What Really Caused the Eurozone Crisis? (Part 1)
I’ve been doing some work on gaining a better understanding of the root
causes of eurozone (EZ) debt crisis. As a point of departure, let’s take
a couple of dueling quotes. First, Wolfgang Schäuble, Germany’s finance
minister, from his recent piece in the Financial Times:
role the markets have played in catalysing the sovereign debt crisis,
it is an undisputable fact that excessive state spending has led to
unsustainable levels of debt and deficits that now threaten our economic
Next, here’s an excerpt from a statement recently made by Greece’s Deputy Prime Minister and Minister of Finance, Evangelos Venizelos:
should not be the scapegoat or the easy excuse that will be used by
European and international institutions in order to hide their own lack
of competence to manage the crisis and give a definitive and complete
answer to the attacks against euro, the world’s strongest currency.
two statements capture the essence of two radically different views
about the origins of the EZ debt crisis. Which one is right?
Local Causes or Systemic Causes?
believe that the crisis was fundamentally caused by profligate,
irresponsible behavior by governments and individuals in the EZ
periphery. (Note: by the “EZ periphery” I mean Greece, Portugal,
Ireland, and maybe Spain. Italy has not really been accused of such
behavior, to my knowledge, and it seems generally accepted that it is
much more the victim of contagion rather than the cause of the crisis.)
Let’s call this the local causes point of view: government
deficits and debt in the periphery were so large that once the Great
Recession of 2008-09 hit, investors lost confidence in the ability of
those countries to remain solvent. So they tried to dump the bonds from
those countries, triggering the crisis.
An alternative point of
view is that, while the crisis may have had some peculiarly local
triggers (the Greek government’s admission that it fudged some official
statistics certainly didn’t help), much of the current mess is the
result of forces and decisions outside the control of peripheral
Europe’s governments. In other words, the crisis could have non-local, systemic causes.
example, suppose that the adoption of the euro suddenly made it more
attractive for investors in the rest of Europe to buy assets in the
periphery. This could have caused a large, exuberant capital flow from
Europe’s core to periphery, much like NAFTA helped to spark a surge in
capital flows from the US to Mexico in the early 1990s. In theory,
that’s a good thing, and should help the process of economic
convergence. But we know that such “capital flow bonanzas” (so named by Reinhart and Reinhart) are notoriously susceptible to changes in investor attitudes, and can come to an abrupt halt. These sudden stops in capital flows, as they are referred to in the literature, typically trigger a financial crisis. (See this paper by Calvo, Izquierdo, and Mejia
for much more about sudden stops.) As noted by Rudi Dornbusch in the
context of the Mexico crisis of 1994, it’s not speed that kills; it’s
the sudden stop.
Crucially, sudden stops may happen even when a
country is following all the right macroeconomic policies. As a result,
financial crisis may be largely outside the control of a country that’s
on the receiving end of a capital flow bonanza. Mexico in 1994 is a good
example of that, I think. And it could be that some of the peripheral
EZ countries also fit this characterization. If so, then it’s not
appropriate to lay the blame for the crisis entirely at the doorstep of
the peripheral EZ’s governments; while they may have done some things
that contributed to the crisis, the odds were significantly stacked
against them to begin with.
Which view of the EZ crisis – the local causes view or the systemic causes view – better matches the evidence? There are a few different types of clues we can look for.
1. Which deficit predicted the crisis?
the crisis is due primarily to local causes, then we would expect the
best predictor of crisis to be government deficits and debt. On the
other hand, if the systemic causes view is correct, then a better
predictor of the crisis would be large current account deficits, which
necessarily happen when there’s a capital flow bonanza.
following table shows both fiscal (i.e. national government) budget
balances and current account balances during the period after the
adoption of the euro and before the worldwide financial crisis and
recession struck in 2008. All figures are from the OECD and expressed as
a % of GDP.
factor that crisis countries have in common is that, without exception,
they ran the largest current account deficits in the EZ during the
period 2000-2007. The relationship between budget deficits and crisis is
much weaker; some of the crisis countries had significant average
surpluses during the years leading up to the crisis, while some of the
EZ countries with large fiscal deficits did not experience crisis. This
is one piece of evidence that a surge in capital flows, not budget
deficits, may have been what laid the groundwork for the crisis.
