Is the eurozone crisis a sovereign fiscal crisis?

by on September 19, 2011 at 12:37 pm in Uncategorized | Permalink

It is fashionable to say no (Greece aside), citing the low reported deficits before the crisis.  Spain even had a budget surplus for a while.

Yet the correct answer is “yes, the eurozone crisis is a sovereign fiscal crisis.”

It is not only a fiscal crisis, by any means, but a sovereign fiscal crisis it is and not just ex post.

Let’s say a government had on paper a balanced budget, but wrote a very large naked put, large relative to gdp.  That is not a fiscally sound position, even though it may look OK in the published budget.  If the implicit financial position becomes a vulnerable one,  that government is then insolvent or nearly insolvent, even though you can point to their ex ante balanced budget.

That situation is analogous to the EU, pre-crisis.  The implied naked put was the commitment of governments and banking systems to maintain a one-to-one price between euros in German banks and euros in the banks of the periphery countries. That position has now gone bad.

In bad times, and when accounting gimmicks are rampant, a government’s fiscal policy is best understood as a portfolio of options positions, not in terms of a static balance sheet.

To point to the initial balance sheet is to miss why the whole system didn’t work in the first place.

That said, it remains the case that fiscal austerity on the published balance sheet isn’t a solution.  The governments either have to stop writing the naked puts or prove they can make good on them.

Lazy Federal Employee Posting from Work September 19, 2011 at 1:05 pm

I find it really cute that you continuously comment on the Eurozone as if it were an economic issue. It seems obvious to me that the Euro is not an economic exercise: it is a political exercise. The elites who run the European Union will never abandon or roll back the Eurozone, because they view it as crucial to creating the pan-European identity that will one day form the basis of the single European state that they wish to create. This is an aesthetic, autonomous decision, and reason will have to bend around it rather than bend it.

I don’t know what will happen in Europe, they clearly have issues that need to be resolved, but I am willing to bet money that the use of the Euro will only expand and that the central EU will come out of this with more authority.

Bill September 19, 2011 at 1:31 pm

Agreed.

Rather, it is an issue of who will bear the costs: the banks (and their bondholders and shareholders) or the public.

And, the public is none to keen on it.

Banks purchased bonds knowing the conditions of Greece. Ireland’s problems arise from its government backstopping the banks and their lending, as it will be the case in Spain as well.
There are public costs from poor bank regulatory practices. (Oh, remember the days when Wall Street said that Englands light regulation would cause them to move to London.)

Its just a question of who pays for them.

ThomasT September 19, 2011 at 2:01 pm

100% agree. The EU never was about economic issues and it never will be. Nonetheless, Tyler and his fellow practitioners of the dismal science are a neverending source of amusement to me and deserve every penny of public funding they get just for teh lulz they provide.

Samuel September 19, 2011 at 10:26 pm

Lulz are a positive externality. Where’s my cheque?

charlie September 19, 2011 at 1:08 pm

Isn’t the issue simply that property tax revenues in Euro-zone countries belong to the central government? Property collapses and your revenue plummets. That’s even more true when you cut corporate tax rates in anticipation of property taxes.

Mike September 19, 2011 at 7:51 pm

Their tax systems are probably highly volatile from narrow tax bases and progressive structures.

Tyler describes this in terms of options. Options increase in value with market volatility. If revenues are volatile and expenditures grow faster than average revenues, its only a matter of time before the budget is busted. I’d we clink to the put analogy, we must believe that 1) the government expected volatility to remain low and 2) it received some consideration for writing the put.

The real question is: what consideration does a government get for writing such a put. The answer is the scary part.

The Spanish system is not only volatile by the rate structure and base, but also because of rampant tax evasion and avoidance. People who parade Spain’s surplus around are usually the people who parade Clinton’s surplus, but both were doomed by the very policies which created them – tax and expenditure policies unsustainable with the integral volatility of the tax code.

prior_approval September 19, 2011 at 1:22 pm

‘That said, it remains the case that fiscal austerity on the published balance sheet isn’t a solution. The governments either have to stop writing the naked puts or prove they can make good on them.’
Why does this say ‘dollar’ to me, and not euro? Well, apart from the fact that the U.S. can print as many dollars as it wishes, while at least in theory, the ECB can’t create as many euros as it wants?

