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.


Except for Greece, it is unsustainable private sector debt in the banking sector that has been the problem. No surprise here. If banks begin to fail, are insolvent, or reluctant to lend because their assets are under water, government backstop them, and find ways to transfer private debt to government debt or guarantees.

This should make you think a little bit differently about the calls this spring for fiscal austerity in Europe. Were Merkel and others really concerned about their current public debt, or were they really concerned about the debt they knew they might have to assume in the future, and so had to make some room in their budgets for this new private debt.

European leaders probably recognized then that their banking system was overleveraged, and they may need to cut government programs (or raise taxes) to shoulder new private debt from the the private banking system.

In other words, they never believed, nor could you have rationally believed, that there was really a plan to for the Europeans to "austere" their way out of a recession. The Europeans were suckered.

What they were really doing is making room for the private debt they would assume or guarantee in the future.

The Europeans have been conned to the benefit of their banking system, bondholders and bank shareholders. Yeah, it was austerity alright; austerity to benefit someone else other than their citizens.

I think the psuedo-analogy to EU countries as US states forgets about labor mobility (besides lack of fiscal union): Not too many Greeks, Spaniards, or Portuguese able to speak German and English or Irish that can speak German.

One wonder's if Tyler is suggesting that the separation of public and private debt has permanently changed or if it's a temporary condition related to the size of the current problem.

The measured levels of government debt are not the reality. Governments use accounting methods different from those in the private sphere. The question is this- what are government debts of these countries using identical accounting for public pensions and other entitlement promises? For the US, the number you get is much, much higher (and increasing every single year) than if you just count the publicly held debt.

Everyone will have to take a haircut in the end, though we may first go through the charade of transferring private debts to the public ledger and pretend they are all safe.

If I were a space alien visiting Earth for the first time, I might think "Hmm, private capital withholds its resources to drive up the cost of public borrowing, which triggers a huge infusion of public capital to the private sector. I guess these government things are effectively under the control of large-scale private capital interests and intermediaries and exist primarily for their benefit." At least, that's what would seem apparent to my over- or under-size non-Terran head.

While the point of the paper may well still stand, it is unenlightening to compare the debt of governments (which doesn't generally finance the purchase of items on the other side of the balance sheet) with the debt of households (where some of it does) or the debt of banks (where virtually all of it does). The debt of banks is leverage. The debt of governments is taxpayer-funded insolvency.

De Grauwe seems to approve of the practice of governments assuming responsibility for bad private debt, without obvious limits. ("Financial markets were undisciplined and governments took their responsibility when they saved them.") That is what blurs the line between public and private debt. Leaving aside the obvious problem of massive moral hazard created by such a policy, it raises the issue of what kind of reserves governments should maintain against this kind of contingent liability. If the government is to assume contingent liability for private debt during a crisis, it seems to me that it should accumulate much larger reserves during good times. Instead of aiming for cyclical balance of the government budget as usually defined, it should aim for large budget surpluses during good years, surpluses that are larger when the private sector increases its debt. If, for example, Spain and Ireland had run government surpluses of 15 to 20 percent during the boom, they would be in better shape now. De Grauwe's paper would be stronger if he spelled out this implication of his argument.

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