The other culprit for the crisis: Spendthrift governments
In an earlier post, I analysed the new offensive launched by the four presidents of European institutions on the next step in economic governance and saw it as a flawed attempt to rewrite the fundamental narrative of the crisis. By making wages to blame for the crisis, the – astounding – mismanagement of capital flows that occurred in the first decade of the single currency was simply ignored.
However, the four president’s note also targets a second culprit. Besides irresponsible wages, ‘spendthrift’ governments hiking public expenditure are also used as an excuse, with the same aim of getting financial markets off the hook.
Here, the argument goes that member states failed to take advantage of the ‘benign’ macro-economic conditions of the first decade of monetary union. If they had done so, if the Stability & Growth Pact (S&GP) had been respected, then balanced or surplus budgets would have been reached and public debt levels would have been lower. Public finances would then have had a reserve margin to avoid the banking crisis becoming a fiscal crisis. The efforts to save banking systems would still have pushed public debt and deficits up but they would have gone up from a lower level to start with and the collapse of financial market confidence in the sustainability of public finances would have been avoided – or so their argument goes.
Are public finances able to stand up against a financial tsunami?
In other words, their claim is that, by squandering the opportunity of transforming reasonable growth during the first years of monetary union into budget surpluses, governments themselves laid the foundations of the public finances crisis that erupted from 2010 and that pushed many member states into a catastrophic policy of brutal austerity.
To assess this claim, the experiences of Spain and Ireland are interesting. Contrary to what many may think, these two countries did indeed follow the policies that were described above. They did use the ‘benign’ macro-economic conditions of the first decade of the single currency. Spain went into the financial crisis with a budget surplus of 2% of GDP and Ireland even with one of 3% of GDP. However, these budget surpluses simply evaporated in the face of the financial tsunami that followed. As can be seen from the graph, the turnaround in public finances that took place under the financial crisis was enormous: the 2% and 3% budget surplus in Spain and Ireland morphed into a 10% and a 30% deficit respectively.
The same story holds for public debt. Spain and Ireland entered the crisis with debt levels far below the 60% threshold set by the S&GP. Spain had a government debt ratio of 35% of GDP, Ireland’s was just 24%. Under the impact of the financial crisis, however, their debt loads reached respectively 92% and 123% of GDP in 2013.
Judging by these numbers, it’s unrealistic to expect public finances to be able to cope with the forces unleashed by a major financial bust. Even if the surpluses of Ireland and Spain had been twice as high, the financial meltdown would still have pushed their budgets into deep negative territory and the subsequent pressure to cut that deficit to the magic threshold of 3% would still have produced prolonged and dismal growth and unemployment outcomes.
A look outside monetary union reveals another interesting dimension ignored by the four presidents.
Indeed, the next graph below presents an enigma. It shows that the pattern of deficits in Spain and Italy on the one hand and the UK and the US on the other hand is quite similar. All of them went into the crisis from about the same level of deficit and then ran up deficits of the same order of magnitude during it. So, why did financial markets turn on Spain and Italy, not on the US or the UK, and impose a ‘sudden stop’ of capital flows, a stop that devastated the sustainability of their public finances, their banking system and credit flows to their real economy? With public deficits following an almost identical pattern in the US and the UK, why did financial markets not lose confidence in these economies as well?
The explanation for this enigma is that the US and the UK have what the individual members of the euro area are now missing. In these countries, the central bank acts as a ‘government banker’ by standing behind sovereign debt. Markets know that the US and the UK will never default on their sovereign debt because, even if the worst scenario were about to happen, their central banks would step in and print the money necessary to service the debt.
On top of this, both the Federal Reserve as well as the Bank of England actually turned on their printing press years ago to buy up their economies’ sovereign debt, thereby helping the state to access the finance necessary to provide support for aggregate demand. In this way, both central banks were able to avoid self-defeating market expectations.
The ECB, however, failed to do this. With the aim of gaining leverage over member states’ economic and social policy making, it first allowed negative market expectations to take hold. This was then followed by piecemeal and relatively modest ECB interventions in sovereign debt markets, interventions that were accompanied by strict and counterproductive conditionalities such as cuts in public sector wages or undermining trade union ability to bargain collectively. It was only in mid-2012, after more than two years of turmoil in euro sovereign debt markets, when the very existence of the euro started to come into serious doubt, that the ECB – via an oral intervention (the famous Draghi quote of ‘do whatever it takes to save the euro’) – finally managed to calm down the markets. By that time, however, the damage had already been done.
The famous four presidents, in their debate on future economic governance, would be much wiser to attack the roots of the problem. Instead of allowing finance to spin totally out of control by triggering debt-financed asset price bubbles and expecting public finances to clean up the mess afterwards, it’s a much better idea to develop the instruments for a ‘hands-on’ policy in financial markets: the public authorities steering capital flows inside monetary union away from financing speculative bubbles.
And instead of using public finances and social spending as a scapegoat, it is time to address the core problem of EMU: it is the only monetary union in the world where the central bank does not fully back up sovereign debt.
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