Christoph S. Weber*
* Friedrich-Alexander Universitaet Erlangen-Nuernberg, Institute of Economics. Address: Kochstraße 4 (17), 91054 Erlangen, Germany. E-mail: [email protected]
Abstract
The term “Euro crisis” gained prominence following the 2008 international financial crisis. However, labeling it a currency crisis is misleading. This article delves into the multifaceted nature of the Euro crisis, arguing it stems from inherent flaws in the Eurozone’s design and was exacerbated by the global financial turmoil. Firstly, we will explore the foundational weaknesses of the Euro. Secondly, we will demonstrate how public debt escalation was triggered by bank bailouts and counter-cyclical fiscal measures. Thirdly, we posit that the Euro crisis is not a singular sovereign debt crisis but a convergence of macroeconomic challenges, including stunted growth, labor market distress, mounting public debt, and persistent current account imbalances.
Keywords: Euro crisis, financial crisis, sovereign debt crisis, unemployment, balance of payment imbalances.
Introduction
In the nascent stages of the subprime mortgage crisis in 2006, few anticipated its potential to trigger the most profound global recession in the post-war era. This perception shifted dramatically with the collapse of Lehman Brothers in September 2008. The ensuing shockwaves reverberated across the US, Europe, and beyond, as numerous financial institutions faced substantial losses from investments in asset-backed securities. The US financial crisis cascaded into Europe, precipitating a recession within the Eurozone in 2009. Yet, the prevailing belief was that the subprime crisis would not morph into the most severe crisis post-war Europe had encountered. By 2009, the financial crisis in Europe morphed into a distinct entity, the “Euro crisis.” This crisis is fundamentally economic and political, but crucially, it is not a crisis of the Euro currency itself. Therefore, the term “Euro crisis,” while widely used, can be considered a misnomer.
This article aims to dissect the primary factors underpinning the Euro crisis. As previously indicated, the crisis is largely an outgrowth of the 2008 financial crisis. Furthermore, this analysis will reveal that Europe is grappling not with a singular macroeconomic crisis, but a cluster of interconnected challenges. The Euro crisis encompasses a Gross Domestic Product (GDP) growth crisis, a surge in unemployment, a sovereign debt crisis, and a balance of payments crisis.
The structure of this article is as follows: initially, we will provide a historical overview of the Euro and examine theoretical considerations pertinent to currency unions. Subsequently, we will analyze the root causes of the Euro crisis. Following this, we will delineate the various facets of the Euro crisis. Finally, we will present concluding remarks.
A Brief History of the Euro
The Euro’s origins can be traced to two preceding systems. The first was the “currency snake,” established in 1972/73 by the European Economic Community (EEC) to manage exchange rate fluctuations. This system aimed to maintain currencies within a ± 2.25% band. However, it proved unsustainable. The second precursor was the European Monetary System (EMS), created in 1979, which introduced the European Currency Unit (ECU), an artificial currency. The EMS comprised 12 member states but faced speculative pressures. Consequently, the UK and Italy withdrew from the EMS in 1992. Around the same period, Jacques Delors proposed the concept of a unified European currency. This vision materialized with the Maastricht Treaty of 1991/1992, which significantly reshaped the European Community (EC). The treaty was built upon three pillars. Crucially, it incorporated the EC, which itself encompassed four components, including the Economic and Monetary Union (EMU). The EMU was implemented in three phases. The initial phase involved the European Exchange Rate Mechanism (1990-1994). The second phase (1994-1999) saw national central banks gain instrument independence and the establishment of the European Monetary Institute (EMI), the precursor to the European Central Bank (ECB). The ECB commenced operations in 1999 and is an integral part of the European System of Central Banks (ESCB), which now dictates monetary policy for the Eurozone. The Euro was launched as an electronic currency at the start of 1999, while physical domestic currencies remained in circulation until 2002. Since 2002, the Euro has been the sole legal tender within the Eurozone. Prospective Eurozone members must satisfy the Maastricht criteria. These include: inflation rates no more than 1.5 percentage points above the average of the three best-performing EU countries; exchange rate stability within EMS bands for two years; long-term nominal interest rates not exceeding the top three performers by more than 2 percentage points; and crucially, government budget deficits capped at 3% of GDP and a debt-to-GDP ratio not exceeding 60%. While the initial three criteria were generally manageable, the fiscal benchmarks posed challenges for several nations. However, budget deficits could be artificially reduced through privatization and similar measures, shifting the focus to gross public debt. Ultimately, most EC countries met these criteria, with notable exceptions like Italy, Belgium, and Greece. Although Greece was initially excluded from Euro adoption in 1999, Italy and Belgium were admitted despite not fully meeting the debt criterion. Greece subsequently joined in 2001, even with a debt-to-GDP ratio exceeding 60% and, as revealed in 2004, falsified economic statistics. This highlights a fundamental flaw in the Euro’s architecture. The intended fiscal discipline enforced by the Maastricht criteria proved to be flexible. Political maneuvering allowed goalposts to be shifted. Over the past two decades, numerous countries have breached the deficit criterion, some repeatedly. Yet, the Maastricht deficit procedure, which stipulated penalties, was inconsistently applied. In 2002 and 2003, France and Germany exceeded deficit limits but pressured Eurozone partners to waive sanctions, undermining the Maastricht Treaty’s legal framework. Consequently, the Maastricht criteria functioned more as guidelines than binding rules. The Treaty also incorporated a no bail-out clause, prohibiting member states from assuming responsibility for others’ debts. The foundational premise – that criteria would serve as benchmarks and the no bail-out clause would prevent debt contagion – proved overly optimistic.
