nominal GDP relative to the pre-crisis trend that have caused European debt ratios to skyrocket in the last four years.
That is easily illustrated – just see the graph below:
The conclusion is very clear. The change in public debt ratios across the euro zone is nearly entirely a result of the development in nominal GDP.
The “bad boys” the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain (and Slovenia) are those five (six) countries that have seen the most lackluster growth (in fact decline) in NGDP in the euro zone. These countries are obviously also the countries where debt has increased the most and government bond yields have skyrocketed.
This should really not be a surprise to anybody who have taken Macro 101 – public expenditures tend to increase and tax revenues drop in cyclical downturns. So higher budget deficits normally go hand in hand with weaker growth.
The graph interestingly enough also shows that the debt development in Greece really is no different from the debt development in Germany if we take the difference in NGDP growth into account. Greek nominal GDP has dropped by around 10% since 2007 and that pretty much explains the 50%-point increase in public debt since 2007. Greece is smack on the regression line in the graph – and so is Germany. The better debt performance in Germany does not reflect that the German government is more fiscally conservative than the Greek government. Rather it reflects a much better NGDP growth performance. So maybe we should ask the Bundesbank what would have happened to German public debt had NGDP dropped by 10% as in Greece. My guess is that the markets would not be too impressed with German fiscal policy in that scenario. It should of course also be noted that you can argue that the Greek government really has not anything to reduce the level of public debt – if it had than the Greece would be below to the regression line in the graph and it is not.
There are two outliers in the graph – Ireland and Estonia. The increase in Irish debt is much larger than one should have expected judging from the size of the change in NGDP in Ireland. This can easily be explained – it is simply the cost of the Irish banking rescues. The other outlier is Estonia where the increase in public debt has been much smaller than one should have expected given the development in nominal GDP. In that sense Estonia is really the only country in the euro zone, which have improved its public finances in any substantial fashion compared to what would have been the case if fiscal austerity had not been undertaken. The tightening of fiscal policy measured in this way is 20-25% of GDP. This is a truly remarkable tightening of fiscal policy.
Imagine, however, for one minute that Greece had undertaken a fiscal tightening of a similar magnitude as Estonia and assume at the same time that it would have had no impact on NGDP (the keynesians are now screaming) then the Greek budget situation would still have been horrendous – public debt would have not increase by 50% %-point of GDP but “only” by 30%-point. Greece would still be in deep trouble. This I think demonstrates that it is near impossible to undertake any meaningful fiscal consolidation when you see the kind of collapse in NGDP that you have seen in Greece.
Concluding, the European debt crisis is not really a debt crisis. It is a monetary crisis. The ECB has allowed euro zone nominal GDP to drop well-below its pre-crisis trend and that is the key reason for the sharp rise in public debt ratios. I am not saying that Europe do not have other problems. In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc. However, these problems did not cause the present crisis and even though I think these issues need to be addressed I doubt that reforms in these areas will be enough to drag us out of the crisis. We need higher nominal GDP growth. That will be the best cure. Now we are only waiting on Draghi to deliver.
PS The graph above also illustrate how badly wrong Arthur Laffer got it on fiscal policy in his recent Wall Street Journal article – particular in his claim that Estonia had been got conducting keynesian fiscal stimulus. See here, here and here.