20 February 2012

What the European Debt Crisis ISN’T: A Contrarian View

The conventional wisdom of late is that the debt crisis in Europe is a result of profligacy and poor public policy leading to out-of-control public debt, which in turn causes higher interest rates, which in turn choke growth. The sentiment here in the U.S. seems to be that such results are the natural outcome of overly-liberal policies of public spending on social programs, pensions, etc. I'm interested in examining these assumptions and seeing if they are truly valid. Having done so, the result is a contrarian view, one that seeks to cast the European debt crisis in a new light.

The roots of the European Debt Crisis arguably go back decades, all the way back to the beginnings of post-war European economic growth, social program planning and pan-European integration. The crisis itself, however, began in February of 2010, when Greece’s struggle to put its financial affairs first gained widespread public exposure when their government announced drastic measures to increase revenue and cut spending. Since then, the crisis has spread to other countries and now threatens the very foundations of the European Union and the very existence of its common currency.

Given the vast size of the economy of the Eurozone and the large number (17) of different sovereign countries in it, any attempt to analyze the entire scope of the crisis as it impacts all the relevant countries, would stretch to a (lengthy) book, so I'll limit the scope to eight players: Greece (since it is there that the crisis originally flared up), Spain and Portugal (typical representatives of other developing, heavily-indebted Western European Eurozone economies), France and Germany (because these are the pillars of the Eurozone and the prime movers behind European unity since World War II), as well as Italy, Netherlands and Belgium (representing wealthier Western economies). This selection gives us a good cross-section of the Western European politico-economic scene.

I will use this cross-section of the European Union (EU) to examine the nature and consequences of the debt crisis, taking the contrarian view that far from being a crisis caused by public spending, it is in fact a crisis of perception and of overly-conservative, anti-Keynesian government policies.

A note re terminology: in the context of this analysis, I'll often refer to ‘poor’ and ‘rich’/’wealthy’ countries. It must be stressed that these are relative terms appropriate only to the European context. For example, Greece may be ‘poor’ by Western European standards, but by global standards, it is in fact quite wealthy.

What the Debt Crisis ISN’T

The general sense one gets from observers of the debt crisis is that unmanageable sovereign debt is primarily a problem stemming from poorer countries in the zone and often associated with excessive government largesse (which in turn is associated with left-wing governing parties who favor higher social spending). The talking heads and pundits in the media also make much of the 100% threshold: a country that owes more than it produces in Gross Domestic Product (GDP) in a given year must be a country beyond hope. (One wonders why one calendar year is somehow such a magical figure? Why not debt v two years of GDP? Or six months? From a quantitative point of view, this ratio is arbitrary.) However, my analysis of these eight countries’ debt and political situations from 1995 to present reveals a very different picture. First let us look at debt as a percentage of GDP for the eight countries:

Fig. 1: Debt as % of GDP, 1995-2010

Of the three countries consistently above the group’s 16-year average, one was (relatively) poor Greece, but the other two were Italy and the Belgium, two wealthy countries with strong, advanced economies. And of the three with the lowest debt levels vis-à-vis GDP, we find two are poorer (Spain and Portugal) and only one is a wealthy country (Netherlands).

Perhaps it is a question of political ideology then? Are tax-and-spend leftist parties running up wild debts? Again, reality is quite different from expectations. If we examine these countries’ debt as percentage of GDP in years when they were ruled by left-leaning parties v years when they were ruled by right-leaning parties, a startlingly consistent picture arises:

Fig. 2: Debt as percentage of GDP in selected countries under Left v Right governments

In every single case (albeit by an extremely slim one in Portugal), the average percentage of debt was higher on average under right-leaning governments than under left-leaning ones. For the group over the 16-year period, the gap was 8.2 percentage points.

Regardless of who ran up the debt and the characteristics of countries that have done so, does high debt by itself lead to ruin? Obviously not. Let’s take that arbitrary 100% threshold and look at countries that have such high levels of debt. In the 2000s, before the debt crisis, the three ‘worst’ debt countries noted above (Italy, Greece and Belgium) had GDP growth of on average 1.48%, practically indistinguishable from that of the ‘best’ (Portugal, Netherlands, Spain) at 1.44%.