Optimum Currency Areas and the Eurozone’s Reality
The Euro’s creation was primarily a political endeavor, not purely an economic one. This political impetus explains the inclusion of countries with high public debt and the overall establishment of the currency area. Extensive academic literature explores the conditions under which countries should form a currency union. The “impossible trinity” model posits that a nation can only simultaneously maintain two of the following three policies: free capital mobility, autonomous monetary policy, and fixed exchange rates. Eurozone countries have opted for fixed exchange rates within the bloc and full capital mobility, thereby relinquishing autonomous monetary policy. But why would a country willingly forgo monetary policy independence? Economic theory offers insights. Robert Mundell (1961) pioneered the theory of optimum currency areas. The central question is: How effectively can economies manage asymmetric shocks? Nations with flexible exchange rates can devalue their currencies to enhance external competitiveness. This mechanism is absent within a currency area; only the entire currency bloc can devalue against external currencies. However, factor mobility (capital and labor) can compensate. If a negative demand shock hits one member (e.g., Spain) while another experiences a positive shock (e.g., Germany), wages and returns on capital should adjust accordingly – decreasing in Spain and increasing in Germany. Migration of labor and capital from Spain to Germany would theoretically restore equilibrium, leading to price and wage increases in Spain and decreases in Germany. This hinges on free factor mobility and the willingness of workers and investors to relocate. While the EMU mandates free capital and labor movement, practical limitations exist, especially for labor.
Moving to another country is significantly more complex and costly than transferring capital. Language barriers pose a substantial obstacle. The Eurozone encompasses 18 countries with 16 official languages. English is not universally the working language, particularly in manufacturing. Furthermore, professional qualifications are not easily transferable across borders. For instance, nursing education requirements vary significantly between countries like Italy and Germany. Most importantly, personal and social ties often deter individuals from relocating internationally. However, McKinnon (1963) argued that openness, rather than factor mobility, is paramount for a successful currency area. Highly open economies are less driven by domestic supply and demand. In such economies, currency devaluation might be counterproductive, leading to imported inflation that erodes competitiveness. If imports are crucial inputs for exports, export prices might also rise. Furthermore, domestic wages could increase in response to imported inflation, further diminishing price competitiveness. Therefore, the viability of a currency area depends on the degree of economic interconnectedness. The following tables illustrate intra-regional trade percentages for various regions.
Tables 1 and 2 display average intra-trade percentages for selected regions. Notably, intra-Eurozone trade is not exceptionally high, even without currency risk. The Free Trade Area of the Americas (FTAA) exhibits higher intra-regional export proportions despite currency risks. Moreover, the European Union (EU) as a whole, rather than just the Eurozone, appears to be the primary driver of intra-regional trade. EU 27 figures surpass those of the Eurozone, despite the Eurozone being smaller. Finally, intra-Eurozone trade percentages have slightly decreased since 2003. However, the McKinnon criterion of openness is largely satisfied.
Kenen (1969) offered a third perspective, suggesting that diversified economies are better equipped to handle asymmetric shocks. Economies producing a wide array of goods and possessing diversified export sectors are less vulnerable to sector-specific shocks. Such shocks tend to be self-correcting in diversified economies. Thus, fixed exchange rates are advantageous for countries with diversified production. Limited research examines this specifically within the Eurozone. Baldwin and Wyplosz (2004) suggest that product diversification is reasonably high in Europe, albeit with significant inter-country variations.
