In my earlier post The Euro – A Fatal Conceit I argued that had the euro not be introduced and had we instead had freely floating exchange rates then “European taxpayers would (not) have had to pour billions of euros into bailing out Southern European and Eastern European government”. Said in another way had we not had the euro then there would not have been a European “debt crisis” or at least it would have been significantly smaller.
A simple way of illustrating this is to have a look at the debt development in the euro countries (and the countries pegged to the euro) and comparing that with the debt development in the European countries with floating exchange rates.
I use the same countries as in my previous post – The Euro – A Monetary Strangulation Mechanism. 21 euro countries (and countries pegged to the euro) and 10 countries with more or less floating exchange rates.
The graph below shows the development in (median) gross public debt (% of GDP) in the two groups of countries. (All countries are hence equally weighted).
The picture is very clear – while both the floaters and the euro countries saw their public debt ratios increase sharply on the back of the 2008 shock (albeit less extremely for the floaters than for the euro countries) – from 2011 there is a very clear difference in the debt development.
Hence, from 2011 the floaters have seen as seen a gradual decline in gross public debt (as share of GDP), while the euro countries (and the peggers) have seen a steep increase in public indebtedness.
So while the floaters have seen their public debt increase by just above 10% of GDP from 2007 to 2014 the euro countries have seen a rise in public debt of more than 25% of GDP!
The graph below shows the individual breakdown of the data.
Again the picture is very clear – the euro countries (and the euro peggers) have had significantly more negative debt dynamics than the European floaters. Even if we disregard the PIIGS countries then the euro countries are on average doing a lot worse than the floaters in terms of public debt dynamics .
The euro countries are trying harder, but are succeeding less
One could of course argue that the difference in debt development simply reflects that some countries are just less prudent than other. However, the graph below shows that this is not a very good explanation.
The graph shows the annual change in the fiscal stance (measured as the annual change in IMF’s estimate for the structural public balance as share of GDP). Positive (negative) values are a fiscal easing (tightening).
A few interesting conclusions emerge. First of all overall both euro countries and floaters seem to have had rather pro-cyclical fiscal policies – hence, both groups of countries eased fiscal policy in the ‘good years’ (2005-2009), but tightened the fiscal stance in the ‘bad years’ (2010-14.)
Second, it is notable that the fiscal stance of the euro countries and the floaters is highly correlated and is of a similar magnitude.
So even if the fiscal stance has an impact on growth in both groups of countries it seems a bit far-fetched to in general attribute the difference in real GDP growth between the two groups of countries to difference in the fiscal stance. That said, it seems like overall the euro countries and peggers have had a slightly more austere fiscal stance than the floaters after 2010. (Some – like Greece of course have seen a massive tightening of fiscal policy.)
This of course makes it even more paradoxical that the euro countries have had a significantly more negative debt dynamics than the floaters.
It is not a debt crisis – it is an NGDP crisis
So we can conclude that the reason that the euro countries’ debt dynamics are a lot worse than the floaters is not because of less fiscal austerity, but rather the problem seems to be one of lacking growth in the euro countries. The graph below illustrates that.
The graph plots the debt dynamics against the growth of nominal GDP from 2007 to 2014 for all 31 countries (both euro countries and the floaters).
The graph clearly shows that the countries, which have seen a sharp drop in nominal GDP such as Ireland and Greece have also seen the steepest increasing the public debt ratios. In fact Greece is nearly exactly on the estimated regression line, which implies that Greece has done exactly as good or bad as would be expected given the steep drop in Greek NGDP. This leaves basically no room for a ‘fiscal irresponsibility’ explanation for the rise in Greek public debt after 2007.
This of course nearly follows by definition – as we define the debt ratio as nominal public debt divided by nominal GDP. So when the denominator (nominal GDP) drops it follows by definition that the (debt) ratio increases. Furthermore, we also know that public sector expenditure (such as unemployment benefits) and tax revenues tend to be rather sensitive to changes in nominal GDP growth.
As a consequence we can conclude that the so-called ‘Europe debt crisis’ really is not about lack of fiscal austerity, but rather a result of too little nominal GDP growth.
