The Euro – A Fiscal Strangulation Mechanism (but mostly for monetary reasons)

In my earlier post The Euro – A Fatal Conceit I argued that had the euro not be introduced and had we instead had freely floating exchange rates then “European taxpayers would (not) have had to pour billions of euros into bailing out Southern European and Eastern European government”. Said in another way had we not had the euro then there would not have been a European “debt crisis” or at least it would have been significantly smaller.

A simple way of illustrating this is to have a look at the debt development in the euro countries (and the countries pegged to the euro) and comparing that with the debt development in the European countries with floating exchange rates.

I use the same countries as in my previous post – The Euro – A Monetary Strangulation Mechanism. 21 euro countries (and countries pegged to the euro) and 10 countries with more or less floating exchange rates.

The graph below shows the development in (median) gross public debt (% of GDP) in the two groups of countries. (All countries are hence equally weighted).

debt change 2007 20014 floaters peggers

The picture is very clear – while both the floaters and the euro countries saw their public debt ratios increase sharply on the back of the 2008 shock (albeit less extremely for the floaters than for the euro countries) – from 2011 there is a very clear difference in the debt development.

Hence, from 2011 the floaters have seen as seen a gradual decline in gross public debt (as share of GDP), while the euro countries (and the peggers) have seen a steep increase in public indebtedness.

So while the floaters have seen their public debt increase by just above 10% of GDP from 2007 to 2014 the euro countries have seen a rise in public debt of more than 25% of GDP!

The graph below shows the individual breakdown of the data.

Publ debt green red

Again the picture is very clear – the euro countries (and the euro peggers) have had significantly more negative debt dynamics than the European floaters. Even if we disregard the PIIGS countries then the euro countries are on average doing a lot worse than the floaters in terms of public debt dynamics .

The euro countries are trying harder, but are succeeding less

One could of course argue that the difference in debt development simply reflects that some countries are just less prudent than other. However, the graph below shows that this is not a very good explanation.

Fiscal tightening

The graph shows the annual change in the fiscal stance (measured as the annual change in IMF’s estimate for the structural public balance as share of GDP). Positive (negative) values are a fiscal easing (tightening).

A few interesting conclusions emerge. First of all overall both euro countries and floaters seem to have had rather pro-cyclical fiscal policies – hence, both groups of countries eased fiscal policy in the ‘good years’ (2005-2009), but tightened the fiscal stance in the ‘bad years’ (2010-14.)

Second, it is notable that the fiscal stance of the euro countries and the floaters is highly correlated and is of a similar magnitude.

So even if the fiscal stance has an impact on growth in both groups of countries it seems a bit far-fetched to in general attribute the difference in real GDP growth between the two groups of countries to difference in the fiscal stance. That said, it seems like overall the euro countries and peggers have had a slightly more austere fiscal stance than the floaters after 2010. (Some – like Greece of course have seen a massive tightening of fiscal policy.)

This of course makes it even more paradoxical that the euro countries have had a significantly more negative debt dynamics than the floaters.

It is not a debt crisis – it is an NGDP crisis  

So we can conclude that the reason that the euro countries’ debt dynamics are a lot worse than the floaters is not because of less fiscal austerity, but rather the problem seems to be one of lacking growth in the euro countries. The graph below illustrates that.

NGDP debt

The graph plots the debt dynamics against the growth of nominal GDP from 2007 to 2014 for all 31 countries (both euro countries and the floaters).

The graph clearly shows that the countries, which have seen a sharp drop in nominal GDP such as Ireland and Greece have also seen the steepest increasing the public debt ratios. In fact Greece is nearly exactly on the estimated regression line, which implies that Greece has done exactly as good or bad as would be expected given the steep drop in Greek NGDP. This leaves basically no room for a ‘fiscal irresponsibility’ explanation for the rise in Greek public debt after 2007.

This of course nearly follows by definition – as we define the debt ratio as nominal public debt divided by nominal GDP. So when the denominator (nominal GDP) drops it follows by definition that the (debt) ratio increases. Furthermore, we also know that public sector expenditure (such as unemployment benefits) and tax revenues tend to be rather sensitive to changes in nominal GDP growth.

As a consequence we can conclude that the so-called ‘Europe debt crisis’ really is not about lack of fiscal austerity, but rather a result of too little nominal GDP growth.

And who controls NGDP growth? Well, overall NGDP growth in the euro zone is essentially under the full control of the ECB (remember MV=PY). This means that too tight monetary policy will lead to too weak NGDP growth, which in turn will cause an increase in public debt ratios.