Considering these theoretical frameworks, the Eurozone’s status as an optimum currency area is debatable. However, other currency areas, including the US, also fall short of ideal criteria. Yet, the US features fiscal transfer mechanisms from prosperous to less prosperous regions, a feature absent in the Eurozone, where fiscal and economic policies remain national prerogatives. Why, then, did countries like Greece seek Eurozone membership despite potential drawbacks? A primary motivation was likely the expectation of reduced interest rates for domestic borrowers, including governments, upon Euro adoption. This indeed materialized after the Euro’s introduction. In conclusion, the common currency project was fundamentally political. Political decisions shaped the Euro’s design and the inclusion of countries that did not fully meet economic criteria. The EMU, therefore, possessed inherent structural weaknesses from its inception. While these weaknesses did not directly cause the crisis, they amplified its impact in various ways.
Root Causes of the Euro Crisis
Having examined the Eurozone’s institutional framework, and noting instances of Maastricht criteria breaches, we must consider whether the current crisis is solely attributable to excessive government spending. Analyzing government debt and deficit data is instructive. Tables 3 and 4 present public deficit and debt figures for all Euro member states.
Bold figures in tables 3 and 4 indicate Maastricht criterion violations. Several key observations arise. Greece and Portugal consistently exceeded deficit targets throughout their Euro membership. Even Germany occasionally failed to meet the deficit criterion. Conversely, Spain and Ireland, which later faced severe economic challenges, were initially exemplary in terms of public deficits, even achieving budget surpluses before 2008. However, Spain and Ireland could have leveraged their revenue booms from credit and housing bubbles more effectively (Lane, 2012). From 2009 onward, most nations struggled to meet the 3% deficit limit. Public debt data reveals a similar pattern. Austria, Belgium, Greece, and Italy consistently failed to meet debt requirements. Germany met the debt criterion only once. Spain and Ireland again stood out as top performers, reducing their debt-to-GDP ratios until 2008. The Eurozone as a whole reduced its aggregate debt-to-GDP ratio between 1999 and 2007. However, the situation drastically changed after 2008. Debt-to-GDP ratios surged across the Eurozone, directly linked to the onset of the 2008 financial crisis.
Therefore, the primary driver of the current European crisis is not structural flaws in the Eurozone’s design. No sovereign debt crisis existed in Europe prior to 2008. The Euro crisis is fundamentally a consequence of the US subprime crisis that began in 2007. This raises the question of why Europe was so acutely affected. Many European banks held substantial investments in Asset-Backed Securities (ABS). European monetary policy after 2001 was relatively expansionary. This encouraged banks and investors to seek alternative investments as traditional bonds yielded low returns. ABS appeared attractive due to consistently high ratings and better yields. Banks could cheaply borrow from the ECB and invest in high-yield ABS. Another factor contributing to European exposure to subprime ABS was the large US current account deficit, requiring external financing. This deficit was partly funded by selling ABS to surplus countries, particularly Germany and the Netherlands. When the Federal Reserve (FED) raised interest rates in 2006-2007, the US housing bubble burst, and ABS values plummeted, leading to massive bank write-downs and interbank mistrust. Depositors withdrew funds, and interbank lending froze. However, relative calm prevailed until Lehman Brothers’ collapse, which triggered global stock market crashes, further bank losses, and widespread solvency and liquidity concerns.
A key distinction between continental Europe and Anglo-Saxon economies is the financial system structure. Anglo-Saxon systems are market-oriented, while continental European systems are bank-dominated. European companies, especially SMEs, primarily rely on bank loans for financing, making banks central to the real economy. Furthermore, domestic banks in Europe are relatively large compared to their national economies. Several banks’ balance sheets exceed 100% of their home country’s GDP. European banks also tend to invest heavily in domestic assets and government bonds, creating interdependence between banks and governments. Bank solvency is linked to sovereign solvency, and vice versa. This interdependence compelled European governments to bail out banks. Many banks required restructuring, recapitalization, or liquidity injections. Figure 1 illustrates the scale of bank rescue measures in the Eurozone.
Figure 1. Rescue Measures in the Euro Area
Alt text: Bar chart showing the total rescue measures in billions of Euros in the Euro Area from 2007 to 2010, broken down by guarantees, relief measures, recapitalization measures, and liquidity measures. The chart shows a significant increase in guarantees from 2008 to 2009, followed by a slight decrease in 2010, while other measures remain relatively stable.
