[NOTE: The second part of this analysis is posted in the next post: Eurozone Government Debt and Current Account Deficits]
In my previous post discussing the recent EU "fiscal union" summit, I said:
You'll notice that Spain and Ireland were running fiscal surpluses with acceptable debt/GDP in the years immediately preceding the financial crisis - yet these countries are amongst the worst affected by the meltdown and and in the crosshairs of the ECB and austerity hawks. Slovenia had run modest deficits ahead of the financial crisis and its debt to GDP ratio was low and declining ahead of the crisis - yet, Slovenia's bond yields have been in crisis territory recently and its debt situation is worsening as the economy teeters into recession. Undoubtedly, countries like Greece made their problems much worse with very high levels of deficits and debt prior to the crisis. That said, even Germany ran significant deficits and had high debt levels prior to the crisis - yet, Germany remains relatively unscathed because it has run massive current account surpluses thanks in part to the Eurozone periphery that ran massive trade deficits that benefited countries like Germany.
This is a point that has been made by many people before: rather than fiscal profligacy, the main root cause of the current European financial crisis can be traced back to large current account deficits run by many EU members following the establishment of the Euro as a common currency, culminating in a sudden stop (in the vicinity of the Great Recession) that pummeled the economic and fiscal health of those countries. A useful chart is available from Kash Mansori at The Street Light - along with his follow-up observations...
In their book "This Time is Different: Eight Centuries of Financial Folly", Carmen Reinhart and Kenneth Rogoff point out:
An even stronger regularity found in the literature on modern financial crises is that countries experiencing sudden large capital inflows are at high risk of experiencing a debt crisis . The preliminary evidence here suggests that the same is true over a much broader sweep of history, with surges in capital inflows often preceding external debt crises at the country, regional, and global levels since 1800, if not before.
[I've discussed some of these issues in more detail in a couple of other prior posts: Capital Flow Bonanzas and Their Aftermath and Q&A with President Bill Clinton at the 2011 Clinton Global Initiative, Part 2 - The Financial Crisis in Europe]
Given the known impact of large net capital inflows and current account deficits on fiscal stability, here's a natural question that came to mind in the context of the Eurozone:
Do pre-crisis current account balances, as opposed to pre-crisis fiscal balances, better predict crisis-period fiscal balances (quantitatively) for countries that are part of the European currency union (EMU)?
This post focuses on that question. The answer, as it turns out, is yes and the implications of this are obviously significant in the context of the recently concluded EU summit.
In this post, I summarize the results of a simple analysis of the average current account (CA) and fiscal balances, as a percentage of GDP, for nearly a dozen European countries that use the Euro as their currency [Section 1]. The analysis focused on CA and fiscal balances in the 7 years preceding the start of the Great Recession (pre-crisis) and fiscal balances in the 2008-2010 (crisis) time period. Countries that joined the Euro currency union in 2007 or beyond were excluded from the analysis since they were not on the Euro long enough in advance of the financial crisis. The key finding from this analysis is that the average CA balance/GDP by country for 2000-2007 [Section 3a, 3b] is a much better quantitative predictor of the average fiscal balance/GDP for the same country in 2008-2010, than is the average fiscal balance/GDP of the country in 2000-2007 [Section 2a, 2b].
The analysis was completed with and without Ireland in the mix. Ireland is a massive outlier in the data when it comes to fiscal deficits - likely due to the fact that the main issue in Ireland was large-scale private debt rather than sovereign debt, and sovereign debt ballooned only later because of the Irish government's huge borrowing to bail out private banks during the crisis. With the exclusion of Ireland, the positive correlation between average pre-crisis CA balance/GDP to crisis-era fiscal balance/GDP is very high and even more stark [Section 3c, 3d]. It is significantly higher than the correlation between average pre-crisis fiscal balance/GDP to crisis-era fiscal balance/GDP [Section 2c, 2d].
The findings here raise more questions about the effectiveness of the recently touted EU "fiscal union" which was largely a fiscal austerity pact, with inordinate emphasis on fiscal balances as opposed to CA balances. Specifically, the data shown here indicate that pre-crisis fiscal balances do not effectively predict fiscal balances during downturns/crises - they are less effective in doing so than pre-crisis CA balances. Hence, a "fiscal union" that demands fiscal austerity as a way to ensure low fiscal deficits in the future, with no attention paid to CA balances, is unlikely to consistently prevent large future fiscal deficits. Further, given the limited direct correlation between CA and fiscal balances over the same period of time [see "Baseline Charts" in Section 3], it is quite possible that countries might run fiscal surpluses along with large current account deficits over the same time period, and yet have little or no protection against future fiscal deficits during downturns [as shown in Section 3a-3d]. Finally, a misguided focus on short-term fiscal deficits and debt (as opposed to longer-term fiscal health) is more likely to drive deflationary results as well in the current environment - which could be another negative consequence of the recently announced EU "fiscal union".
1. The Eurozone Countries
According to the European Commission:
The euro is the single currency shared by (currently) 17 of the European Union's Member States, which together make up the euro area. [...]
