[NOTE: The second part of this analysis is posted in the next post:
Eurozone Government Debt and Current Account Deficits]
Background
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 [15]. 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.
Summary
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