What about the impact of high public debt on interest rates? It is often argued that the very high level of public debt in several European countries has been the culprit for higher interest rates, which in turn put a chokehold on growth. But as Henri Sterdyniak argued in his presentation to the Franco-German Conference in May of 2010, this is not a tenable argument, given that the higher levels of public investment (and thus debt) merely offset lower borrowing by the private sector, leading to no net increase in debt. In his view, it is thus “ridiculous to pretend that high public debt will bring high interest rates.”

So if these high levels of public debt are not caused by out-of-control left-wing spending binges in poorer countries, they are not choking growth, not leading (directly) to higher interest rates, then what exactly is the crisis about? In my view, it is a crisis of governments being driven to panicked and ill-advised policy shifts by markets that insist on austerity and restraint at exactly the time that traditional Keynesian economic policy tells us we should be doing the exact opposite. This alternative viewpoint is not unique: analysts such as Sterdyniak take the same position.

As evidence to support this thesis, look just outside the Eurozone at the United Kingdom. Following their election victory in 2010, the new Conservative government implemented severe austerity measures to get government spending and debt under control. The impact on the economy has been noticeable: in the four quarters prior to austerity measures taking effect (Q4 of 2009 through Q3 of 2010), UK economic growth lagged Eurozone growth by less than 1/3 of a percentage point. In the subsequent four quarters (Q4 2010 through Q3 2011), that spread more than doubled to .75 percentage points of growth. Applying Okun’s rule of thumb and given the size of the UK labor force, this translates into thousands of more unemployed British workers, which in turn only reduces the tax base even more, while increasing the strain on already curtailed public services, thus reinforcing a vicious cycle with very real human costs.

Unringing the Bell: European Integration Too Advanced for Retreat

Regardless of the causes and consequences, the question must be asked: can Europe simply turn back? The knock-on effect of the crisis from one country to the next is a result of these countries being bound together by a single currency, so could the Eurozone simply go back to the pre-2000 world and restore their national currencies, freeing up each country to pursue its own fiscal policies independently? In a word, no.

First of all, the euro is not the only thing – or even necessarily the most important thing – binding the 17 countries of the Eurozone (not to mention the 27 of the wider EU) together. Economic integration began long before currency integration, and it has advanced too far to be unraveled without serious consequences. One stark example of this is the debt itself: it is spread around Europe in a complex web of interdependence such that, for example, French investors have USD 365 billion worth of exposure to Italian debt; Germany USD 117 billion in Spanish debt; and Spain USD 325 billion worth of UK debt. So no country can afford to see any other country go under without serious consequences for its own economy.

Economic interdependence aside, there is also just the sheer legal and financial complexity that would accompany any attempt to turn back the clock. Consider the billions (if not trillions) of euros worth of personal/consumer debts, contracts, purchase orders and other agreements currently in effect and denominated in euros. Now imagine these 17 countries reverting back to their respective francs, marks, pesetas, etc., and trying to revalue these old currencies in light of new realities and then adjusting terms, payments and contracts accordingly. The resulting lawsuits alone would be a nightmare.

So it is unlikely that Europe can go back. But how can it move forward when the Eurozone members have such varying levels of debt, creditworthiness, local policy and sometimes conflicting needs? There is a growing consensus among Eurozone leaders that the status quo will not hold. In December, European leaders met at a summit whose aim was nothing less than the salvation of the euro through ever-tighter integration and stricter rules. By the end of the week, the road map was clear: for better or worse, there was no going back.


I've sought to look at the European Debt Crisis in a new light. The resulting analysis has shown that the crisis is quite different in nature than the ‘talking heads’ have portrayed it, both with respect to cause and impact. I've also shown that the reaction to the crisis in the form of austerity measures, may in fact have proven counter-productive. Finally, I've shown that for all the perils of integration, the Eurozone countries cannot go backwards: a way forward must be found.

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