2. Which deficit grew after euro adoption?
the crisis is due to the profligacy of governments in the peripheral EZ
that took advantage of EZ membership to increase spending, we would
expect to see budget deficits grow in the periphery after the common
currency was introduced in 1999. But if the crisis was really the result
of a post-euro adoption surge in capital flows from the EZ core that
then came to a sudden stop, we would expect current account deficits
(i.e. capital flows) to have grown more after adoption of the euro.
following charts show the path of both types of deficits during the
years before and after adoption of the euro. (Data from the OECD,
expressed as % of GDP.)
flows (i.e. current account deficits) increased substantially in all
the EZ periphery countries in the period after adoption of the euro.
Meanwhile, the peripheral countries generally tended to have tighter
fiscal policies after adopting the euro than before euro adoption.
that the capital flow bonanzas in evidence in these charts were
directly the result of the adoption of the euro by the peripheral EZ
countries, which made it easier for capital in the core EZ countries to
find investment opportunities in the periphery. In fact, this was
exactly what the advocates of the common currency intended and expected,
and has always been touted as a selling point
for the euro project – it’s called “financial integration”. The problem
is the sudden stop that frequently follows such a capital flow bonanza.
3. What did the periphery countries spend their money on?
the crisis is due to irresponsible behavior by governments and
individuals in the EZ periphery, then one indicator of that would be a
rise in government spending and/or personal consumption after euro
adoption. On the other hand, the systemic causes view would suggest that
crisis could strike even if a country is behaving ‘responsibly’ (in a
macroeconomic sense) by spending more on investment goods (i.e. capital
formation) and less on personal consumption.
The next table shows
the fraction of domestic purchases spent on consumption and investment
goods in each of the EZ periphery countries. Germany is included in the
table for comparison.
is a clear tendency for investment spending to rise in the periphery
countries (with the exception of Portugal), and for consumption to fall.
This is consistent with the convergence story; capital flowed from the
core to the periphery to take advantage of and fund investment
opportunities there. Meanwhile, with the periphery countries
experiencing fiscal contraction, a smaller share of purchases going to
personal consumption, and a higher share of purchases going to
investment goods, it is hard to see evidence for the story that the
capital inflows were simply frittered away on a spending binge either by
individuals or governments.
So… What Really Caused the Crisis?
it all together, it seems that the EZ crisis is more consistent with
the systemic causes view than the local causes view. In other words,
while they didn’t necessarily make the right decision every time, the
peripheral EZ countries were up against powerful exogenous forces –
capital flow bonanzas and sudden stops – that tended to push them toward
financial crisis. They were playing against a stacked deck.
useful to reevaluate the macroeconomic history of peripheral Europe in
light of this interpretation. Rather than large current account deficits
being the result of fiscal mismanagement or excessive consumption, the
current account deficits were the necessary and unavoidable counterpart
to the surge in capital flows from the EZ core. Rather than
above-average inflation rates and deteriorating competitiveness being
signs of labor market inefficiencies or lax fiscal policies in the
peripheral countries, appreciating real exchange rates were inevitable
as the mechanism by which those current account deficits were effected.
eurozone debt crisis is big enough that there’s plenty of blame to go
around, and some of it certainly should go to the crisis countries
themselves. But it must also be recognized that as soon as those
countries adopted the euro, powerful forces were set in motion that made
a financial crisis likely, and very possibly unavoidable, no matter
what the governments of the peripheral euro countries did. Irresponsible
behavior by the periphery countries did not set the stage for the
eurozone crisis; the common currency itself did.
Causes of the Eurozone Crisis (Part 2): Policy Implications
In the previous post
I sketched out the origins of the eurozone crisis, and argued that
powerful systemic forces, not irresponsible behavior, pushed the
periphery countries toward crisis – and may well have done so no matter
what the peripheral eurozone countries had done. The common currency
encouraged (in fact, was designed to encourage) large-scale capital
flows from the eurozone (EZ) core to periphery. We know from experience
that such “capital flow bonanzas” are susceptible to sudden changes in
investor sentiment, and very often come to a sudden stop. The sudden
stop in this case happened in 2009 (exploring the specific reasons for
that stop is interesting, but will have to wait for another day), made
it difficult for the periphery countries to roll over their debt, and
thus caused a crisis.