In that regard it is worth noticing that it is hardly a coincidence that the ECB’s two unfortunate rate hikes in 2011 also caused a sharp slowdown in NGDP growth in certain euro zone countries, which in turn caused a sharp rise in public debt ratios as the first graph of this post clearly shows.

Consequently it would not be totally incorrect to claim that Jean-Claude Trichet as ECB-chief in 2011 played a major role in dramatically escalating the European debt crisis.

Had he not hiked interest rates in 2011 and instead pursued a policy of quantitative easing to get NGDP growth back on track then it seems a lot less likely that we would have seen the sharp increase in public debt ratios we have seen since 2011.

Of course that is not the whole story as the ECB does only control overall euro zone NGDP growth, but not the NGDP growth of individual euro zone countries. Rather the relative NGDP growth performance within the euro is determined by other factors such as particularly the initial external imbalances (the current account situation) when the shocks hit in 2008 (Lehman Brothers’ collapse) and 2011 (Trichet’s hikes.)

Hence, if a country like Greece with a large current account deficit is hit by a “funding shock” as in 2008 and 2011 then the country will have to have an internal devaluation (lower prices and lower wage growth) and the only way to achieve that is essentially through a deep recession.

However, that is not the case for countries with a floating exchange rate as a floating exchange country with a large current account deficit does not have to go through a recession to restore competitiveness – it just has to see a depreciation of its currency as Turkey as seen since 2008-9.

Concluding, the negative debt dynamics in the euro zone since 2008 are essentially the result of two things. 1) The misguided rate hikes in 2011 and 2) the lack of ability for countries with large current account deficits to see a nominal exchange rate depreciation.

The Euro is Fiscal Strangulation Mechanism, but for monetary reasons 

We can therefore conclude that the euro indeed has been a Fiscal Strangulation Mechanism as fiscal austerity has not been enough to stabilize the overall debt dynamics in a numbers of euro zone countries.

However, this is only the case because the ECB has first of all failed to offset the fiscal austerity by maintaining nominal stability (hitting its own inflation target) and second because countries, which initially had large current account deficits like Greece and Spain have not – contrary to the floaters – been able to restore competitiveness (and domestic demand) through a depreciation of their currencies as they essentially are “pegged” within the euro zone.

PS I have excluded Croatia from the data set as it is unclear whether to describe the Croatian kuna as a dirty float or a dirty peg. Whether or not Croatia is included in the sample does not change the conclusions.

Update: My friend Nicolas Goetzmann pointed out the Trichet ECB also hiked interest rates in 2008 and hence dramatically misjudged the situation. I fully agree with that, but my point in this post is not necessarily to discuss that episode, but rather to discuss the fiscal implications of the ECB’s failures and the problem of the euro itself.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Leave a comment


  1. You said “Whether or not Croatia is NOT included in the sample does change the conclusions.” (all-caps added)

    I think you might have meant “Whether or not Croatia is included in the sample does NOT change the conclusions.”

    • Thanks. It has been correct.

      • Tom Brown

         /  July 21, 2015

        You said “It has been CORRECT.” (all-caps added)

        I think you might have meant “It has been CORRECTED.”

        Lol… sorry, I couldn’t resist. (c:

        Good post, BTW.

  2. They(ECB and Germany) don’t understand how debt/gdp works and factors affecting it.

  3. pmsap

     /  July 20, 2015

    Can you point Portugal on the last graph (the plot of gross pub debt vs ngdp change)? Im curious to see where do my country stands on the regression line.

    • Portugal and Spain are more or less on top each other. Portugal has seen a 1.4% drop in NGDP from the average to 2007 to the average of 2014 and gross public debt as share of GDP has increased by 61.7%-point in the same period.

      This means that the Portugues debt development has been slightly worse than one should have expected given the development in nominal GDP (the actual observation is to the right of the regression line. That said I would be careful in drawing too strong conclusion regarding individual countries based on this graph alone.

      Portugal is somewhat different than the other PIIGS in the sense that Portugal (and Italy) also prior to 2008 had fairly weak NGDP growth compared to Spain, Ireland and Greece.

  4. Jussi Lindgren

     /  July 20, 2015

    The main problem is probably that even if one would assume that its technically feasible to control the NGDP-growth in countries like Greece, the amount of QE needed for that would involve, up to some extent at least: 1) The moral hazard via monetizing debt while allowing not to implement structural reforms etc vis a vis compliance with the EU primary and secondary legislation
    2) The side effect of a sufficiently early and strong QE programme would have caused rather high inflation in countries like Germany, which would have lead to substantial political problems in Germany, not least because of the hyperinflation era albeit its an ill-guided fear
    3) The asymmetry of the EZ is still there.

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