A common narrative has developed that the euro zone crisis is being misdiagnosed as a crisis requiring a fiscal cure. See, Larry Summers here, for example; or Paul Krugman here.
I think most of us can agree that the Irish crisis was predominantly the result of an interacting property and credit bubble. Rising property prices fuelled credit inflows, which in turn fuelled the property bubble. What made the Irish property bubble ultimately so damaging was the fact that it was both a property price and construction bubble. Usually a strong supply response can help deflate or at least limit a price bubble. But the forces driving the price bubble were so strong that the supply response did little to tame it. When it burst it led to both a massive wealth shock and a massive structural shock to the economy given the resources that had been misallocated by the bubble to construction. This in turn led to a series of adverse feedback loops: banking, growth and fiscal. The policy challenge has been so severe because policies to try to stabilise one element of the crisis – e.g. debt stabilisation – tends to make another worse – e.g. growth. The interacting crises reached a second stage of severity once the banks and Government began to lose their creditworthiness. Official support was all that stood in the way of complete meltdown.
It now seems rather beside the point to focus on the fact that the original source of the crisis was not primarily fiscal. (Even the idea that fiscal imbalances were not a major part of the initial vulnerabilities is exaggerated. For Ireland, a large structural deficit was hidden by revenues directly and indirectly associated with the property bubble, as expenditure grew strongly and non property-related revenues lagged. It is true that the design of the Stability and Growth Pact was poorly designed to identify this imbalance. The new Excessive Imbalance Procedure should go some way to rectifying this.) But whatever its cause, restoring debt sustainability and State creditworthiness is now an essential part of the solution to exiting the crisis.
One thing that has become evident is how fragile creditworthiness is in the monetary union for countries with high debts and doubts about political capacity to achieve debt stabilisation. Not having a domestic central bank available to print money as a last resort to repay debt and avoid default is a major source of vulnerability. Euro zone countries have shown themselves to be subject to bad expectational equilibria, where concerns about default risk leads to high market yields, which can make the initial concerns self-fulfilling.
Stronger mutual support mechanisms are needed to give vulnerable countries a reasonable chance of sustaining or regaining creditworthiness. But stronger countries – who themselves have vulnerabilities – are understandably reluctant to take on large contingent liabilities and weaken incentives for fiscal discipline (moral hazard) without reasonable assurances of disciplined fiscal policies from their euro zone partners. Even with beefed up mutual support mechanisms, potential bond buyers are also looking for strong fiscal frameworks to support the political capacity to work back towards debt sustainability and ultimately less vulnerable debt levels. Of course, the solution to the crisis goes beyond the fiscal – a more growth-oriented response from the ECB, for example, would be hugely helpful. But pointing out that the original cause was not primarily fiscal does not seem particularly enlightening or helpful in charting a way out.