When the euro was launched on 1 January 1999, it became the new official currency of 11 Member States, replacing the old national currencies – such as the Deutschmark and the French franc – in two stages. First introduced as a virtual currency for cash-less payments and accounting purposes, while the old currencies continued to be used for cash payments and considered as 'sub-units' of the euro, it then appeared in physical form, as banknotes and coins, on 1 January 2002. The euro is not the currency of all EU Member States. Two countries (Denmark and the United Kingdom) agreed an ‘opt-out’ clause in the Treaty exempting them from participation, while the remainder (many of the newest EU members plus Sweden) have yet to meet the conditions for adopting the single currency. Once they do so, they will replace their national currency with the euro.
Which countries have adopted the euro – and when?
2. Eurozone Government Fiscal Balances - Pre-Crisis v. Crisis Periods
The recent EU summit resulted in what one might objectively characterize as a fiscal austerity pact rather than a true "fiscal union" - as discussed before. The pact focused primarily on fiscal deficits (or budget deficits) and sovereign debt of the member countries and sought to set limits on those entities as a percentage of GDP. The strong emphasis on fiscal balances naturally raises the question - is past performance a good predictor of future results? To start with, I therefore compared the average fiscal balance (i.e., government budget surplus or deficit) for each country during the 2000-2007 time period to the average fiscal balance for the same countries during the 2008-2010 period, as well as to the 2010 fiscal balance for the same countries.
I picked 2000 as a staring point since the Euro was only introduced in 1999 (as it turns out, the numbers barely changed even when I used 1999). The 2007 cut-off year was picked to align to the start of the Great Recession in the US and the attendant massive financial crisis. I also looked at the year 2010 by itself to sort of isolate the fiscal situation of the various countries in the first full year after the nominal end of the Great Recession in the U.S. in 2009. Finally, I excluded the following countries from the analysis because they were on the Euro currency for either zero years or a very minimal time period prior to the financial crisis:
- Estonia - since it only joined the EMU in 2011
- Slovakia - since it only joined the EMU in 2009
- Cyprus and Malta - since they only joined the EMU in 2008
- Slovenia - since it only joined the EMU in 2007
All of the fiscal balance, current account balance and GDP data were obtained from Eurostat. I calculated the averages. The data points that are the basis of the charts in this post are summarized in the table below. I took some care to make sure I used the right numbers and even cross-checked some of the fiscal balance numbers with independent sources on the web - so I believe the numbers are correct. Kash Mansori previously published numbers on average CA balances for the 2000-2007 time period and the data below is close to his data but differ sometimes by about 0.5-1.0 % points - he sourced his numbers from OECD and my source is Eurostat and that might explain the deltas. If you find any significant errors, please do alert me (via Twitter or by adding a comment to this post) so that I can make a correction if needed.
Let's dive into the data using a series of charts.
(a) EMU countries - Average Fiscal Balance/GDP for 2000-2007 vs. Average Fiscal Balance/GDP for 2008-2010
The goal of this chart is to see if average fiscal balances prior to 2008 strongly correlated with the average fiscal balances in the 2008-2010 period. The nominal correlation is very weak (R-squared is ~0.08), yet the chart appears to show some limited positive correlation to the naked eye. The #1 reason for the low R-squared is the massive outlier - Ireland (shown in a different color). We'll take a look subsequently at this same chart with Ireland excluded.
(b) EMU countries - Average Fiscal Balance/GDP for 2000-2007 vs. Fiscal Balance/GDP for 2010
The goal of this chart is to see if average fiscal balances prior to 2008 strongly correlated with the fiscal balances for 2010 - the first full year after the nominal end of the Great Recession in the US in 2009. The correlation here is non-existent at face value, with an R-squared of essentially 0. However, as we'll see in a minute, the #1 reason for the poor R-squared is the massive outlier - Ireland (shown in a different color). The large borrowing to bailout private Irish banks caused Ireland's budget deficit to sink.
(c) EMU countries MINUS Ireland - Average Fiscal Balance/GDP for 2000-2007 vs. Average Fiscal Balance/GDP for 2008-2010
In charts (a) and (b) above, Ireland is clearly a massive outlier. Ireland's situation was in some ways more extreme than even that of the U.S., in the aftermath of the Great Recession. As this study shows, Ireland' asset price bubble was much higher than the ridiculously large bubble in the U.S. and the recklessness of some of Ireland's banks is well known. In the early 2000s, Ireland was actually running CA surpluses or small CA deficits - its CA deficits only exploded in the latter years. A key difference between Ireland and some other countries currently suffering from the threat of financial collapse is that sovereign debt was quite modest to small in Ireland - the problem was the enormous private debt of Irish banks, which the Irish government decided to address by going deep into debt at the expense of taxpayers, in order to bail out the banks. Of course, other Eurozone countries also accumulated high private debt, but Ireland was #1 by far. Hence, Ireland's surging sovereign debt was largely the consequence of dealing with large private debt. With the recent Irish bailout, the result was a skyrocketing fiscal (budget) deficit, particularly in 2010 (~minus 31% of GDP !) This bailout-induced single data point significantly distorts the entire data set. I was therefore curious to see what the charts looked like without Ireland in the mix.
