Reckless fiscal policy on periphery didn't cause euro crisis


THERE ARE MANY aspects to the euro zone crisis but the message from EU policymakers remains the same – the turmoil was precipitated by fiscal profligacy on the part of peripheral nations including Greece, Ireland, Portugal and Spain.

This diagnosis means that the solution advocated by countries belonging to the euro’s core is centred upon fiscal austerity and structural reforms. But, is the standard European narrative supported by the facts?

The Germanic view (and conventional line at EU policy level) is not corroborated by the evidence and is an inaccurate representation of the facts at best. The data suggests that unsustainable fiscal positions among the periphery were largely a result of the crisis and not its primary cause. Indeed, following the adoption of the single currency and up until the crisis struck, the average fiscal deficit registered in the peripheral countries was below the Maastricht criteria of 3 per cent of GDP and not materially higher than the core countries’ average fiscal deficit until 2008.

The record reveals that only Greece can be accused of fiscal profligacy over the period in question, with its fiscal deficit exceeding the Maastricht criteria each year between 2001 and 2007 – averaging over 5.5 per cent of GDP for that period. The average deficit for the other peripheral countries was below 2 per cent each year until 2008, and lower than Germany’s deficit between 2001 and 2006.

The evidence demonstrates that deficit spending was not prevalent among the periphery pre-crisis. Ireland registered a surplus through most of the period, and Spain recorded a surplus between 2005 and 2007. The facts also dispel the notion that Germany was a “paragon of virtue” in the years leading up to the crisis. The record shows Germany had a fiscal deficit in excess of the Maastricht criteria between 2002 and 2005. This undermined the Stability and Growth Pact, and was a slap in the face to countries such as Austria and the Netherlands, which had taken hard decisions to comply with its terms.

Gross government debt ratios pre-crisis tell a similar story. Greece is an outlier again. Its public debt/GDP ratio was over 100 per cent pre-crisis – the Maastricht criteria is just 60 per cent. Figures for Ireland and Spain looked healthy at 36 and 24 per cent respectively. Portugal was 68 per cent, close to France and Germany at 64 and 65 per cent respectively. The periphery’s average public debt ratio was not significantly higher than France or Germany at 68 per cent, though five of the seven countries, including Germany, were not complying with the stability pact.

It is quite clear that, apart from Greece, the euro crisis cannot be attributed to reckless fiscal policy in peripheral countries. The crisis has less to do with fiscal profligacy and more to do with the large and persistent intra-euro zone imbalances built up during the upswing.

The average current account deficit among the periphery increased from just 4 per cent of GDP in 2003 to almost 11 per cent by the time the crisis struck, which caused net foreign liabilities to rise to more than 70 per cent of GDP in Greece, Portugal and Spain.

External debt indicators all vastly exceeded levels that had previously triggered crises in developing countries, but the warning signs were ignored because the euro zone itself was largely in balance with the rest of the world.

The periphery’s deficits were financed through the flow of capital downhill from the high-income surplus countries, which caused some to argue that the imbalances were a normal part of the convergence process.

But the current account deficits were not a function of higher investment rates that would deliver higher future income growth, but lower savings rates and excessive consumption driven by negative real interest rates and sharply rising asset prices in the case of Ireland and Spain. The rise in net foreign liabilities was not sustainable, and the inevitable cessation of external lending precipitated both a government funding and banking crisis. The surge in public debt/GDP ratios alongside the large jump in yields on government debt prompted Europe’s policymakers to see unsound government finances as the problem and focus on fiscal austerity. But the primary cause of the crisis was unsustainable intra-regional imbalances, which ultimately gave way to a balance of payments crisis, as the cessation of private sector lending to the periphery alongside capital flight led to a deficit position on both the current and capital accounts, which has since been funded by official sources.

The bottom line is that fiscal adjustment in the troubled peripheral nations is not sufficient to end the crisis on its own, as a sharp turnaround in the current account is required to stabilise the level of net foreign liabilities. However, without stimulus in the core countries such as Germany that prompts a narrowing of their surplus position, a reversal will only be achieved through a collapse in imports, which implies a contracting economy. In this scenario, public and private sector debts will continue to rise.

The euro crisis is far from over.