Was private or public debt at fault in Europe?
Drawing an analogy with the ill-fated Exchange Rate Mechanism (ERM) of the pre-eurozone era, Paul De Grauwe argues in a new CEPS Commentary that the creation of a sovereign debt default mechanism is a very bad decision that will make the eurozone more fragile by making financial crises an endemic feature.
The full (short) paper is here, recommended. Excerpt:
[apart from Greece]…the root cause of the debt problems is to be found in the unsustainable debt accumulation of the private sectors. From 1999 until 2008, when the financial crises erupted, private households in the eurozone increased their debt levels from about 50% of GDP to 70%. The explosion of bank debt in the eurozone was even more spectacular and reached more than 250% of GDP in 2008. Surprisingly, the only sector that did not experience an increase in its debt level during that period was the government sector, which saw its debt decline from 72 to 68% of GDP. Ireland and Spain, two of the countries with the severest government debt problems today, experienced the strongest declines of their government debt ratios prior to the crisis. These are also the countries where the private debt accumulation was the strongest.
Once sovereign default is in play, De Grauwe predicts self-reinforcing downward spirals can destroyithe eurozone. His points are well-taken, but I would add a few observations:
1. To be a small country, and to "play with matches" without good fire insurance, is also a form of fiscal irresponsibility. It is a more important form of fiscal irresponsibility than we had thought. A'la Robert Eisner, the government's measured budget position is not the key magnitude for measuring its fiscal stance. The three percent rule is partly to blame here, although a lot of countries couldn't even follow that.
2. The distinction between private and public debt ain't what it used to be.
3. Fiscal union was, is, and will remain a fantasy. The best the eurozone could have done was to abolish national banking systems and have a truly European banking market. It's too late for even that, though.