As figure 1 shows, rescue measures included guarantees, relief measures, recapitalization, and liquidity support. Guarantees constituted the largest portion, reaching €320 billion in 2008 and more than doubling in 2009 and 2010. Examining bank restructuring between 2008 and 2010 reveals that Italy (19) and Austria (17) restructured the most banks, still significantly fewer than the US (53). Interestingly, Spain only closed three banks. Spain, heavily impacted by the crisis and a domestic housing bubble burst, might have been expected to restructure more banks, particularly distressed savings banks (“cajas de ahorro”). Two primary reasons explain Spain’s limited bank closures. First, policymakers were acutely aware of housing market vulnerabilities. More bank closures could have further depressed prices through increased foreclosures. They also aimed to maintain bank lending to stabilize the economy. Second, the government was wary of the substantial fiscal costs of widespread bank restructuring and hesitated to fully address the banking sector’s problems. In hindsight, delaying banking sector cleanup was a major policy error. Countries like the US, which acted decisively to resolve banking issues, are now in a stronger economic position.
However, the fundamental cause of the sovereign debt crisis is excessive private debt accumulation, not solely public debt. Banks and individuals aggressively increased borrowing, but these funds were often channeled into consumption and real estate speculation rather than productivity-enhancing investments.
Figure 2 illustrates private debt trends in selected Eurozone countries. Private debt expanded rapidly until the financial crisis. Only a few countries managed to stabilize private debt as a percentage of GDP after the crisis erupted. Spending in PIIGS countries (Portugal, Ireland, Italy, Greece, Spain) was fueled by capital account surpluses (see section “The Balance of Payment Crisis”). Borrowing was heavily directed towards housing. At the peak of the housing boom, construction investment reached 22% of GDP in Ireland and 18% in Spain (Neubäumer 2011, p. 828). Spain and Ireland experienced pronounced housing price bubbles that burst shortly after the subprime mortgage crisis.
Figure 2. Private Debt in Selected Euro Area Countries
Alt text: Line chart showing the evolution of private debt as a percentage of GDP in selected Euro Area countries (Germany, Ireland, Italy, Portugal, and Spain) from 1999 to 2011. The chart indicates a significant increase in private debt in Ireland, Portugal, and Spain until 2008, followed by stabilization or slight decrease, while Germany and Italy show a more moderate and stable trend.
In summary, the financial crisis is the core origin of the Euro crisis. Before the financial crisis, the Eurozone managed to navigate its inherent structural issues. The Great Recession compelled nations to implement bank and company bailouts and adopt expansionary fiscal policies to mitigate the recession’s impact.
The Multifaceted Euro Crisis
Having analyzed the causes, we now examine the diverse symptoms of the Euro crisis. The current crisis is not merely a sovereign debt issue, but a confluence of crises. The four primary dimensions are: a growth crisis, a labor market crisis, a sovereign debt crisis, and a balance of payments crisis.
The Growth Crisis
The Eurozone is not only facing a sovereign debt crisis, but also a significant growth crisis. The financial crisis triggered a Eurozone-wide recession in 2009, impacting all member states. Figure 3 displays real GDP growth rates for selected countries and the Eurozone average. The data reveals a double-dip recession pattern, characteristic of banking crises.
Figure 3. Real GDP Growth
Alt text: Line chart showing real GDP growth rates for selected Euro Area countries (Germany, Greece, Ireland, Portugal, Spain) and the Euro Area average from 2000 to 2012. The chart illustrates a sharp decline in GDP growth in 2009 across all countries, followed by a partial recovery and a second dip around 2012, with Germany showing a more resilient recovery compared to the other countries.
Prior to the financial crisis, Germany was often termed “the sick man of Europe” due to below-average Eurozone growth rates. This dynamic reversed dramatically. Germany emerged as the Eurozone’s economic anchor. Without Germany’s performance, the Eurozone likely would have experienced recessions in 2010 and 2011 as well. While Germany recovered, other countries remained mired in recession. Several factors explain this divergence. First, Keynesian economics highlights the impact of austerity. Countries with high public debt adopted or were compelled to implement austerity measures. Public spending cuts and tax increases, contrary to Ricardian equivalence, had multiplier effects, exacerbating the recession. Recessions forced further austerity, creating a negative feedback loop. Simultaneously, monetary policy was ineffective as banks, still weakened, were reluctant to lend to businesses and investors. Second, inflation and wage differentials led to varying competitiveness levels. Southern Eurozone states with higher inflation rates lost price competitiveness against northern states like Germany, contributing to current account imbalances (see section “The Balance of Payment Crisis”). Third, some economies grapple with structural weaknesses. Portugal, for example, once a textile producer, now faces competition from cheaper Asian producers and high-quality Italian manufacturing. Some European economies lack sustainable business models, leading to labor market distortions, discussed next.
