Europe: Fiscal or External Crisis?

Matías Vernengo

Central to the different views of conservative and progressive authors, with respect to the European crisis, is the question of causality relating the fiscal and external crises.  Although causality is a thorny issue, the empirical evidence may illuminate the matter.  The following graph (Fig. 1)  shows the evolution of unit labor costs in Germany, and the group of peripheral countries, sometimes referred by their acronym (PIIGS), that were hit by the crisis, or are close to that position.

It shows that while German unit labor costs remain essentially constant, increasing merely 6 percent, in all the other countries the increases were of the order of more than 30 percent.  This translates into significant real appreciation of the real exchange rate in the periphery of Europe.

The euro common currency arrangement precludes nominal depreciations to compensate the increase in wages in the periphery relative to German wages.  Further, there are few mechanisms for large fiscal transfers that would compensate the loss of output associated with reduced competitiveness in the countries with higher costs.

In fact, the regional imbalances within the EU are very clear (Figure 2).  With the exception of Portugal, which had a current account deficit of more than 6 percent at the inception of the euro, all the other countries were essentially close to a balanced position in their external accounts.  In the early part of the decade the current accounts of all countries, with the exception of Italy, deteriorated significantly, while the external position of Germany strengthened.  In other words, it seems fairly reasonable to believe that unit labor costs impacted the external performance of European economies, and that the common currency was central to the outcome.

Further, Figure 3 shows that fiscal balances only deteriorate significantly after the crisis in 2007.  Fiscal balances were more or less stable, and in some case were clearly positive, as is the case with Ireland and to a lesser extent in Spain.  In all cases, the dip takes place only after the recession has already occurred.  It seems fairly clear that fiscal excess was not at the heart of the European crisis.  In fact, when we look at the government debt as a share of GDP (Figure 4), it is clear that public debt was relatively constant or decreasing in all cases, without exception, up to the 2007-8 crisis.  Only then did the levels of public debt increase at a significant rate.

The evidence against a fiscal crisis is so clear cut that is somewhat perplexing that the academic and political debate is fundamentally about whether the SGP should be strengthened or a new arrangement should be implemented to promote fiscal centralization at the supra-national level.  In fact, according to Charles Wyplosz there are only two views on how to solve the crisis: the German view which involves a reform of the Eurozone’s Stability and Growth Pact (SGP); and the alternative institutional view, to which Wyplosz subscribes, according to which a reform of the EU institutions is needed in order to impose fiscal discipline on the sovereign national institutions, since a revised SGP would be doomed to fail.

Note that the effort for fiscal centralization is seen as a necessary step towards more stringent fiscal adjustment, and not to reduce the problems associated with the common currency, promoting fiscal transfers to the distressed economies.

In fact, the letters of intent of the two countries that have already negotiated with the EU and the IMF clearly accept the notion that fiscal adjustment is essential, even in the face of a recession.  Greece has committed to a reduction of 40 percent of its deficit within a year, while Ireland suggests that it will reduce its deficit by 9 percent of GDP within 3 years.  In both cases, recovery is expected to come from the external sector, which must imply that there is an expectation that deflation will do the work of increasing external competitiveness.

These developments do not bode well for the future of the European recovery, for the euro, and consequently for the world economy, which will be negatively impacted by a sluggish recovery in Europe.

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7 Responses to “Europe: Fiscal or External Crisis?”

  1. Kevin P. Gallagher says:

    Spot on. Important to add that post-2008 PIIGS debt has thus been unjustifiably expensive given that their fiscal positions were similar to most developed nations as they went looking to borrow for the recovery. Central to that run up in prices are the credit rating agencies. The agencies received a lot of scrutiny for wrongly dubbing mortgage-backed securities as AAA, but have received relatively little attention in terms of their sovereign debt ratings. While economists from the IMF and beyond are now arguing for a new macroeconomics, rating agencies impose a 1990s macroeconomics that got us into this mess. Every time a PIIGS nation puts together a deal with the EU, IMF, and creditors, the agencies downgrade the day after, unraveling the negotiations that just occurred days before. More scrutiny needs to be focused towards the macroeconomic models used by rating agencies. It is shocking that these agencies, basically three that rule all global bond markets, are still basically unregulated.

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  3. Excellent thoughts–thank you. Occam’s Razor–simple, easiest to understand answer to a seemingly perplexing response. As a firm beleiver in B.F. Skinner’s maxim that “punishement is only temporary” and seening how the generational distance has induced a loss of behavioral memory in the US, it seems a bit of a stretch to think that simply the fear of inflation is driving German attitudes to further printing–the institutionalization of such fears is not strong enough to overcome the loss of behavioral memory, even one on a collective scale resulting from the narative of German history almost 100 years ago.

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