The narrative outside of Europe about Europe’s fiscal crisis is wrong

Avinash Persaud 17 June 2010



It is commonly argued that because the market knows Eurozone members will bailout their recalcitrant fellow members, market interest rates provide little restraint on deficits, while credit spreads are small and driven by liquidity concerns, not credit.

In this environment, deficits grow to the point where bailouts are no longer credible. It is one of those elegant stories only spoiled by the facts. Paul De Grauwe has marshalled these facts well in his Vox column “Fighting the wrong enemy” (De Grauwe 2010). So what is the real enemy and how do we engage it?

Fiscal trends: US versus the Eurozone

Professor De Grauwe shows that the Eurozone has had a better fiscal trend than the US. Over the past 10 years, US public sector debt to GDP has risen by a third, while it has risen by only half that in the Eurozone.

At the root of the macroeconomic imbalances of the past decade was excessively loose US fiscal policy, not loose European fiscal policy. If the US had tightened monetary policy earlier, it would have improved its internal balance – a euphemism for a less overheated labour market – but it would have potentially worsened the external balance, assuming the higher interest rates would have also led to a stronger dollar that priced the US out of its remaining export markets.

Tighter US fiscal policy on the other hand would have slowed growth and thus eased market interest rates, which in turn would have weakened the dollar, so that both internal and external balance would have been reached. But it does appear likely that higher taxes in particular and tighter fiscal policy can get past the combined force of what the Washington locals call the “Republicants” and the “Demonoes”.

Private versus public debt in the Eurozone

Professor De Grauwe goes on to argue that the real problem in the Eurozone was a rise in private debt, not public debt. Before the financial crisis, Ireland and Spain were the poster children for responsible fiscal policy. Ireland’s debt-to-GDP ratio was halved to 23%, and Spain exhibited a reduction from 60% to 40% in the decade before the crisis. But fiscal conservatism by the public sector was matched by corporate and personal largesse. Once the crash arrived and the private sector had to be bailed out, private sins became public problems.

The need for a new policy instrument for private debt accumulation

Let us now depart from De Grauwe’s little gem of a note. It may not be coincidental that public debt reduction was matched by private debt increases. A combination of lower deficits, credible monetary policy, and low interest rates may have crowded in private investment. Whatever the mechanism and however endogenous, my point is that the rise in private debt was not independent of policy.

We do have a “Tinbergen problem”, i.e. we have run out of policy instruments to deal with a new policy goal. Regional monetary policy focused on Eurozone inflation cannot help crack a national boom. Nor can national fiscal policy be sufficiently finely calibrated to deal with private debt issues. The solution is national regulatory policy.

National regulation, which could take the form of countercyclical charges, loan-to-value limits, tighter leverage ratios, transaction taxes, or other macroprudential tools, would strengthen the integrity of Europe by providing an additional policy tool to manage macroeconomic developments that are more national than regional (Brunnermeier at al, 2009). Macroprudential regulation would have to be focused on activity within a jurisdiction and would be more easily carried out by the host country regulator. It would be made possible by making contracts unenforceable if they have not been subject to host country regulation.

National barriers to the movement of capital are not permissible within the single market, but that does not stop prudential bank regulation from having differentiated regulation. Spain was able to run a mild countercyclical provisioning mechanism. Elements of host country regulation already occur, and as long as activities are defined by where they take place and not by bank origin, this will be possible.

There are parallels between differences in national regulation and differences in national VAT rates among EU members. The mapping and mechanism of higher capital charges could be made consistent across countries to maximise transparency and promote one of the purposes of such tools, which is to direct lending to areas that are depressed from areas that are not.

If the Eurozone’s private debts had risen more moderately, the Eurozone would not be in such a fiscal mess and the euro’s credibility would not be so undermined. What the sharp rise in private debts in certain regions highlights is the difficulty of managing a large region with a single monetary policy, a single economic space, and inflexible and national fiscal policy.

Plainly we need an additional policy instrument – one that is sufficiently flexible to deal with boom-bust. It must also operate on a geographic basis that coincides with potential asset market bubbles, which are more often national than regional or Eurozone-wide.

My European friends may consider this to be un-European, but it is important that the euro is not lost through the excessive worship of common standards. In finance, homogeneity is a false god. Engineering and other disciplines teach us that the integration of diversity creates systemic strength. It is the basis for the robustness of the World Wide Web. Just one superhighway is vulnerable; it is not "fail-safe". Excessive homogeneity will make for a highly brittle system.

Further institutional developments needed

These measures could moderate a private boom, limiting the potential spillover effects on public debt. But Europe needs further institutional developments to deal with Eurozone members that reach unsustainable fiscal positions – regardless of the reasons.

There are many good ideas for institutional development in this eBook. I cannot comment on them all, but I do not believe that a status-quo option is a wise course of action for such a highly interconnected region.

Equally, while I recognise that it was not as much of a problem as feared, the expectation of bailout does allow market discipline to act on fiscal deficits, creating incentives for fiscal largesse. If the solution sounds as if it should lie somewhere in between, then I think it does.

I propose a mechanism where countries can automatically access a fund to swap their debt for the debt of other Eurozone countries, but only on condition that there is an effective 30% haircut. This will address the moral hazard of bailouts – by making them painful – but at the same time “contain” them. For more detail of this proposal see my recent column "How to save the Eurozone: A Greek debt swap" (Persaud 2010).


Part of the panic of crises is the fear that it is uncontained and all-conquering – that no one knows where the bottom of the well is. In this sense, creating a mechanism that puts a bottom on how bad a sovereign debt crisis can get could help prevent panic and contagion.


Brunnermeier , Markus K, Andrew Crockett , Charles A Goodhart , Avinash Persaud, Hyun Song Shin (2009). The Fundamental Principles of Financial Regulation, Geneva Report on the World Economy 11, CEPR and ICMB.

DeGrauwe, Paul (2010) “Fighting the wrong enemy”,, 19 May.

Persaud, Avinash (2010) "How to save the Eurozone: A Greek debt swap",, 18 May.



Topics:  EU institutions

Tags:  fiscal policy, Eurozone crisis, private debt, Eurozone rescue

Emeritus Professor of Gresham College; Non-Executive Chairman of Elara Capital PLC