The Labor Market Crisis
The severe European recession deeply impacted labor markets. Rising unemployment is a typical consequence of banking crises (Reinhart and Rogoff, 2008), and Europe was no exception. Figure 4 presents unemployment rates for selected countries and the Eurozone average.
Figure 4. Unemployment Rates
Alt text: Line chart showing unemployment rates for selected Euro Area countries (Germany, Greece, Ireland, Portugal, Spain) and the Euro Area average from 2000 to 2012. The chart depicts a significant increase in unemployment rates in Greece, Ireland, Portugal, and Spain after 2008, while Germany shows a decrease in unemployment during the same period. The Euro Area average also increases but less dramatically than the crisis-affected countries.
Brada and Signorelli (2012) argue that labor market performance variations post-recession are largely explained by institutional quality, labor market flexibility, and structural factors. We have already noted structural issues in economies like Portugal. In Spain, at the peak of the real estate bubble, approximately one in four workers was employed in construction, a sector severely impacted by the bubble’s collapse. Neoclassical theory offers another perspective, focusing on unit labor costs. Figure 5 displays unit labor costs for select Eurozone countries.
Figure 5. Unit Labor Costs (Index)
Alt text: Line chart showing unit labor costs index for selected Euro Area countries (Germany, Greece, Ireland, Italy, Portugal, Spain) from 1991 to 2012 (Index, 1999=100). The chart indicates increasing unit labor costs for Spain and Portugal throughout the period, a slight increase for Italy until 2009, decreasing costs for Ireland, and relatively stable costs for Germany after an initial increase and subsequent decrease.
Figure 5 shows unit labor costs indexed to 1999. Spain and Portugal experienced continuous increases in unit labor costs. Italy’s costs rose until 2009. Germany’s costs increased until 1996 and then slightly declined. Ireland shows the most dramatic decrease. Rising unit labor costs in Spain and Portugal suggest that nominal wage increases outpaced inflation and productivity gains. Why did these countries fail to achieve productivity gains? Nominal wages rose excessively, pushing up unit labor costs. Increased aggregate demand boosted labor demand, but capital inflows were primarily directed to consumption rather than productivity-enhancing investment, resulting in modest productivity growth. Consequently, competitiveness eroded. It’s important to note that this figure does not reflect absolute unit labor cost differences between countries. Germany’s absolute unit labor costs remain higher than in countries like Greece. However, cost is not the sole determinant of competitiveness. Germany’s competitive advantage lies partly in high-quality products (e.g., engineering goods), where product quality and customer focus are more critical than price (Schröder, 2010). This explains Germany’s strong performance despite relatively high real wages. Wage bargaining structures may also explain wage trend variations.
Calmorfs and Driffill (1988) argue that centralized or decentralized wage bargaining systems lead to lower real wages and unemployment. Sector-level wage bargaining tends to result in higher unemployment due to higher real wages. Trade union density, a proxy for wage bargaining centralization, is high in Finland, slightly above OECD average in Germany, Portugal, and the Netherlands, and above average in Spain. Greece, Italy, and Ireland have moderate trade union density. However, employment protection strictness is another factor. OECD data indicates Portugal has very high employment protection. Germany also has relatively high levels. This suggests that trade union density data alone is insufficient to explain labor market outcomes. However, dismissal protection and minimum wages are significant contributors to high youth unemployment in countries like Spain. Finally, labor market institutions play a critical role. The Diamond-Mortensen-Pissarides model highlights search frictions in labor markets, leading to simultaneous vacancies and unemployment. The Beveridge curve (figure 6) illustrates the relationship between vacancy (v) and unemployment rates (u). The current state depends on the Beveridge curve and labor market tension (Θ), which is influenced by labor demand and employee bargaining power (wage-setting curve).
Figure 6. Beveridge Curve: Germany and Spain
Alt text: Scatter plot showing the Beveridge Curve for Germany and Spain, plotting unemployment rate against vacancy rate (both in percentages) from 2005 to 2012. The chart illustrates Germany’s Beveridge curve shifting inwards over time, indicating improved matching efficiency, while Spain’s curve appears to shift outwards, suggesting worsening matching efficiency.
Simultaneous decreases in vacancy and unemployment rates require improved matching efficiency, achievable through reduced regional and qualification mismatches, i.e., lower separation rates or improved matching processes. Germany’s labor market “miracle” can be attributed to several factors, including labor market reforms in 2003/5 that improved matching processes. These reforms also aimed to incentivize unemployed individuals to accept lower-wage jobs by shortening unemployment benefit entitlement periods. Increased labor market flexibility through temporary employment and flexible working hours (working-time accounts) also contributed (Möller, 2010). These combined reforms significantly improved Germany’s labor market. The Beveridge curve shifted inward, reducing structural unemployment. Labor market reforms in other Eurozone countries should prioritize improving matching processes and reducing regional and qualification mismatches through active labor market policies.