But note that other aspects of the common
currency meant that the odds were stacked even more heavily against the
peripheral EZ countries. Euro-adoption not only set the stage for the
crisis by encouraging a capital flow bonanza to the EZ periphery; it
also made it impossible for the periphery countries to deal with the
sudden stop to those capital flows if and when it came. In his
excellent recent paper (pdf),
Paul De Grauwe has pointed out that the adoption of the euro by
Europe’s periphery effectively caused them to be “downgraded to the
status of emerging countries”, in the sense that they could no longer
issue sovereign debt in their own currency. This made those countries
peculiarly vulnerable to changes in investor sentiment. As Paul Krugman
recently put it, thanks to the common currency, the periphery countries
lacked the tools to manage their balance of payments.
that, the heavy firepower for dealing with the crisis necessarily had to
come from the rest of the EZ, i.e. the core (by which I generally mean
Germany, France, Benelux, Austria, and maybe Finland). But does this
understanding of the origins of the crisis tell us anything else about
proper policy responses?
1. Being judgmental is not helpful.
of the objections raised by some who oppose support from the EZ core to
the periphery is that such a bailout of the periphery countries may
just encourage future irresponsible behavior. The periphery behaved
badly, according to that argument, must pay the price, and clean up its
But if the very structure of the common currency area
contained the essential ingredients for this crisis, and if the easy
answer (namely, that the crisis is due to the irresponsible behavior of
the periphery countries) is not the right answer, then such an argument
no longer works. Since the crisis was largely the result of forces
outside the control of the EZ periphery countries, it’s not appropriate
to try to punish those countries through the bitter medicine of
insufficient assistance. In other words, this crisis should not be
turned into a morality story.
2. Austerity is not helpful.
fiscal austerity by the periphery EZ countries has been the condition
attached to assistance from the core EZ. But that austerity requirement
brings with it several problems.
First, it is largely counterproductive with respect to reducing annual deficits; a simple textbook example
illustrates how fiscal contraction during a recession will typically
fail to meet deficit reduction goals, because the austerity itself makes
the recession worse. That’s exactly why Greece keeps missing its
deficit reduction goals: not because they aren’t trying hard enough, but
because it’s inherently unrealistic and unreasonable to try to balance a
budget through austerity during a recession.
is completely counterproductive with respect to reducing debt burdens.
As the economy shrinks thanks to austerity, the debt burden skyrockets
relative to the country’s income. Just look at the debt, GDP, and
debt-to-GDP ratios for Greece to see how that works. It’s no wonder that
it has recently become crystal clear that Greece will never have enough
income to repay this level of debt. (Note: data from Eurostat; 2011 figures are forecast.)
finally, and most importantly in the context of this analysis,
austerity shifts most of the burden of dealing with the crisis onto the
EZ periphery countries. And that means that citizens of the core EZ
countries like Germany, France, and Benelux are essentially getting a
All of the members of the EZ have enjoyed the
benefits of the common currency; that’s apparent simply from the fact
that they have worked so hard to construct and maintain it (recent
evidence notwithstanding). Many of those benefits are political, but
some are baldly financial as well: the large capital flows from the EZ
core to the periphery during the years 1999-2007 are evidence that
investors in the core EZ countries enjoyed and took full advantage of
the high returns they could get on new investment opportunities in the
periphery. Furthermore, the capital outflows from the core meant that
the core EZ countries had to run current account surpluses; they have
been able to enjoy significantly stronger exports for the past 10 years
thanks to the euro.
But there is a fundamental asymmetry that
goes along with international capital flows: the country on the
receiving end risks a serious financial crisis when that flow stops,
while the country that is the source of the capital bears no similar
risk. In other words, the periphery of the EZ bore the bulk of the
systemic risks inherent to the common currency area, while the benefits
were shared by both the core and the periphery. In a sense, the
periphery countries “took one for the team” when they allowed themselves
to be placed at risk for the greater good of the entire eurozone.
Given that, it doesn’t seem appropriate that the burden of solving the
crisis should be placed so overwhelmingly on the periphery countries
that had such little control over the crisis to begin with. Trying to
solve the crisis primarily through austerity is thus just plain unfair.
(For reference, I provide an estimate of the cost of the eurozone crisis to its members.)
