Ad Hoc Commentary – the European Franco-German core has virtually no Keynesian capacity

Greece successfully returned to the global capital markets yesterday and sent some Eurozone government yields tumbling to record lows. Yours truly maintains our prediction at the beginning of the year:
“…the European sovereign debt crisis had returned to Europe to target the Franco-German core. Is history repeating itself again now with the Greeks giving France and Germany the Trojan horse of sovereign debt crisis?”

Effectively, France and Germany helped their Greek brethren but they are not immune themselves. This is the year to watch the Franco-German core.

Figure 2.1 on page 22 of the recently released Apr 2014 IMF Fiscal Monitor shows general government expenditure in selected advanced economies had reached over 40% of GDP:
The corresponding dataset is at (we shall refer to it as ‘Fiscal Monitor dataset’):

The data underlying Figure 2.1 of the IMF report comes from Mauro. You can find the paper at:
With the corresponding raw data at (we shall refer to it as ‘Mauro dataset’):

Before we look at the numbers, we remember that most economists out there today are either Keynesians or Monetarists. The Keynesians believes in low interest rates and taxes, and are also well known for their fiscal stimulus. On the other hand, the Monetarists draw mainly on the work of Milton Friedman who believes in the primacy of the money supply. If you had been wondering why Europe suddenly went on a QE fever, as evidenced by even the previously unimaginable Bundesbank tacit approval, it is likely because there is no Keynesian capacity left there.

To embark on a Keynesian journey, one does three things: 1. lower interest rates, 2. lower taxes and 3. employ fiscal stimulus. We look at each of these in turn. First, we cannot possibly lower interest rates much further in Europe because we are hitting zero. To prevent hoarding in a negative rate environment, we need electronic money. No electronic money, no negative rates. Secondly, there is probably no capacity for tax reduction in Europe. We refer readers to Box 6 of the Oct 2013 Fiscal Monitor if they need any further convincing:
“…The tax rates needed to bring down public debt to precrisis levels, moreover, are sizable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) a tax rate of about 10 percent on households with positive net wealth…”

Thirdly, yours truly do not think the constrained balance sheet allows for more fiscal stimulus. To understand why, we remember that it is likely that the hot money that left Asia during the Asian Financial Crisis of the 1990s found its way to the then newly formed European Union and largely remained there till today. Thus, the Europeans had to be very careful with their balance sheet because the foreign holders likely have a propensity to run for the doors as they did in 1997 Asia.
“…The Franco-German core of Europe has combined foreign holdings of 62%. In fact, Europe as a whole seems to boast of a higher % of foreign holdings than most the world. There are many reasons but capital flight from Asia for the glitter of the European Union in the late 1990s could have contributed to it…”

To measure the constraint on more fiscal stimulus, we calculate a metric called ‘constraint’.

‘prim_exp’ be the government primary expenditure as a % of GDP (Mauro dataset)
‘d’ be the gross public debt as a % of GDP (Mauro dataset)
‘% foreign’ be the non-resident holding of general government debt (statistical table 12 Fiscal Monitor dataset)

We define:
‘constraint’ = ‘prim_exp’ + ‘d’*’% foreign’

This is the constraint for the G20:

country prim_exp d % foreign constraint
France 54 86 64 108
Germany 44 81 61 93
Italy 45 120 37 89
United States 39 103 32 72
United   Kingdom 42 82 30 67
Canada 42 85 22 61
Japan 39 230 8 58
Argentina 37 45 29 51
Australia 36 24 46 47
Brazil 32 65 19 44
Mexico 23 44 47 44
Turkey 32 39 29 44
South Africa 30 39 34 43
Indonesia 17 24 50 30
India 23 67 6 28
China 23 26 0 23
South Korea 22 34 0 22


As you can see, France at 108 and Germany at 93 are most constrained. It is likely they cannot embark on any further fiscal stimulus. There are four parts to the expenditure version of GDP, i.e. GDP (Y) = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (X-M). The French public sector is already spending 54% of GDP. Further increases in government spending will be inefficient. Additionally, further deficit spending will deteriorate the public balance sheet that is largely held by foreigners. As Asian Financial Crisis had shown, it is the foreign holders that are most susceptible to run for the door.

The pedantic will point out that latest data point for Mauro dataset is for 2011, while the Fiscal Monitor data is for 2013. The foreign holdings numbers are not a % of all public debt. That is all true, but any further refinement is unlikely to change the big picture that the Franco-German core has virtually no more Keynesian capacity. No wonder investors are flocking into European bonds in anticipation of European QE. There is probably no other way to bring the unemployment down.

Good luck in the markets.