The Sovereign Debt Crisis
The sovereign debt crisis is often mistakenly equated with the entire Euro crisis. Some aspects were discussed in “Causes of the Euro Crisis.” Public debt was already elevated in some countries before Euro adoption, while in others, it surged due to the financial crisis. Large post-crisis public deficits resulted from bank bailouts and recession-fighting fiscal policies. Increased government spending, expansionary fiscal policies, and rising social expenditures (e.g., unemployment benefits) coincided with decreased public revenues due to lower income and corporate tax receipts and reduced social security contributions. However, this is only part of the narrative. Government bond yields in selected European countries (figure 7) provide further insights.
Figure 7. Government Bond Yields
Alt text: Line chart showing 10-year government bond yields for selected Euro Area countries (Germany, Greece, Ireland, Italy, Portugal, Spain) from 2005 to 2012. The chart illustrates a convergence of bond yields before 2008, followed by a sharp divergence after the financial crisis, with yields for Greece, Portugal, and Spain increasing dramatically, while German yields remain low, indicating increased risk perception for peripheral Eurozone countries.
Prior to the Euro, government bond yields varied considerably. As the Euro’s introduction approached, spreads between German and French bonds and those of Italy, Spain, Portugal, and Greece narrowed significantly. From 1999-2001, yield differences were minimal, suggesting investors perceived similar risk across these countries. The turning point occurred in the latter half of 2008. German and French bond yields decreased, while Greek, Italian, Spanish, and Portuguese yields rose sharply. Portugal and Greece exhibited the most dramatic increases. Spreads between these countries’ bond yields and German yields widened from near zero in January 2005 to over 25% (Greece) and 10% (Portugal) within a few years. This raises doubts about investor rationality and information processing. Rating agency actions further fuel these doubts. Between October 2003 and September 2004, Greek government bonds held an A+ rating (Fitch), the fifth-highest investment grade. Ireland held a AAA rating until 2009, Portugal AA until September 2009, and Spain AA+ until March 2011. Greece’s rating plummeted from A to RD (partial default) within just 2.5 years. This questions the initial A rating’s accuracy. This is not to criticize rating agencies, but to illustrate the widespread belief that Eurozone countries were immune to such severe crises or would be bailed out if trouble arose.
With public debt elevated post-financial crisis, debt reduction is crucial. However, simultaneous reduction of public and private debt is challenging. The US prioritized private debt reduction. Several European countries pursued austerity to reduce public debt, leading to continued private debt growth. The latter approach appears less effective as neither public nor private debt has been substantially reduced. Equation (1) illustrates debt dynamics:
(1) bt = ( 1 + r – g ) bt-1 + dt
Where bt is the debt-to-GDP ratio in year t, r is the interest rate, g is GDP growth, and dt is the primary balance (revenues minus expenditures excluding interest payments). Debt-to-GDP ratio reduction requires GDP growth exceeding the interest rate or a primary surplus (dt > 0). PIGS countries face high interest rates. While figure 7 shows yields, not actual interest rates, it illustrates the challenges. Consider Portugal in 2012: GDP declined by 3.2%, and yields reached ~12%. Portugal would need a primary surplus exceeding 15% of GDP just to stabilize its debt-to-GDP ratio. However, table 5 shows Portugal had a primary deficit.
Table 5 displays primary balances for selected Eurozone countries. Bold figures indicate primary deficits. Portugal consistently ran primary deficits. Pre-2008 debt-to-GDP ratio stability was due to GDP growth. Why didn’t debt-burdened countries implement deeper spending cuts? They faced a dilemma. Spending cuts and tax increases might create a primary surplus, but they also trigger deeper recessions due to Keynesian multipliers, potentially increasing the debt-to-GDP ratio. GDP growth is essential for debt reduction, but it cannot be driven by increased public spending. Growth can be stimulated by expenditure in less indebted countries (e.g., Germany) or structural reforms. The IMF (2012) suggests successful debt reduction requires policy mixes and loose monetary policy. Fiscal consolidation should prioritize structural reforms over short-term austerity. Fiscal repression is unlikely for Eurozone countries, necessitating cautious debt reduction. Sustainable primary budget improvements are typically around one percentage point annually. Excessive austerity can also exacerbate banking problems (Lane, 2012). Europe must accept that public debt reduction will be a protracted process. Short-term austerity is not a panacea.
