A puzzling aspect of European leaders’ fixation on fiscal profligacy is that, of the five PIIGS (ie, Portugal, Italy, Ireland, Greece and Spain), two had government debt-to-GDP ratios that were among the lowest in the eurozone. At least until the outbreak of financial turmoil in 2007.
As the chart below — taken from an article in the European Central Bank’s monthly bulletin — shows, back in 2007 both Ireland and Spain were well within the 60% debt-to-GDP limit prescribed by the Maastricht criteria. And Portugal was only a touch above it.
Ireland had a debt-to-GDP ratio of less than 30%. But it still ran into trouble after having to bail out its banks on the back of Ireland’s monster housing bubble.
Three years on, Ireland’s government debt accounts for more than 100% of GDP.
But, as the ECB article notes, in the conventional analysis of whether or not a country’s debt is sustainable not much attention is paid to levels of private sector “imbalances”.
The research proposes changing this by ensuring that any analysis of fiscal sustainability also includes contingent liabilities, under which falls the cost of rescuing banks.
Contingent liabilities refer to future government liabilities that arise only if a particular event materialises. In the euro area, government guarantees given to financial institutions feature prominently among these liabilities.
In Ireland’s case, government guarantees alone account for an amount equivalent to just short of 43% of GDP.
The article makes an excellent point in highlighting the worrying deficiencies in conventional debt sustainability analysis; the sovereign debt crisis has underlined all too clearly the vicious circle between a state’s finances and the health of its banking sector.
It is of concern too that there is little in the European Commission’s much-vaunted six-pack arrangements that acknowledges the role that credit booms such as Ireland’s have played in the sovereign debt crisis. Though the Commission’s macroeconomic surveillance system – the macroeconomic imbalance procedure – pays attention to levels of private sector debt and house prices, financial sanctions are imposed for missing the targets for fiscal deficits and debt-to-GDP ratios.