Economic Untruths

The popular story is that the current European economic crisis is a debt crisis. Euro zone countries have gotten themselves into their mess because of fiscal profligacy – spending wantonly and racking up huge levels of national debt. The story sounds convincing, but on close inspection it is not true.

The source of the current Euro problems stems from the fact of a single currency for the EU. While there are efficiency gains from sharing a single currency, the downside is a loss of flexibility when asymmetric shocks hit the system, affecting some countries but not others.

Paul Krugman, in his latest book, End This Depression Now, effectively debunks the debt story as being the cause of the EU problems. Krugman identifies a “Eurobubble”, arising from trade imbalances, primarily between Germany and its poorer southern European neighbours. These trade imbalances created capital inflows which if turn fed booms that led to increasing wages and prices in the southern countries and, in Spain, fed a massive housing bubble among other things.

If one looks at the debt to GDP ratios for some key EU countries, we can see that high levels of debt did play a part in the problems of Greece and, to a lesser extent, Italy (see table below). However, many other countries, such as Spain and Ireland, had not accumulated massive debt to GDP levels when the crisis hit.

People who tell the fiscal profligacy story are those who want to tell less than the truth. They are those who would have you believe that all debt is bad and that the answer to the current EU crisis is austerity. The debt story is used to give cover to an ideological agenda that promotes less government and more inequality in the distribution of wealth. The facts, however, show that the debt story is simply not true.

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