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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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.

More on Laffer and Estonia – just to get the facts right

Arthur Laffer’s recent piece in the Wall Street Journal on fiscal stimulus has generated quite a stir in the blogosphere – with mostly Keynesians and Market Monetarists coming out and pointing to the blatant mistakes in Laffer’s piece. I on my part I was particularly appalled by the fact that Laffer said Estonia, Finland, Slovakia and Ireland had particularly Keynesian policies in 2008.  In my previous post I went through why I think Laffer’s “analysis” is completely wrong, however, I did not go into details why Laffer got the numbers wrong. I do not plan to go through all Laffer’s mistakes, but instead I will zoom in on Estonian fiscal policy since 2006 to do some justice to the fiscal consolidation implemented by the Estonian government in 2009-10.

In his WSJ article Laffer claims that the Estonian government has pursued fiscal stimulus in response to the crisis. Nothing of course could be further from the truth. One major problem with Laffer’s numbers is that he is using public spending as share of GDP to analyze the magnitude of change in fiscal policy. However, for a given level of public spending in euro (the currency today in Estonia) a drop in nominal GDP will naturally lead to an increase in public spending as share of GDP. This is obviously not fiscal stimulus. Instead it makes more sense to look at the level of public spending adjusted for inflation and this is exactly what I have done in the graph below. I also plot Estonian GDP growth in the graph. The data is yearly data and the source is IMF.

Lets start out by looking at pre-crisis public spending. In the years just ahead of the escalation of the crisis after the collapse of Lehman Brother in the autumn of 2008 public spending grew quite strongly – and hence fiscal policy was strongly expansionary. I at the time I was a vocal critique of the Estonian’s government fiscal policies.

There is certainly reason to be critical of the conduct of fiscal policy in Estonia in the boom-years 2005-8, but it does not in anyway explain what happened in 2008. Laffer looks at changes in fiscal policy from 2007 to 2009. The problem with this obviously that he is not looking at the right period. He is looking at the period while the Estonian economy was still growing strongly. Hence, while the Estonian economy already started slowing in 2007 it was not before the autumn of 2008 that the crisis really hit. Therefore, the first full crisis year was 2009 and it was in 2009 we got the first crisis budget.

So what happened in 2009? Inflation adjusted public spending dropped! This is what makes Estonia unique. The Estonian government did NOT implement Keynesian policies rather it did the opposite. It cut spending. This is clear from the graph (the blue line). It is also clear from the graph that the Estonian government introduced further austerity measures and cut public spending further in 2010. This is of course what Laffer calls “fiscal stimulus”. All other economists in the world would call it fiscal consolidation or fiscal tightening and it is surely not something that Keynesians like Paul Krugman would recommend. On the other hand I think the Estonian government deserves credit for its brave fiscal consolidation. The Estonian government estimates that the size of fiscal consolidation from 2008 to 2010 amounts to around 17% (!) of GDP. I think this estimate is more or less right – hardly Krugmanian policies.

And maybe it is here Laffer should have started his analysis. The Estonian government did the opposite of what Keynesians would have recommend and what happened? Growth picked up! I would not claim that that had much to do with the fiscal consolidation, but at least it is hard to argue based on the data that the fiscal consolidation had a massively negative impact on GDP growth. Laffer would have known that had he actually taken care to have proper look at the data rather than just fitting the data to his story.

Laffer of course could also have told the story about the years 2011 and 2012, where the Estonian government in fact did introduce (moderate) fiscal stimulus. And what was the result? Well, growth slowed! The result Laffer was looking for! Again he missed that story. I would of course not claim that fiscal policy caused GDP growth to slow in 20011-12, but at least it is an indication that fiscal stimulus will not necessary give a boost to growth.

I hope we now got the facts about Estonian fiscal policy right.

PS David Glasner has an excellent follow-up on Laffer’s data as well.

PPS If you really want to know what have driven Estonian growth – then you should have a look at the ECB. Both the boom and the bust was caused by the ECB. It is that simple – fiscal policy did not play the role claimed by Laffer or Krugman. It is all monetary and I might do post at that at a later stage.

PPPS Time also has an article on the “Laffer controversy”

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