The first chart below compares the average fiscal balances prior to 2008, for the EMU countries with the exception of Ireland, to the average fiscal balances of the same countries in the 2008-2010 period. Compared to the full data set above - 2(a) - the extent of the positive correlation is higher without Ireland in the mix (R-squared is ~ 0.54 versus ~ 0.08 previously). That said, it is hard to infer any causation - i.e., conclude that past fiscal balances correlate more or less in linear fashion to future fiscal balances - because there are still several outliers and, as you will see, in a few upcoming charts, this moderate correlation might more likely be a coincidence and could be a result of the relationship between current account balances and fiscal balances.
(d) EMU countries MINUS Ireland - Average Fiscal Balance/GDP for 2000-2007 vs. Fiscal Balance/GDP for 2010
This chart compares average fiscal balances prior to 2008, for the EMU countries excluding Ireland, with the fiscal balances for 2010 - the first full year after the nominal end of the Great Recession in the US in 2009. In comparison to the nominal zero correlation for the full data set - 2(b) above - the correlation here is better; however, it is weaker than case 2(c) above and still has several outliers making it inconclusive.
3. Eurozone Government Current Account Balances (Pre-Crisis) and Fiscal Balances (Crisis)
The more interesting set of charts in my view are the ones below, comparing current account balances (sometimes loosely referred to as trade deficits or surpluses) to fiscal balances (budget deficits or surpluses).
I'd like to start with two charts that show the average current account balance/GDP for 2000-2007 versus the average fiscal balance/GDP for the same time period. The goal of these charts is to serve as a reference to assess whether current account balances are positively correlated to fiscal balances in the same time period.
First, a chart that includes Ireland.
Second, the same chart excluding Ireland - notice the higher R-squared value of 0.47.
In combination with the charts shown below, the above charts suggest that the modest R-squared values for fiscal balances (section 2) are likely the result of the modest same-time-period correlation between CA and fiscal balances.
(a) EMU countries - Average Current Account Balance/GDP for 2000-2007 vs. Average Fiscal Balance/GDP for 2008-2010
Straight away, the significantly higher R-squared (0.50) in comparison to the fiscal balance chart in 2(a) where the R-squared was 0.08, is noteworthy. Even here, Ireland is a major outlier and we'll address that shortly.
(b) EMU countries - Average Current Account Balance/GDP for 2000-2007 vs. Average Fiscal Balance/GDP for 2010
The slightly higher R-squared (0.21) in comparison to the fiscal balance chart in 2(b), where the R-squared was essentially zero, is to be noted - as is the issue of the outlier - Ireland.
(c) EMU countries MINUS Ireland - Average Current Account Balance/GDP for 2000-2007 vs. Average Fiscal Balance/GDP for 2008-2010
Without Ireland, the correlation in the charts gets much stronger. Notice the fairly high R-squared (0.84) - clearly higher than the fiscal-only case of 2(c), where the R-squared was 0.54.
(d) EMU countries MINUS Ireland - Average Current Account Balance/GDP for 2000-2007 vs. Fiscal Balance/GDP for 2010
The stunningly high R-squared (almost 0.9) with Ireland excluded is significantly higher than the fiscal-only case of 2(d), where the R-squared was 0.47.
I do concede that correlation does not always imply causation, that economies are complex and it is not always easy to assess causation. That said, the charts in Section 3 do provide strong evidence that in getting to the root cause of the current Eurozone financial crisis, we are ill-served by ideological lenses that are focused almost solely on fiscal deficits (and debt) and barely on the current account and its impact (not to mention critical measures such as unemployment). Further, given the limited direct correlation between CA and fiscal balances over the same period of time (see "Baseline Charts" in Section 3), it is quite possible that countries might run fiscal surpluses along with large current account deficits over the same time period, and yet have little or no protection against future fiscal deficits during downturns [as shown in Section 3a-3d].
Let me wrap up this post by quoting Paul Krugman:
Germany moved from small current account deficits (the current account is a broad version of the trade balance) to massive, and I mean massive, surpluses.
So what the Germans are in effect saying is that everyone should run huge trade surpluses.
May I humbly suggest that this poses an arithmetic problem?
And this isn’t trivial — the adding-up constraint, the point that if Southern Europe is going to shrink its trade deficits somebody has to move in the opposite direction, is the core of the problem.
Stated differently, how effective is the recently touted EU "fiscal union" likely to be, if it ignores the single biggest contributor to crisis-period budget deficits - i.e., large current account deficits in the pre-crisis years? How likely is such a "fiscal union" to succeed in maintaining low unemployment, low inflation and strong growth for all the countries in the union, when Germany and other core Eurozone countries continue to run ultra-low inflation and high current account surpluses while periphery countries such as Spain, Portugal, Greece and Italy continue to run significant current account deficits? Not very likely, it would seem.