Though an exchange rate of 1 dollar to one euro would certainly solve a lot of the eurozone’s difficulties. And for some strange reason, I actually think a couple of people in the current U.S. administration realize that. Especially after the only recently strident anti-eurozone political party in Germany just got blown out of the water in the Berlin elections – though there is no question Germans remain both deeply scared of and adamantly opposed to simply inflating/devaluing a currency. Excessively, that is – export industries remain the basis of the German economy, after all. And such eurozone inflation/devaluing would play no role in eurozone import/exports – one would almost suspect that to have been a factor in creating the euro as part of EU integration within a unified market.

Why would devaluing be something simply reserved for Portugal or Greece? After all, the entire eurozone is very unlikely to see anything too wrong with a 1:1 exchange rate. As for the U.S.? Well, who thinks the people running the eurozone care that much about the U.S.?

The race to the bottom is on – and Europeans have a long and intricate history when it comes to currency manipulation. Just ask the Greeks. Though most people would agree that the Swiss have a solid tradition of currency manipulation through probity, not fraud, which they are currently counting on – to help preserve their export markets.

mw September 19, 2011 at 1:42 pm

‘That said, it remains the case that fiscal austerity on the published balance sheet isn’t a solution.’

Sighhhh..That is Krugman’s entire point. Regardless of whatever enlightened views you might have on the stupidity of the entire Euro system at outset (which Krugman agrees with!), today’s garden variety austerity arguments are premised on the idea that Spain and Ireland’s past behavior means they need to atone for sins of big deficits and reckless spending. Yet no such sins existed at the onset of the crisis, by the same austerity proponents’ own (prior, not anymore, naturally) acknowledgment back when Ireland was the free-marketeers’ poster child.

Mike September 19, 2011 at 8:19 pm

No, you don’t get it at all and neither does Krugman.

Governments get revenue mainly through taxation. They tax the income, sales, and property of their citizens. These sources are volatile and subject to flight. If their tax base is narrow or if their rate structure is progressive, then volatility in income, sales, and property values are amplified in the tax system.

When all is well, revenues are very strong, and such governments must RESIST the temptation to spend or commit the additional revenue, particularly if they think the boom is actually a bubble and not sustainable growth. The stronger the state is committed to welfare, the more its expenditures will rise during the ensuing recession or bust. If the boom attracts migrants, it adds to the government’s expenditures on publicly provided private goods. So these nations must be MORE austere than a more market-oriented model. They can either soak the rich or support the poor, but they CANNOT DO BOTH.

Expenditures must rise at a rate SLOWER than average revenue growth. The more volatile revenues are, the slower expenditures must grow to avoid catastrophic failure of spending and commitments.

So it is precisely their tax policies, welfare policies, and prior sin of excessive spending that got them into fiscal trouble despite any previous accounting surpluses. With such systems, it doesn’t take even a bad recession to erase any surpluses retained as sovereign wealth. And if the sovereign wealth was subject to market risk, its even worse.

If the nation’s sovereign “wealth” consisted merely of being debt free with good revenue potential, a prolonged recession could still do irreparable harm.

mw September 19, 2011 at 8:46 pm

The question seems pretty simple: what is your example of a responsible country to which such a self-fulfilling solvency crisis could not occur, to which recession ought not be met with austerity? If it doesn’t exist, then what value does your model have? Conversely, what is the difference between Greece and Ireland in your worldview? And why should everyone who pronounced the glory of Ireland’s free-market revolution 5 years ago casting off the bondage of big government and regulation not have to admit outright that they were wrong?

The problem with almost every discussion in this ideological corner of the world is that no one is ever willing to describe and accept predictions of their models and say: if x happens in the world, my model must have been wrong. Krugman has been quite clear what his are. The other side, by contrast, is simply never wrong and is, therefore, useless.

Mike September 20, 2011 at 1:05 am

I never made any claims wrt Ireland. Go argue with someone who did.

A government that will not succumb to insolvency is one which has a broad tax base, and low, flat taxes sufficient to pay for minimal provision of public goods, and nothing more. In the case of a truly exogenous crisis, that nation would have sufficient credit to see itself through.

What people with your worldview don’t understand is that most recessions are the result of prior policies aimed at expanding credit, spurring growth, and achieving socioeconomic objectives. There is a big difference between adequate resolution of market failures and all encompassing rule by petty, self interested bureaucrats with unlimited and capricious discretion.

