Indeed, I would add that the claim that welfare policies are somehow responsible for the current debt crisis in Europe is particularly implausible in the case of the Spanish government, which, prior to the financial crisis and ensuing recession, was actually running sizeable fiscal surpluses (see Chart 1). This fact alone should be sufficient to dispel the myth that the current European crisis was the result of uncontrolled and unsustainable government spending. (See Addendum below for data on Ireland and Iceland)
|Chart 1: Cash Surplus/Deficit for Spain, Source: St. Louis Fed|
In fact, in regard to the causes of macroeconomic instability, there is very little empirical evidence to support the view that public sector debt and deficits cause debt crises or have any significant impact on macroeconomic stability. This was demonstrated recently by the research staff of the International Monetary Fund (IMF) in the May 2010 edition of the IMF Fiscal Monitor (2010:67).
As you can see from the chart contained in the Fiscal Monitor (see below), the relationship between government debt as a percentage of GDP and macroeconomic volatility is extremely weak.* The reason for this is that financial crises can afflict nations with either small or large debt burdens. Examples of nations with relatively small debt burdens that were impacted by a financial crisis include those nations affected by the East Asian crisis in the late 90s.
|Chart 2: Macroeconomic volatility and debt level, Source: IMF|
* The purpose of the red horizontal line in the chart is to show that the level of volatility is more or less the same at any ratio of debt.
IMF, Fiscal Monitor: Navigating the fiscal challenges ahead, World Economic and Financial Surveys, May 2010
See here to read Part 1 of this series on deficit myths: The effect of deficits on interest rates
Addendum (added on November 11, 2011)
|Central government debt: Ireland, Spain, Iceland, Source: St. Louis Fed|
|Central government surplus: Ireland, Spain, Iceland, Source: St. Louis Fed|