Greece is not really worse than Germany (if you adjust for lack of growth)

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:

I have simply plotted the change in public debt to GDP from 2007 to 2012 (2012 are European Commission forecasts) against the percentage change in nominal GDP since 2007.

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.

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  1. Martin

     /  August 28, 2012


    If you would graph those that lost their job since 2007 and those that did not lose their job since 2007, I am pretty certain then that a similar pattern could be found: the increase in debt-to-nominal income of the unemployed is wholly a result of a decrease in nominal income.

    Similarly, you could probably find such a relationship between debt-to-nominal income of the unemployed and the employed, and change in nominal income for almost any set of consecutive years in the great moderation.

    What would the difference be between that graph, and the graph above, that makes you conclude that the euro debt crisis is a monetary crisis?

    Alternatively, as I read you, it is not so much the slope of the line that makes it a monetary crisis, as it is the sheer size of it; had NGDP been humming along then the numbers on the axes would have been a lot smaller.

    • Martin, it is really very simply. The ECB is fully in control of NGDP. The ECB has consistently allowed nominal GDP to decline and euro zone nominal GDP is well-below the the pre-crisis trend due to the extremely tight monetary policy in the euro zone.

      • Martin

         /  August 29, 2012


        In a monetary union, is the central bank also 100% responsible for the NGDP growth of every arbitrary geographical area in such a union?

        I am not disagreeing with you here that the central bank let NGDP-collapse and that this is a big part of the problem; I am disagreeing with you however that the slope of the line shows that the debt crisis is a monetary crisis. You could draw a sloped line regardless, provided you get to pick the area with the shocks.

        What shows that this is a monetary crisis, is that the abscissa ranges from -20% to +25% for 2007-2012 and the assumption that no observed real shock could be wholly responsible for such a difference.

        The slope of the line is the result of asymmetric shocks; the numbers on the axes are the result of bad monetary policy exacerbating these shocks.

  2. Jan

     /  August 28, 2012

    “Tight monetary conditions is reason for the so-called debt crisis.”

    I think you confuse correlation with causation.

    • Jan, no…but you might have a better explanation?

      • Jan

         /  August 28, 2012

        I would say that too much (mostly private) debt led to tight monetary conditions.

      • Jan

         /  August 29, 2012

        But I do agree that a serious increase in NGDP for the Eurozone would be healthy for the Eurozone.

        I have another remark/question concerning the following:

        “In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc.”

        Do high taxes belong in this list? Sweden has the second highest tax ratio in the European Union but also had the strongest rates of growth for the last two years. Doesn’t it also depend on who/what is taxed and how taxes are spent? And most of the PIIGS had a lower tax ratio than the European Union average:

        Denmark: 48,1% (of GDP)
        Sweden: 46,9%

        Ireland: 28,2%
        Greece: 30,3%
        Spain: 30,4%
        Portugal: 31%

        Italy is the exception with 43,1% of GDP

        So too high taxes didn’t seem to be their biggest problem when the crisis struck them.

        (numbers are for 2009,

  3. Mark A. Sadowski

     /  August 28, 2012

    I think there is an error in your graph. Slovakia’s NGDP is forecast to increase by 30.9% between 2007 and 2012 according to Eurostat. This is important because it makes Slovakia the second largest outlier, not Estonia.

    I agree with your interpretation concerning Ireland. It took on about 40% of GDP in bank debt. I would be careful about making any policy judgements concerning Estonia.

  4. Very nice post. Thank you.

    On question. The ECB could only target NGDP growth of europe not of every single country. Suppose they would have hit NGDP growth target but greeks NGDP would still have fallen.

    How would you address that? Is that even possible to happen? Is that even possible to address?

  5. marksadowski

     /  August 29, 2012

    I think there is a slight mistake in the graph. Slovakia’s NGDP is forecast increase by 30.9% between 2007 and 2012 according to Eurostat. Thus it is the second largest outlier, not Estonia.

    I agree about Ireland, as the bank debt it took on was about equal to 40% of GDP. And I’m curious why Estonia has done so well, but I don’t think this is can be at all interpreted as evidence in favor of a successful internal devaluation.

    Even Scott Sumner acknowledges that within a monetary zone local fiscal spending changes local GDP. In fact he has used this fact to deride studies estimating fiscal multipliers based on differences in state and local spending. Thus were Greece to cut government spending even more severely, its NGDP would have course dropped even more.

  6. Benjamin Cole

     /  August 29, 2012

    Excellent blogging. The theo-monetarists are obsessed with inflation, but I would prefer we get obsessed with growth.

  7. Ravi

     /  August 29, 2012

    Lars, what do you make of CEE economies like Serbia, where they are in recession but also have consumer price inflation? Not sure if CPI inflation is the right benchmark to look at, but would be curious as to your thoughts.

  8. Here is the fine analysis with no hope of any particular solution to an unnamed problem. What is the crisis that we speak of here? Is it one in which governments cannot pay their debts? Is it one of lack of jobs for those who want to work? Is it an inability of the people of a country to live decent and fulfilling lives? Something else entirely?

    Look, if we are feeling sorry for banks (holders of the unpayable debt) have the ECB make some money and give it to them. Done.

    If we people can’t find employment, make some jobs doing what needs to be done in the various countries and pay the people with money created by the ECB, or tax the rich sufficiently in order to pay those working. Done.

    If all the necessary and desirable work is done, print some money and give it to the citizens so that they need not needlessly suffer and they will be able to purchase the available goods and services to make their lives better. Done.

    Sitting around and making graphs and trying to figure out if Europe is in a debt crisis or a monetary crisis does nobody any good whatsoever. It fosters a ridiculous attitude of “we can’t do that!”. Yes, we can. And we should.

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