3. Shared responsibility is very helpful.
opposite of trying to solve the crisis through austerity – which places
the burden of escaping from the crisis on the periphery countries
themselves – is for the core EZ countries to substantially share the
cost of getting out of this mess. Once it is clear that the systemic
risk of crisis that came along with the creation of the euro was borne
disproportionately by the EZ periphery, while the benefits of the common
currency were enjoyed by both core and periphery, the calculus of how
to respond to the crisis changes. In that context, substantial
assistance from the core to the periphery in response to the crisis is
not only helpful, but can in fact be viewed as the responsibility
of the core EZ countries. The degree to which they choose to accept
that responsibility – and pay for it – will determine how the crisis is
And let’s not kid ourselves about something:
policy-makers in Europe know exactly how the crisis can be solved. It’s
not a mystery that if the core EZ countries contribute sufficient funds
to finance Greece’s debts for the foreseeable future, accept a
substantial write-down on the amount owed by Greece, and provide funds
to recapitalize banks in Greece and elsewhere in the EZ, then the crisis
will be over. So the question is simply whether the core EZ countries
are willing to pay that required price. If they are, then the EZ will
remain intact. If not, it will not. The current debate going on among
European policy-makers is simply the unpretty process of figuring out
the answer to that question.
After the Crisis
that at some point the EZ emerges from this crisis. And let’s be as
hopeful as possible, and further suppose that the EZ emerges
more-or-less intact, i.e. with most or all of its member countries still
exclusively using the euro. What then?
The problem is that the
logic that led to this crisis will not have changed. At some point, if
financial integration and convergence between the core and periphery is
to resume, there will once again be capital flows from the EZ core to
the periphery. It might take 10 or 15 years, but investors at some
point will regain confidence and once more try to seek out the higher
returns that are available in the periphery countries. And the
recipients of the resulting capital flows will once again be vulnerable
to a sudden stop. And they will once again lack any policy tools to deal
with it when it happens. So can anything be done to fundamentally make
the eurozone system more stable?
A few thoughts come to mind.
1. Impose policies to reduce capital flows.
financial crisis seems to generate renewed suggestions from economists
that it might make sense to use policy to slow down international
capital mobility, and this one should do the same. The most famous
incarnation of this idea is the Tobin Tax,
the suggestion put forward by Nobel prize-winning economist James Tobin
in the early 1970s that each international transaction (in his case he
was specifically talking about currency transactions) be subject to a
small transaction tax. This would make investors think more carefully
and move more slowly both into and out of international capital markets.
2. Make explicit institutional changes to explicitly support the EZ periphery countries ahead of time.
of the reasons that this crisis has gotten so bad is that the EZ
periphery countries lacked any tools to deal with it, largely because in
a common currency area they have no central bank to fall back on in the
event of a liquidity crunch. This problem can be solved, however,
through a number of steps. For example, if the ECB promises to provide
unlimited liquidity to any EZ country that needs it. Yes, the
Maastricht treaty would probably have to be amended. And yes, such a
policy could potentially be expensive for the core EZ countries. But
crucially, it would be a mechanism for the EZ core to carry its share of
the burdens that come with the currency union. Paul De Grauwe’s paper
suggests other institutional changes that would help. But details
aside, the point is basically quite simple: one way or another, if the
eurozone is going to survive in the long run, there needs to be a
recognition that since all members benefit from the common currency, all
will have to pay the price of dealing with its vulnerabilities when
3. Restrict the eurozone to the core.
the core EZ countries are simply not willing to accept the burden of
substantially footing the bill to clean up the mess left by a capital
markets crisis, then the only real remaining solution will be to make
sure that all of the countries using the euro are similar enough that
there won’t be any large-scale capital flows from one to another. If
there are no significant and systematic capital flows within the EZ,
then the likelihood of crisis goes away. The remaining eurozone would
probably be half of its current size; but it would be stable.
basic choice that policy-makers face is therefore fundamentally the
same in both the short-run and the long-run: the core EZ countries need
to be willing to pay a substantial portion of the cost of fixing the
current mess, and they need to be willing to remain on the hook for any
similar future events. In return, they will be able to continue
enjoying the substantial political and economic benefits that the euro
has brought them. If they decide that it’s not worth the price, then
the eurozone will not continue to exist in its current form for much