The best way to get out of a trap is to avoid the trap.

Your corner of the world supported the debt financed housing and securitization bubbles.

Your corner of the world supported ever expanding entitlement programs funded with the empty promise of stolen wealth.

Your corner of the world predicted that easy money and fiscal stimulus would hasten this recovery.

Your Xs have already happened, and I’m eagerly awaiting your admission of errors.

mw September 20, 2011 at 8:38 am

I see. Well…I’m taken aback with shock and surprise. Refusal to answer direct questions, make specific predictions or put any model on the line, followed by a series of unqualified broadsides varying from misleading to false (“easy money” in a liquidity trap model–right…). Another fruitful and enlightening debate to reinforce my shining hope for the future.

E. Barandiaran September 19, 2011 at 2:11 pm

Earlier today the NYT reported on Obama’s expected deficit-reduction plan with a headline that said that it will trim spending by $3 trillion. It was a lie as anyone could confirm it by reading the WP headline –$3 trillion in savings, half from new tax revenue. Now Tyler asks if the Eurozone faces a sovereign debt crisis because a NYT columnist said that some years ago most Eurozone countries didn’t have such a crisis.

I have only one question. Why do Americans let the NYT –part of a political party’s mercenary media– insult their intelligence?

Bill September 19, 2011 at 4:16 pm

Yeah, let’s keep those Bush tax cuts that will cost $2.8 billion for the next ten years.

The Anti-Gnostic September 19, 2011 at 5:26 pm

How awful. That’s like, three weeks of operations in Iraq. I just don’t know what we’re going to do.

JSK September 19, 2011 at 5:48 pm

Bill probably meant “billion” where he wrote “billion”.

Bill September 19, 2011 at 7:51 pm

Trillion.

The Anti-Gnostic September 19, 2011 at 8:16 pm

Hey Bill. Over here on the net paying side of the equation, we call taxes costs.

Bill September 20, 2011 at 9:49 am

Anti, I pay much more in taxes than you do. When you put a tax cut on a credit card, like a $2.8 trillion bush tax cut over the next ten years, YOU are not paying. You can’t call your tax cut on a credit card a cost to you.

E. Barandiaran September 19, 2011 at 8:21 pm

At least one American enjoys that the NYT insults him.

Mike September 19, 2011 at 8:24 pm

Tax cuts don’t cost anything. Expenditures cost.

Taxes are costly through their collection costs and deadweight losses as well as their long run impact on growth.

Taxes are only necessary to support the minimal level of public goods and other market failures. We exceeded that minimum level long ago, and we don’t even get all the government we pay for.

Silvia Plank September 19, 2011 at 3:10 pm

@Lazy F. : Yep, I also think, that the Euro is a political exercise to bring Europe closer together and not start wars against each ohther as wars are costly. However the pressure rises as some of the “rich countries” don´t want to pay for the extravagance of the “deptful countries” Greece has very high cost for their military while in Germany there are way too many people very poor, in Germany with HARTZ IV they get unemployment aid only, if they really have nothing left to sell. No car, for instance.

@Bill: My guess is that the tax payers will pay for the costs. I am European and 55,04% go to the state for Taxes and statutory social insurance. If I take the sales taxes into this calculation, it´s 62,5% and I can keep 37,5%. I don´t wish this to anyone.

@charlie: The Property Tax revenues go to the state one usually lives in. However the tax payer can not decide what the state does with them.

@prior: When the Euro was worth only 0,85 Dollars people were really afraid and doubted that the euro was a good idea. Now investors are afraid that the Euro could break down and go out of this currency. That´s why it got cheaper. Swiss tries to have a stable currency, but the currency was manipulated by speculations.

Bill September 19, 2011 at 4:19 pm

Oh, but Sylvia, you don’t get to pay 68% of federal non-discretionary spending on your military (excluding other military expenditures in other agencies). It can be worse if you buy something that has no value. At least you get health insurance which costs around $14-$17k here.

Silvia Plank September 19, 2011 at 4:25 pm

Bill: Well, this year social insurance (= health insurance) gets from me € 20k. We one person untertakers have a very, very small riot going on on facebook (which is great!). And has no value for me. I had to pay € 3k for three teeth and health insurance gave me € 0,28 back. grrmmmlll…

Bill September 19, 2011 at 5:16 pm

Does your social insurance include retirement and lifetime medical care. We still pay for part of medical care when we retire.
Sign me up if it does.

