The Euro crisis may soon be over. This is what German Finance Minister Schäuble thinks and his view is finding an echo among a growing community in the financial markets. But is it true?
For Chancellor Merkel and her followers, we are experiencing a debt crisis caused by irresponsible fiscal policies. Their remedy is therefore a “debt brake” and harsh austerity measures. It is not always clear, however, who was irresponsible. Sometimes it is claimed that southern member states used the low interest rates after joining the euro in order to borrow massively. At other times, lack of fiscal consolidation after the crisis is blamed. Let us look at the facts.
Table 1 shows the development of the debt-GDP ratio for two periods: from 1999 until 2007, i.e. from the start of monetary union until the last year before the Lehman crisis; and for 2007-2012, the post crisis period, including the Commission estimates for 2012. It indicates clearly that prior to the financial crisis, not only Portugal and Greece, but also Cyprus, France and Germany increased their public debt relative to GDP. So far for irresponsibility. In fact, debt came down for the euro area as a whole (-7.4%) and also for Italy, Spain and Ireland. After the financial crisis, debt ratios increased everywhere (except in Sweden): 32.9% in the euro area, less than half of this in Italy, slightly more in Portugal and Greece and substantially more in Ireland and Spain. Interestingly, public debt increased less in Italy than in Germany. Furthermore, Ireland and Spain achieved the greatest public debt reductions before the crisis. Clearly, these countries did not violate Europe’s fiscal rules. What would a debt brake have helped? Given these data, it is hard to support the claim that we are in the middle of a debt crisis caused by irresponsible borrowing.
The truth is that the debt dynamics have more to do with economic growth. The five southern European member states, which have been at the centre of financial markets’ concern, are among those who have been hardest hit by the recession (see Table 2). Economic output has fallen substantially and has still not yet returned to pre-crisis levels. Over the 4 year period, Greece has shrunk on average -3.57% per annum, i.e. on aggregate over 4 years -14.3%. The euro area as a whole is still half a percentage point below the pre-crisis GDP level. Of course, Slovenia is also hard hit and the only reason why it is not (yet?) a target of financial worries is the low debt ratio it started with.
With such dramatic output losses, growing debt ratios are inevitable: Public revenue depends largely on output. The European Commission has calculated that the elasticity by which revenue responds to growth is close to 1 in Europe. Hence, if Greek GDP has fallen by 3.6% every year since 2008, the deficit would have increased each year by the same rate, had expenditure remained constant. Thus fulfilling the Stability and Growth Pact is impossible. Yet, the prevailing German view is that these low growth member states must consolidate in order to prevent debt from rising more. But cutting expenditure in a situation of serious output loss re-enforces the recession. In fact, standard economic theory says that if the private sector does not spend enough the public sector must come in to compensate until confidence is restored.
The Greek case is a dramatic example for Europe’s misguided policies: Each and every driver of demand has been down, except net exports (and they are only positive because of the drop in imports – see Table 3). Under these circumstances, it is impossible for Greece – or any other state – to reduce deficits or public debt.
Source: European Commission, 2011a
What is the solution? The economic policies imposed by Chancellor Merkel and her conservative base on the rest of Europe are an Autobahn to disaster. They are causing a new recession in the euro area and will undermine confidence by financial markets again when it becomes clear that new output losses are further deteriorating public finances. No doubt structural reforms are needed to improve the growth potential in southern European member states. Mario Monti has courageously embarked on this road in Italy. But unless demand is restored to levels where the potential is realised, these policies will not produce the results and promises of today. Debt will increase further, unemployment will shoot up even more and ultimately the European Union will disappear.
Time is running out. There is only one way out of Europe’s difficulties: Mrs. Merkel must follow the example of Silvio Berlusconi and resign.