The Balance of Payment Crisis
Beyond national-level challenges, Eurozone countries are interconnected through trade, creating interdependencies and balance of payments issues. Current account imbalances among Eurozone members have worsened. Table 6 shows current account balances for selected Eurozone countries.
Table 6 reveals significant current account surpluses in Germany and the Netherlands. Germany, initially in deficit in 1999-2000, developed a surplus reaching 7.0% of GDP in 2012. The Netherlands’ surplus is even larger. Conversely, Portugal, Greece, and Spain run current account deficits. These imbalances are concerning. Price and wage increases were higher in deficit countries than in surplus countries. Greece and Spain experienced real exchange rate appreciations, while Germany “depreciated” against other Eurozone members. Higher GDP growth in deficit countries further fueled imports. These imbalances have broader implications. For the Eurozone as a whole, the foreign exchange balance is zero. Current account surpluses equal capital account deficits, and vice versa.
Table 7 shows financial accounts, the counterpart to current accounts. Germany and the Netherlands, with current account surpluses, have financial account deficits. Capital flows from Germany and the Netherlands to other countries (mainly via loans, portfolio investment, and direct investment). German and Dutch savings partly finance consumption and investment in deficit countries. Financial account deficits in surplus countries mirror financial account surpluses in deficit countries, like Greece and Portugal, financing their current account deficits. Capital account deficits equate to increased external debt if the foreign exchange balance is zero. Figure 8 shows external indebtedness trends.
Figure 8. International Investment Position
Alt text: Line chart showing the international investment position (net) as a percentage of GDP for selected Euro Area countries (Germany, Greece, Ireland, Italy, Portugal, Spain) from 1999 to 2011. The chart indicates Germany and Netherlands accumulating net foreign assets, while Greece, Ireland, Italy, Portugal, and Spain become net debtors, particularly after 2008, reflecting capital flows and current account imbalances.
Figure 8 illustrates that Germany and the Netherlands’ current account surpluses led to a massive increase in claims against other countries. Germany’s claims exceed €1 trillion. Liabilities of deficit countries also increased. Spain’s external liabilities rose dramatically by around €0.96 trillion. This has significant implications. A country leaving the Euro would see its Euro-denominated obligations increase in value in the new domestic currency, potentially triggering sovereign default or debt restructuring. If Germany reintroduced the Deutschmark, its value would likely surge, reducing the Deutschmark value of Euro-denominated claims. This explains Germany’s vested interest in the Eurozone’s stability. Conversely, Italy could leave the Euro relatively easily as Italian government bonds are largely held domestically, minimizing external debt implications and insolvency risks.
It may seem paradoxical that debt-ridden countries maintained capital account surpluses post-2008, despite investor concerns. Capital flight might be expected. However, table 7 shows PIGS countries did not experience large financial account deficits. The Eurozone payment system explains this. When a Spanish consumer buys French cheese, their Spanish bank instructs the Banco de España (Spanish central bank) to transfer funds to the Banque de France (French central bank), which credits the French cheesemonger’s bank. However, the Banco de España doesn’t directly transfer funds to the ECB. Instead, it places an order to credit the Banque de France’s account. The Banco de España incurs liabilities to the ECB, while the Banque de France gains claims. The Banque de France then creates new money and credits the cheesemonger’s bank. Money effectively disappears in Spain and is created in France. This also applies to Italian savings invested in Ireland. Pre-crisis, liabilities and claims against the ECB balanced out as current account deficits were funded by capital inflows. Post-crisis, European banks and investors became reluctant to lend to deficit countries. Investors withdrew funds from troubled economies, seeking “safe havens” like German government bonds. The impact on Target balances is shown in figure 9.
Figure 9. Net Target Balances
Alt text: Bar chart showing net Target balances with the Eurosystem for selected Euro Area countries (Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain) in billions of Euros from January 2001 to July 2012. The chart illustrates balanced Target balances until mid-2007, followed by a significant increase in Germany and Netherlands’ net claims and negative balances for Greece, Spain, and Portugal, indicating capital flows within the Eurosystem.
Figure 9 shows net balances with the Eurosystem. Accounts were largely balanced until mid-2007, a turning point. Germany’s net claims reached unprecedented levels, exceeding €751 billion in July 2012. The Netherlands’ claims also rose substantially. Conversely, Target balances of Greece, Spain, and Portugal turned negative. Italy is a unique case, with a positive balance until mid-2009, which then declined, turning negative, likely due to capital flight rather than current account deficits. These net balances mirror current account deficits and surpluses and capital movements. Capital inflows to deficit countries were replaced by Target “credits,” enabling countries like Greece to finance trade deficits and Germany to maintain trade surpluses within the Eurozone. Resolving this capital account crisis requires either current account rebalancing or attracting investors back to Target deficit countries.
