Evidence for the Monetary View of the Eurozone Crisis

Some observers argue that the current problems in the Eurozone are actually the result of a monetary crisis not a sovereign debt crisis.  They acknowledge there are structural problems with European currency union but point back to the failure of the ECB to stabilize and restore nominal spending to expected levels during the crisis of 2008-2009 as the real culprit behind the Eurozone crisis.  This failure to act by the ECB--a passive tightening of monetary policy--has been devastating because it means nominal incomes are far lower than were expected when borrowers took out loans fixed in nominal terms.  European borrowers, both public and private, are therefore not able to pay back their debt and the result is a fiscal crisis.

But it gets worse.  The reduced ability for Europeans to payback debt also means that risk premiums on countries with lots of debt or ones perceived to have debt problems increases, further raising these country's debt burden with higher financing costs.  The fiscal crisis gets bigger, and being easy to observe, gets wrongly credited as the cause of the Eurozone's problems.  Consequently, the Eurozone crisis is prescribed with the fiscal solution of austerity.  The real solution, however, implied by the monetary view of crisis is restoring nominal incomes to their originally expected values. Thus, David Glasner argues that "Europe is having a NGDP crisis not a debt crisis" and Ambrose Evans-Pritchard claims that the Eurozone crisis "is a monetary crisis caused  by a jejune central bank [.]"

I find this monetary view a compelling explanation--though there are deeper structural and political problems that make me question the long-term viability of the Eurozone--for the current crisis in Europe.  It can be summed up in one figure:

This figure shows a remarkably strong relationship between (1) the deviation of nominal income from its expected level and (2) the growth of the debt burden lagged by four quarters.  Thus, if European nominal incomes are less than expected then eventually higher debt burdens increase for the reasons outlined above.

Now lest you think the strong relationship is simply the result of nominal GDP being in the denominator of the the debt burden measure take a look at the following figure.  It shows actual  nominal GDP for the Eurozone and its trend for 1995:Q1-2006:Q4 which are used to construct the percent deviation of nominal income from its expected level in the figure above.  The trend provides an indicator of what nominal income growth expectations were prior to the 2008-2009 crisis.

Note that nominal income falls sharply between 2008:Q2 and 2009:Q3, but actually grows thereafter.  Thus, the ongoing rise in the debt-to-GDP ratio (see figure below) is not just because of the sharp fall in nominal income.  It is because monetary policy has not allowed nominal income to grow fast enough to restore it to expected levels where the debt burden is more manageable.  This in turn, has caused Eurozone debt burden to take off with no end in sight as seen in the figure below of the government debt-to-GDP ratio for the Eurozone:

So yes, the Eurozone crisis is a monetary crisis, a crisis catalyzed by the failure of the ECB to stabilize and restore nominal spending to its expected level.  Again, though, there are longer-term structural and political problems with the Eurozone that arguably are behind the monetary crisis.  Still, if the Eurozone experiment is to be salvaged, then a proper monetary diagnosis of the current crisis has to be realized so that the currency union can survive long enough for it to be salvagable.

Update I: Martin Wolf similarly notes that for many of the crisis-stricken countries in the Eurozone, their fiscal positions did not look that bad prior to the crisis:

Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years. After the crisis, the picture changed, with huge (and unexpected) deteriorations in the fiscal positions of Ireland, Portugal and Spain (though not Italy). In all, however, fiscal deficits were useless as indicators of looming crises (see charts).

Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable. Again, after the crisis, the picture transformed swiftly. Ireland’s story is amazing: in just five years it will suffer a 93 percentage point jump in the ratio of its net public debt to GDP.

 So most of the fiscal problems are a result, not the cause, of the Eurozone crisis.

Update II:  Ezra Klein also shows that the Eurozone crisis at its core is not a debt crisis.