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Three debts: A view from emerging Europe

As the debate rages over the best path for fiscal policy, this column looks at the causes of the Eurozone crisis, especially in emerging Europe. It argues that despite the debate focusing on public debt, the key issue is the development of private debt. That suggests that the key policy remedy would be private debt consolidation supported by countercyclical fiscal policy.

The pressures on fiscal consolidation have mounted dramatically in the wake of the Greek crisis and the “contagion” that followed it across the so-called “weakest links” of Ireland, Italy, Portugal, and Spain. What has come to be called the Eurozone crisis is in part a problem of fiscal sustainability (Wyplosz 2010).

In this column we first examine the development of the “three debts” (public, private, and foreign) and then address the problems of stability and growth in the Eurozone and the transition economies, both those in the EU as well as those aspiring to membership (recent comments on some of the issues include Caballero 2010, Cinzia and Gros 2010, de Grauwe 2010, and wiiw and CEPS 2009). In recent research (Gligorov and Landesmann 2010), we focus on the emerging economies in the east (and south) of Europe where – as in the Eurozone – the debate has recently singularly concentrated on fiscal and public debt problems. We conclude that the key issue has been the development of private debt, both in the bubble period and now after the bubble has burst, and thus the key policy remedy would have to be private debt consolidation especially when it goes together with high foreign debt. Public debt management and thus fiscal policy should be countercyclical in order to support private debt consolidation.

Private and other debts

It may clarify to review the developments of debts in emerging Europe, in the east and the south, before discussing the developments in the euro member states because the debt dynamics, which is essentially the same, is perhaps easier to discern in the former countries. Figures 1 through 3 show the developments of external, private, and public debts for new member states (NMS) of the EU and external and public debts for candidate countries (CMS) for membership in the EU in the Balkans. Invariably, increased opportunity to borrow abroad led to fast growth of foreign and private debts. Public debts are for the most part either stable or declining before the crisis (Hungary being the main exception).

Figure 1. Private debt (% of GDP)

Source: Eurostat and national statistics.

Figure 2. Gross external debt (% of GDP)

Source: Eurostat and national statistics.

Figure 3. Public debt, EU-definition (% of GDP)

Note: BA; MK, ME, RS public debt acc. national definition. Source: Eurostat and national statistics.

Similar developments characterise the Eurozone that have hit the headlines as fiscal delinquents, i.e. Greece, Ireland, Portugal, and Spain. In Figure 4 their public and private debts as well as net foreign assets are displayed. Austria and Germany are added for comparison.

Clearly, private debt growth has been the main driving force in the four countries since the introduction of the euro; household debt is growing the fastest (in Spain corporate debt was also growing). By contrast, there were no significant changes in the various debt ratios in Austria and Germany throughout the period (in the latter there was a fall in private sector debt to GDP ratio). The Czech Republic, Poland, and Slovakia have had similar private and public debt developments (Figures 1 and 2), though their foreign debts are significant and their net foreign asset positions (not shown here) are strongly negative.

Figure 4. Public and private debt (% of GDP)

Source: Eurostat, European Commission.

Much of the debt in Greece, Portugal, and Spain is foreign-owned (see Cabral 2010). What is striking is that the growth of their external debts was mostly driven by private debt increases prior to the crisis, as was the case in the new and candidate member states. Figure 4 records net foreign asset developments. Clearly, the levels in Greece, Portugal, and Spain are quite high. Ireland is different, with relatively low negative net foreign assets; in contrast Germany’s net foreign asset position has become significantly positive. Overall then, it was the growth of private debts that pushed the growth in external debts, and a significant part of the public debt is also owned to foreign creditors.

Public debt developments, on the other hand, had – before the crisis – for the most part little to do with increased debt ratios in all these countries, except for Greece and Hungary. In the aftermath of the crisis, it is the private debt deleveraging that is putting pressure on fiscal balances. This conforms to the historical record of private and public debt dynamics as reported and analysed in Reinhart and Rogoff (2010).

Three problems

In a range of below-average-income economies in Europe, there were apparently private and foreign debt bubbles before the crisis with possibly unsustainable public debt growth in some of these countries after the crisis. How was the development of these bubbles possible?

The general issue of debt developments can be illustrated with public debt. Figure 5 compares the GDP growth rate with the interest rate on public debt (the so-called “snowball effect”) in a selection of countries. Germany, which here represents the more developed and slower growing countries, has a lower growth rate of GDP than the interest rate on public debts. Less developed countries (Bulgaria, Greece, and Hungary, for example) exhibit opposite characteristics and had a choice to run fiscal deficits thereby exploiting the bubble. Most countries chose, however, stable or declining public debt to GDP ratios. This opportunity arose due to low interest rates on Eurozone borrowing. Interest rates were low because Eurozone monetary policy took more account of low German growth and inflation than the conditions in faster growing, less developed EU states or the states closely financial integrated with the Eurozone. The same opportunity opened up for private debt bubbles and this – in contrast to most countries’ public debt developments before the crisis – was clearly exploited.

Figure 5. Public debt, growth and interest rates (euro countries)
Implicit interest rate and nominal GDP growth rate (left scale); gross public debt/GDP (right scale)

Source: Eurostat, European Commission, DG: ECFIN, Spring 2010.