And who controls NGDP growth? Well, overall NGDP growth in the euro zone is essentially under the full control of the ECB (remember MV=PY). This means that too tight monetary policy will lead to too weak NGDP growth, which in turn will cause an increase in public debt ratios.
In that regard it is worth noticing that it is hardly a coincidence that the ECB’s two unfortunate rate hikes in 2011 also caused a sharp slowdown in NGDP growth in certain euro zone countries, which in turn caused a sharp rise in public debt ratios as the first graph of this post clearly shows.
Consequently it would not be totally incorrect to claim that Jean-Claude Trichet as ECB-chief in 2011 played a major role in dramatically escalating the European debt crisis.
Had he not hiked interest rates in 2011 and instead pursued a policy of quantitative easing to get NGDP growth back on track then it seems a lot less likely that we would have seen the sharp increase in public debt ratios we have seen since 2011.
Of course that is not the whole story as the ECB does only control overall euro zone NGDP growth, but not the NGDP growth of individual euro zone countries. Rather the relative NGDP growth performance within the euro is determined by other factors such as particularly the initial external imbalances (the current account situation) when the shocks hit in 2008 (Lehman Brothers’ collapse) and 2011 (Trichet’s hikes.)
Hence, if a country like Greece with a large current account deficit is hit by a “funding shock” as in 2008 and 2011 then the country will have to have an internal devaluation (lower prices and lower wage growth) and the only way to achieve that is essentially through a deep recession.
However, that is not the case for countries with a floating exchange rate as a floating exchange country with a large current account deficit does not have to go through a recession to restore competitiveness – it just has to see a depreciation of its currency as Turkey as seen since 2008-9.
Concluding, the negative debt dynamics in the euro zone since 2008 are essentially the result of two things. 1) The misguided rate hikes in 2011 and 2) the lack of ability for countries with large current account deficits to see a nominal exchange rate depreciation.
The Euro is Fiscal Strangulation Mechanism, but for monetary reasons
We can therefore conclude that the euro indeed has been a Fiscal Strangulation Mechanism as fiscal austerity has not been enough to stabilize the overall debt dynamics in a numbers of euro zone countries.
However, this is only the case because the ECB has first of all failed to offset the fiscal austerity by maintaining nominal stability (hitting its own inflation target) and second because countries, which initially had large current account deficits like Greece and Spain have not – contrary to the floaters – been able to restore competitiveness (and domestic demand) through a depreciation of their currencies as they essentially are “pegged” within the euro zone.
PS I have excluded Croatia from the data set as it is unclear whether to describe the Croatian kuna as a dirty float or a dirty peg. Whether or not Croatia is included in the sample does not change the conclusions.
Update: My friend Nicolas Goetzmann pointed out the Trichet ECB also hiked interest rates in 2008 and hence dramatically misjudged the situation. I fully agree with that, but my point in this post is not necessarily to discuss that episode, but rather to discuss the fiscal implications of the ECB’s failures and the problem of the euro itself.
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It is hard to miss that it was Yellen’s hawkish comments that has sent gold prices down in recent weeks. So the drop in gold prices certainly is a indication that US monetary conditions are getting tighter. But it would of course be wrong to reason from the change in one price. We need more – so how about the dollar? 
This is the so-called Dollar Index (DXY). Here the picture certainly is less clear than from the gold price. In fact the dollar index today is more or less a the same level as on July 15 when Yellen hinted at a rate hike this year.
Again the picture is clear – after Yellen and Bullard’s comments 2y/2y inflation expectations have dropped and equally important this happened at a time when inflation expectations already where below 2%. It should also be noted that prediction markets are telling the same story. Hence, from some time Hypermind’s market for nominal GDP growth in 2015 has been somewhat below 4% (which I believe has been Fed’s unannounced target for some time – see here.) The Fed is too hawkish and rate hikes should be postponed Concluding, the Fed’s more hawkish rhetoric has de facto led to a tightening of US monetary conditions already, which has pushed inflation expectations below the Fed’s own 2% inflation target. So effectively the markets are tellling the Fed that monetary conditions are becoming too tight and a September rate hike as suggested by advocated by Bullard would be premature. So if I was on the FOMC I would certainly vote against any rate hike in the present situation.
The Market Monetarist 