The Economist explains
THERE has been an ongoing debate over just how profligate some euro-zone economies were prior to the present debt crisis. Some, like Greece, were obviously irresponsible. For other economies, however, the case is not so clear. Paul Krugman has repeatedly pointed out that Spain was behaving as one might hope before the crash, budgeting responsibly and cutting its debt-to-GDP ratio. Others—among them my colleague—respond that Spain's seemingly sound budget relied on unsustainable capital inflows and was therefore recklessly loose. In the future, they argue, any euro-zone fiscal rules should take into account large capital inflows and require that fiscal policy tighten in response to them in order to prevent dangerous shocks.
These commenters have a point; Spain's fiscal balance created a false sense of comfort unjustified by the gross capital flows facing its economy. But is it reasonable to ask fiscal policy to lean against these inflows? Can tight budgeting prevent the growth of the kinds of imbalances that led to the present European crisis?
In a session on the euro-zone crisis, IMF chief economist Olivier Blanchard offered some reason to be cautious in asking too much of fiscal policy. He agreed that big current-account deficits could be dangerous but pointed out that fiscal policy simply wasn't up to the challenge of controlling typical flows. Mr Blanchard presented the results of an analysis which asked what level of fiscal policy response would have been necessary to keep Spain's current-account deficit at a constant 2.7%. Using a typical estimate of the response of the current account to fiscal changes he showed that it would have taken a Spanish fiscal surplus of 20% of GDP to maintain a reasonable current-account deficit. That's an unthinkably large surplus; achieving it would, in his estimation, have resulted in a contraction of Spanish GDP of 9%. Spain's government would have had to engineer a severe depression to prevent a blow-out in its current-account gap.
That didn't suggest to him that no fiscal efforts would have been justified; a bigger surplus would likely have made sense. Other tools might also have been used; a reduction in allowable loan-to-value ratios in home purchases would have reined in the housing boom and cut capital inflows. But there is only so much a government can reasonably do to constrain these massive capital flows. If the euro zone stays together, they're going to occur again, and corresponding reversals and shocks will also occur again. The euro zone therefore needs to make sure it can handle the shocks without melting down.