Once the bubble burst and the interest rate shot up, these private and foreign debt had to be repaid and recession set in – the GDP growth rate dipped well below the interest rate on all debts. In addition, fiscal deficits increased as governments took over some of the private obligations. As a result, the public-debt-to-GDP ratio shot up. So, these periphery countries are left with three problems:

i. How to increase exports to pay for foreign debts?
ii. How to increase savings to pay for private debts?
iii. How to finance increasing costs of public debts?

Redirecting and widening the policy mix

Given that there are three problems and thus three policy targets, the Tinbergen rule suggests using three instruments. To address short-term crisis management, the three instruments would normally be:

  • exchange-rate correction in order to address the external balance,
  • debt restructuring to support private debt deleveraging and avoid prolonged debt overhang, and
  • a low enough interest rate to avoid unsustainable developments of public debts or an outright default.

The policy approach currently adopted across Europe resembles the preferred model of the IMF in the past (the Polak model): either decrease public spending, increase tax revenues, or both. For this policy to work, there has to exist a causal connection between fiscal consolidation, current-account improvements, and private deleveraging (problems i and ii above). The existence of that causality and its policy availability in current circumstances is a major issue because fiscal consolidation can influence relative prices only indirectly. If public debt deleveraging on top of the on-going private debt deleveraging could lead to real exchange rate adjustment and thus to foreign debt deleveraging, that policy strategy may work. If not, it risks growing debt defaults due to prolonged recession or low growth. Even if that is avoided, the major risk is a prolonged debt deflation or the Japanese type of prolonged banking crisis (see Kobayashi 2008 and Posen 2010). Thus, these pro-cyclical fiscal policies should be avoided if that is at all possible (the need to pursue countercyclical fiscal policies is still the main policy stance of the IMF in the current circumstances; see IMF 2010).

The alternative policy, where it is available, is to address exchange rate adjustment in order to be able to service the foreign debts. In countries with flexible exchange rates, or those that are outside the Eurozone anyway, nominal depreciation may require private debt restructuring, which would normally be supported by public borrowing. In most countries considered here, especially those in the east and south, there is fiscal space for this policy (Hungary is a major exception).

If nominal exchange-rate adjustment is not possible or available however, private debt consolidation still cannot be avoided and public borrowing should support that process. In other words, countercyclical fiscal policy is still the right answer. The adjustment of the exchange rate will have to happen in an indirect manner via lower domestic consumption and possibly with increased public investments. Furthermore, catching-up economies need policies moving them towards longer-run current-account sustainability to avoid heavily distorting real exchange rate developments. Policy instruments and policy reforms at both national and EU are relevant here: national and EU-level reforms of financial market regulation to contain credit bubbles and avoid credit misallocations, more flexible exchange rate arrangements, and forward-looking incomes policy and industrial policy arrangements (for the latter see Rodrik 2009).


The current debt mess has mostly been caused by the private debt bubble that increased foreign debts and has been supported in part by pro-cyclical fiscal policies. That has led to misalignment in relative prices, primarily in the real exchange rate. Thus, that relative price needs to be corrected and fiscal consolidation bears only a weak and tenuous causal link with it. Preferably, nominal exchange rate adjustment should be used where available, jointly with private debt restructuring and with appropriate fiscal support in many cases. The latter two instruments are essential in the case where exchange rate policy is not available together with a range of shorter- and longer-run instruments that aim to contain credit bubbles, which have often been the source of misaligned real exchange rate developments together with other policies targeting competitiveness in the integrated market environment of the extended European economy.


Brunnermeier, M (2009), “Bubbles”, The New Palgrave Dictionary of Economics.

Caballero, R (2010), “Understanding the Global Turmoil: It’s the General Equilibrium, Stupid”, VoxEU.org 21 May.

Cabral, R (2010), “The PIGS’ External Debt Problem”, VoxEU.org, May 8.

Cinzia, A and D Gros (2010), “Is Greece Different? Adjustment Difficulties in Southern Europe”, VoxEU.org, 22 April.

de Grauwe, P (2010), “Fighting the Wrong Enemy”, VoxEU.org, 19 May.

Gligorov, V and M Landesmann (2010), “The Three Debts: A Look from the East”; wiiw Policy Note; The Vienna Institute for International Economic Studies (wiiw); Vienna.

IMF (2010), World Economic Report; Washington.

Kobayashi, K. (2008), “Financial Crisis Management: Lessons from Japan’s Failure”, VoxEU.org, 27 October.

Posen, A (2010), “The Reality and Relevance of Japan’s Great Recession: Neither Ran nor Rashomon”, STICARD Public Lecture, London School of Economics, 24 May.

Reinhart, C and K Rogoff (2010), “From Financial Crash to Debt Crisis”, NBER Working Paper No. 15795.

Rodrik, D (2009), “Growth after the Crisis”, Commission on Growth and Development Working Paper No 45.

wiiw and CEPS (2009), “Final Report on Financial Risks in Candidate and Potential Candidate Countries”; DG EcFin, European Commission, Brussels.

Wyplosz, Charles (2010), “The Eurozone’s levitation”, in Richard Baldwin and Daniel Gros, Completing the Eurozone rescue: What more needs to be done? A VoxEU.org publication, 17 June.

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