Why have ‘austerity’ failed in the PIGS countries and succeed in Iceland?

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).

Fiscal tightening PIGS Iceland

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.

Public debt PIGS Iceland

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.

NGDP PIGS Iceland

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.

Are we about to get a new ”euro spasm”?

 

I hate to say it, but I fear that we are in for a new round of euro zone troubles.

My key concern is that monetary conditions in the euro zone remains far to tight, which among other things is reflected in the continued very low level of inflation expectations in the euro zone. Hence, it is clear that the markets do not expect the ECB to deliver 2% inflation any time soon. As a consequence, nominal GDP growth also remains very weak across the euro zone.

And with weak nominal GDP growth public finance concerns are again returning to the euro zone. This is from Reuters:

Spain plans to ask the European Commission for an extra year to meet its public deficit targets, El Pais reported on Sunday, after missing the mark with its 2015 deficit and raising the prospect of further spending cuts to narrow the budget gap.

The country last month reported a 2015 deficit of 5 percent of economic output, one of the largest in Europe and above the EU-agreed target of 4.2 percent. To reduce that to the 2016 target of 2.8 percent of gross domestic product (GDP), the Spanish government will need to find about 23 billion euros ($25 billion) through tax increases or spending cuts.

The economy ministry declined to comment on the newspaper report, which cited government sources as saying that acting Economy Minister Luis de Guindos would include revised economic projections in the stability program to be presented to Parliament on April 19.

And Spain is not the only euro zone country with renewed budget concerns. Hence, on Friday Italy’s government cut it growth forecast for 2017 and increased it deficit forecast. Portugal is facing a similar problem – and things surely do not look well in Greece either.

So soon public finances problem with be back on the agenda for the European markets, but it is important to realize that this to a very large extent is a result of overly tighten monetary conditions. As I have said over and over again – Europe’s “debt” crisis is really a nominal GDP crisis. With no nominal GDP growth there is no public revenue growth and public debt ratios will continue to increase.

ngdp-debt

So why are we not seeing any NGDP growth in the euro zone?

Overall I see four reasons:

  1. Global monetary conditions are tightening on the back of tightening of monetary conditions from the Fed and the PBoC.
  2. Regulatory overkill in the European banking sector – particularly the implementation of the Liquidity Coverage Ratio (LCR), which since mid-2014 has caused a sharp drop in the euro zone money multiplier, which effectively is a major tightening of monetary conditions in the euro zone.
  3. Continued fiscal austerity measures to meet EU demand is also adding to the negative aggregate demand pressure.
  4. And finally, the three factor above would not be important had the ECB been credibly committed to its 2% inflation target. However, has increasingly become clear that the ECB is very, very reluctant in implemented the needed massive quantitative easing warranted to offset the three negative factors described above (tighter global monetary conditions, regulatory overkill and fiscal austerity). Instead the ECB continues to fool around with odd credit policies and negative interest rates.

Therefore, urgent action seems needed to avoid a new “euro spasm” in the near-future and I would focus on two factors:

  1. Suspend the implementation across of the new Liquidity Coverage Ratio until we have seen at least 24 months of consecutive 4% nominal GDP growth in the euro zone. Presently the implementation of the LCR is killing the European money market, which eventually will be draining the overall European economy for liquidity.
  2. The ECB needs a firm commitment to increasing nominal GDP growth and to bring inflation expectations back to at least 2% on all relevant time horizons. Furthermore, the ECB need to strongly signal that the central bank will increase the euro zone money base to fully offset any negative impact on overall broad money growth from the massive tightening of banking regulation in Europe.

So will we get that? Very likely not and the signs that we are moving toward renewed euro troubles are increasing. A good example is the re-escalation of currency inflows in to the Danish krone. Hence, the krone, which is pegged to the euro, has been under increasing appreciation pressures in recent weeks and Danish bond yields have as a consequence come down significantly.

This at least partly is a reflection of “safe haven” flows and fears regarding the future of the euro zone. These concerns are probably further exacerbated by Brexit concerns.

Finally, there has been signs of renewed banking distress in Europe with particularly concerns over Deutsche Bank increasing.

So be careful out there – soon with my might be in for euro troubles again.

The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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