Mortal Sins

It is much more popular to decry the sins of the embattled countries on the eurozone's periphery than to praise their efforts to return to the narrow path of fiscal virtue. Yet these efforts have been considerable, as shown by calculations released in the most recent Annual Report of the German Council of Economic Experts.

These calculations look at the fiscal balance of each country, adjusted for business cycle fluctuations. Interest payments on public debt are then subtracted from this balance, for higher interest payments undermine efforts to achieve fiscal consolidation in the same way as an unfavourable business cycle. In the German Council of Economic Experts report, this ‘cyclically adjusted primary balance’ is then placed in relation to each country's economic strength – namely, to its production potential. According to this method of calculation, the GIIPS countries – Portugal, Ireland, Italy, Greece, and Spain – as well as the U.S. are all highly indebted.

This is a peculiar finding, for, on average, the GIPPS countries reduced their primary balances from -9.3 per cent in 2009 to -1.7 per cent in 2011. In the case of Greece, these figures are -13.1 per cent and -0.4 per cent. The trend in Italy is perhaps most surprising. Italy not only sets itself apart from the other GIIPS countries due to its positive (!) primary balance. Between 2009 and 2011, it even increased its balance from 0.9 per cent to 1.9 per cent. Yet these efforts have done little to impress financial markets. Quite to the contrary: the financial markets have continued to punish the GIIPS countries with higher interest payments.

We find a completely different situation in the U.S. – a country whose politicians do not grow weary of doling out advice to eurozone nations. The primary balance of the U.S. remained practically unchanged between 2009 and 2011, falling slightly from -4.9 per cent to -4.8 per cent. Yet it would have been a massive miscalculation to expect that the financial markets would punish these deficits with higher bond rates. In fact, the opposite has occurred: financial markets have rewarded the U.S. with low interest rates. Are financial markets simply irrational?

While confidence in the rationality of markets may have suffered a serious blow in recent years, the fact that the GIIPS countries have yet to convince the markets of their stability is more readily attributable to the considerable structural problems that they face, including high public debt ratios, unit labour cost increases that have weakened their international competitiveness, as well as political turbulence in the form of government crises. Yet all of this confirms the key importance of confidence-building efforts to achieve fiscal consolidation and improve international competitiveness.

It is crucial that all parties who seek assistance from the European Central Bank be aware of the overarching importance of stable fiscal policies – and, by extension, of fiscal consolidation in the embattled countries of the euro zone. Some advocate ECB assistance as an alternative to fiscal consolidation. In concrete terms, this would mean the ECB should purchase Italian bonds until Rome finds interest rates to be acceptable. The importance of avoiding this form of central bank intervention cannot be emphasised enough. Historical experience – and not just in Germany – instructs us that the monetisation of public debt is a mortal sin of a central bank. This remains true even in the face of counter-arguments that central bank assistance would only be temporary and that in difficult times one simply has to forget traditional institutional policy wisdom. For clearly, Italy can and must help itself – it has a solid economic basis for doing so. Were Italy to undertake persuasive consolidation efforts that are monitored by the IMF, and gradually reduce its public debt to 120 per cent of GDP, then there is a realistic chance of calming the markets, without the ECB needing to step in as lender of last resort.