European Crisis Realities: There are basically three stories about the euro crisis in wide circulation: the Republican story, the German story, and the truth. The Republican story is that it’s all about excessive welfare states. How does that hold up? Well, let’s look at public social expenditures as a share of GDP in 2007…. Hmm, only Italy is in the top five — and Germany’s welfare state was bigger. OK, the German story is that it’s about fiscal profligacy, running excessive deficits…. Greece is there, and Italy (although its deficits were not very big, and the ratio of debt to GDP fell over the period). But Portugal doesn’t stand out, and Spain and Ireland were models of virtue.
Finally, let’s look at the balance of payments — the current account deficit, which is the flip side of capital inflows (also from the IMF):
We’re doing a lot better here — especially when you bear in mind that Estonia, a recent entrant to the euro, had an 18 percent decline in real GDP between 2007 and 2009. (See Edward Hugh on why you shouldn’t make too much of the bounceback.)
What we’re basically looking at, then, is a balance of payments problem, in which capital flooded south after the creation of the euro, leading to overvaluation in southern Europe…. [That's] the main way you should think about where we are.
And the key point is that the two false diagnoses lead to policies that don’t address the real problem. You can slash the welfare state… but this has very little to do with export competitiveness. You can pursue crippling fiscal austerity, but this improves the external balance only by driving down the economy and hence import demand….
Now, if you’re running a peripheral nation, and the troika demands austerity, you have no choice except the nuclear option of leaving the euro, coming soon to a Balkan nation near you. But non-GIPSI European leaders should realize that what the GIPSIs really need is a general European reflation. So let’s hope that they get this, and also give each of us a pony.