Conclusions
This article aimed to elucidate the causes and symptoms of the Euro crisis, offering valuable lessons. One key question is the overall viability of currency unions given the potential for severe member-state problems. However, substantial evidence supports the positive trade effects of currency unions. Rose and Stanley’s (2005) meta-analysis concludes that a common currency increases bilateral trade by at least 30%, boosting income (Frankel and Rose, 2002). The optimal currency union or currency adoption strategy depends on the specific context. For Mexico, adopting the US dollar might yield greater benefits than joining the Eurozone (Frankel and Rose, 2002), especially if the currency is that of a major trading partner. However, dollarization can also achieve trade gains (Yeyati, 2003), suggesting monetary union is not the sole path to positive trade effects.
The Euro crisis serves as a cautionary tale for countries considering currency unions, highlighting crucial “dos and don’ts.” Organizations like ASEAN and the GCC are contemplating currency unions. Each case requires individual assessment. Evidence suggests a monetary union could benefit ASEAN, given high output shock correlation and openness (Ng, 2002). Arguments also exist for a GCC currency union (Buiter, 2008). However, the Euro crisis underscores the need for effective supranational institutions to oversee central banks and financial institutions, a weakness in the GCC’s current structure (Buiter, 2008). Furthermore, currency unions must prepare for financial crisis scenarios (Volz, 2013), which the Eurozone seemingly failed to do. While the Eurozone aimed to reduce sovereign default risk, it lacked effective rescue mechanisms for member states in financial distress (Buti and Carnot, 2012), primarily to prevent moral hazard. However, this lack of preparedness led to disarray when crises emerged. Eurozone safeguards proved inadequate. Maastricht criteria breaches went unpunished, and meeting criteria did not guarantee crisis prevention (Spain and Ireland). The EU’s proposed scoreboard approach aims to address this by considering multiple macroeconomic stability indicators.
Financial regulation is paramount for all countries. Banking sector problems in a few Eurozone countries triggered a system-wide crisis. Strengthened banking regulation, through Basel III implementation and the move towards a Eurozone banking union with common supervision and resolution mechanisms, are crucial steps. Supranational supervision by the ECB aims to oversee major European banks and facilitate swift resolution of failing banks, regardless of origin, reducing the risk of “zombie banks” propped up by government subsidies. The current crisis demonstrates the need for rapid action by supervisory authorities to prevent prolonged financial crises. However, it’s crucial to remember that the Great Recession is the most severe crisis since the Great Depression. The Euro crisis is a complex phenomenon with multiple interacting components that together precipitated a systemic crisis.
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Footnotes
1 This article is based on a lecture that I gave as a visiting lecturer at the UABC. I would like to thank Martín Arturo Ramírez Urquidy and Ana Bárbara Mungaray Moctezuma for their help. Furthermore, I wish to thank Stuart Jenks, Jürgen Kähler, and Saul Oziel López for very useful comments and suggestions.
2 The three pillars are: the European Community, common foreign and security policy, and police and judicial cooperation in criminal matters.
3 There are, of course, other benefits of currency area. These include, for instance, lower transaction costs and higher price stability. For a discussion of benefits and costs of a monetary union in Europe see De Grauwe (2012).
4 Between June 2003 and November 2005 the interest rate for main refinancing operations was 2%.
5 The ratio of bank assets to GDP is 16 for Luxembourg, 6 for Ireland, 4 for the Netherlands, and around 3.5 for Spain and Germany (Data from June 2001; see Schoenmaker and Werkhoven, 2012).
6 This applies for ING, Santander, and BNP Paribas (International Monetary Fund [IMF], 2013).
7 Data is taken from Demary and Schuster (2013).
8 Data are taken from Eurostat.
9 In comparison, Spain is currently in a situation in which the labour market tension Θ decreased. For instance, the number of employees in the industry, construction, and service sector decreased from 13.1 million to 12.6 million from 2008 to 2012. At the same time the number of vacancies in these sectors increased from 86 000 to 95 970 (Data source: Eurostat). This means that the Beveridge curve shifted outwards, i.e. the matching efficiency worsened.
10 All data are taken from Fitch Ratings website.
11 According to Eurostat data, the real effective exchange rate of Germany went down by 8.8% from 1999 to 2012. On the other hand, it increased in Spain (+9.1%), in Portugal (+5.1%), and in Ireland (+8.5%).
