Recently both the Italian and the Spanish governments have come out and said that they will have to revise their expectations for their budget deficits in negative direction.

Similarly, there has been renewed budget concerns in Portugal and Greece. Hence, last week IMF chief Christine Lagarde expressed strong reservations about Greece’s ability to achievement its fiscal targets.

So far the markets have reacted fairly calmly to rising concerns about the fiscal situation in particularly Southern Europe, but these concerns nonetheless raises the question whether or not we will see renewed euro zone financial turmoil again soon.

Some are eager to claim that the failure to consolidate public finances in Southern Europe is a lack of effort to do so.

However, the fact is that we have seen significant fiscal tightening in countries like Greece and Spain as illustrated by the graph below (the source is IMF and own calculations for all graphs in this post).

What the graph is showing is the accumulative tightening of fiscal policy measured as the sum of yearly changes in structural budget deficit in the PIGS countries (Portugal, Italy, Greece and Spain) as well as Iceland. We use Iceland as an example of austerity in a non-euro country.

The graph clearly shows that particularly Greece has tightening fiscal policy dramatically since 2009-10 and now has tightened fiscal policy by nearly 20% of GDP. We have also seen a dramatic tightening of fiscal policy ins Portugal and Spain (and Iceland), but less so in Italy.

But how about the outcome? Lets look at the development in public debt.

The outcome surely is depressing. Despite tightening fiscal policy by nearly 20% of GDP since 2009/10 public debt in Greece today is nearly 40%-point higher as share of GDP than at the start of the ‘austerity period’. And it is the same sad story for Portugal, Spain and Italy.

However, if we look at Iceland the story is completely different. Here public debt is nearly 40%-point of GDP lower today than when austerity was initiated in 2010.

So why did Iceland succeed with fiscal austerity while the PIGS have failed? Well, my loyale readers already know the answer – nominal GDP growth. Just take a look at the graph below.

Greece have been a depression style contraction in nominal GDP and NGDP is today nearly 30% lower than at the start of the crisis in 2008 and for the rest of the PIGS-countries we are essentially at the same nominal GDP level as eight years ago!

But then look at Iceland’s nominal GDP. Despite a total collapse of the Icelandic banking sector in 2008 and a sharp contraction in real GDP in 2008-10 nominal GDP grew through the crisis years (2008-10) and has grown robustly since then. Some – including me – would even argue that NGDP growth in Iceland has been growing too strongly.

So why this difference in NGDP growth between the PIGS and Iceland? Well it is simple – it is all about the monetary policy regime. The PIGS countries are of course euro members and have not seen enough monetary easing to get NGDP growth back to decent levels of 4-5%, which would be comparable to ECB’s 2% inflation target. On the other hand Iceland has seen significant monetary stimulus in the form of a sharp depreciation of the Icelandic króna and a drop in interest rates.

As a result monetary policy has more than offset the negative impact on aggregate demand from fiscal policy in Iceland and this is the real reason for the success of fiscal consolidation in Iceland.

This obviously has not been the case in the PIGS countries, where monetary policy has failed to offset the negative impact on demand from the fiscal austerity measures.

Without monetary easing fiscal woes will continue

This also leads me to the clear conclusion that we are very likely to see a continued increase on public debt-to-GDP ratios in the PIGS countries if the ECB fails to fundamentally and permanently lift NGDP growth in the euro zone to at least 4-5%.

Until that happens the PIGS countries have no other option that to continue to the fiscal austerity measures, but it is very unlikely to succeed for long unless we see a pick up in growth.

Therefore, policy makers in the PIGS countries should rather focus on growth enhancing policies such as cuts in corporate taxation and labour market deregulation and maybe also more immigration rather than on focusing on fiscal austerity. But the most important thing will be for the ECB to end the deflationary pressures in the euro zone economy. A 4% NGDP target accompanied by significant open-ended quantitative easing would do the job.

Unfortunately I have little hope for either reforms in the PIGS countries or a fundamental monetary policy regime change so I continue to think that we could very easily see an other of ‘euro turmoil’ in the coming months.