Bill September 19, 2011 at 5:18 pm

Silvia, I never want to be on the bad side of an undertaker, even those participating in riots. My wife would say upon looking at my dead body: Yeah, that WAS his smirk but…

Silvia Plank September 19, 2011 at 6:22 pm

Bill, huh… Yes, they take money from retired persons. Taxes on income (i think). One person of our EPUs Ein = one, Person = person, Unternehmen = business) on facebook “amici delle SVA” (italian: Friends of SVA, the insurance company… it should be “della”, but we don´t really speak italian, but we often think of Cosa Nostra when we get the bills… he was retired, tried to earn some money additionally, declared it… he earned € 1,8k a year and SVA charged him for 1,2 k. That´s not fair. Men and women get some money for maternity leave, but often have to pay as much as they get to the SVA. Not fair.
And … some of us self-employed persons tried to litigate against getting another status, but if for instance an artist earns too much, e.g. with ads, he or she automatically becomes an entrepreneur, which means he becomes a “customer” of the SVA.

prior_approval September 20, 2011 at 11:34 am

‘When the Euro was worth only 0,85 Dollars people were really afraid and doubted that the euro was a good idea.’
Not in my part of Germany, though that has a lot to do with the fact that companies like Siemens, Daimler (cars, busses, and trucks, actually), SAP, and other companies (like John Deere) are major components of the economy around here. They enjoyed the chance to use that apparently abnormally low exchange rate to make a lot of money. In the last three decades, I’ve experienced exchange rates ranging from 4 marks to 1 dollar (quite extreme) to 1.4 marks to one dollar (not quite as extreme) – no one questioned the mark in the entire period.

Of course a lot of Germans are not fans of the euro – but the people running major aspects of Germany’s industry remain very big fans.

And the only party that recently attempted to make any sort of (admittedly opportunistic) euro sceptic position part of their politics was the FDP – which just got crushed in the Berlin elections.

Germans are worried about inflation, and are also big fans of austerity – this is not a good thing when looked at through the prism of a deflationary spiral (or even German history – deflation brought the Nazis into power in the 1930s, not inflation), but such concerns are not a common lesson here, though certainly not unknown.

However, the Greens have a very different idea of ‘austerity,’ and it will be interesting to see whether Germany continues to follow a direction which attempts to deal with current foreseeable problems (importing energy is a real burden, for example) by creating different conditions over the longer term. Certainly does seem to be the right time to be borrowing at low rates for long term projects, for example.

nemi September 19, 2011 at 6:03 pm

so – I guess that most of the financial sector was frauds by the same resoning.

Silvia Plank September 19, 2011 at 6:32 pm

Yes, when retired, a person gets the healthcare benefits for free, but has to pay 20% cost sharing when insured in SVA. Workers or employees don´t have to pay cost sharing. However I think there´s income tax on old-age pensions.

Andrew L September 19, 2011 at 6:18 pm

Well… you’re right that this is a sovereign fiscal crisis, but only as this is a (slightly pointless) argument about semantics. Is this a bit of one-up-man-ship versus Paul Krugman?

The point he seems to make is that this is not, if you allow me to coin a phrase, “a crisis of sovereign fiscal indiscipline”. As Ireland and Spain were – on conventional measures at the time – more fiscally disciplined than Germany (and, of course, Greece).

So, yes, Spain and Ireland had the wrong mix of assets/liabilities on its balance sheet (as, for example, did the UK – which also had somewhat larger deficits and, therefore, weaker fiscal discipline). But at the time, they were considered relatively strong on fiscal discipline.

So it’s not a crisis caused by sovereign fiscal indiscipline.

Silvia Plank September 19, 2011 at 6:43 pm

There´s fiscal discipline and there are tax rates. In my country, every person with an income over € 60 k per year pays 50% for every cent over the 60k. That´s a lot, I guess. About land tax/ property tax: For these taxes a cadastral register is quite helpful. Greece does not have a complete cadastral register.

Andrew September 20, 2011 at 8:27 am

The total level of tax doesn’t matter (too much) to whether or not a government, and a society, has a grip on its public finances. (Obviously, higher tax rates will encourage greater avoidance, but it’s more about the willingness and ability of governments to commit to raising sufficient taxes – over the cycle – to matching spending, i.e. how fiscally disciplined can the authorities be.

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