Large current account deficits were present in all of the countries that ultimately required government assistance, including Greece, Ireland, Portugal, and Spain. Large capital transfers from the core to the periphery, as well as inexpensive loans, contributed to the growth of these. Nevertheless, the crisis caused both the usual operation of markets and the discipline of creditors to break down. There was an immediate need to take action on something.
Inflation
While a persistently high level of inflation benefits governments by eroding debt over time, it also prompts lenders to demand higher-risk premia. As a result, the borrowing costs of highly indebted nations such as Greece, Portugal, Spain, Ireland and Cyprus climbed rapidly.
As Beatrice Weder di Mauro explains, “Eurozone governance lacked a regime to deal with cases of excess debt accumulation”. The euro’s lack of a currency devaluation mechanism also meant that Eurozone member countries could not devalue to break out of the debt vortex that had built up over the years. In the end, all the authors of this ebook conclude that excessive debt accumulation and its subsequent unwinding created a perfect storm. The outcome was a classic sudden stop in cross-border capital flows and a public debt crisis that threatened to tear the Eurozone apart.
Unsustainable Debt
As the global financial crisis and slowing growth converged, investors began to lose faith in sovereign debt sustainability. This led them to demand higher risk premiums on sovereign bonds, which drove borrowing costs sky-high for nations like Greece, Portugal, Ireland, and Cyprus.
What’s most remarkable about the Eurozone debt crisis is that the nations that needed bailouts were not those with the highest debt-to-GDP ratios. Instead, the ones that suffered were those with large current account deficits – which means they relied on foreign lending to fill their savings-investment gap.
These foreign flows of capital tended to go towards non-traded sectors like housing and government consumption in the recipient countries, adding to imbalances. This was not sustainable. The doom-loop linking bad bank debt to national solvency eventually pushed Greece, Ireland, Spain, and Portugal over the debt-sustainability edge.
Unsustainable Growth
Before the crisis, capital flows from core nations like Germany and France fueled growth in nations with large current account deficits (like Greece, Ireland, Portugal and Spain). These capital inflows drove up investment and government services and consumption in those countries, harming their competitiveness.
Markets reacted by raising the risk premiums they charged those countries to borrow on the markets. These soaring borrowing costs made it difficult for those countries to repay their debt. The debt-to-GDP ratios of these nations climbed to unsustainable levels. In a classic sovereign debt crisis, the nation in question defaults on its debt. Instead, Eurozone leaders decided that defaulting on their debt was a no-go. Instead, they imposed a 750 billion euro bailout. This bailout included a ‘haircut’ for private investors.
Unsustainable Monetary Policy
The monetary union had to have a common currency but the countries did not need to share their fiscal policy or borrowing. This allowed them to borrow and spend much more than they could repay without being penalised (as they would have been under the EU’s founding Maastricht criteria). All the nations that ended up with bailout programmes ran current account deficits and relied on foreign lending, unlike core Eurozone members like France, Germany or Italy that had substantial surpluses.
As these imbalances grew, investors began to fear that some nations might default and this self-fulfilling prophecy saw yields rise in ways that were self-defeating. As a result, the eurozone became vulnerable to a Lehman Brothers-sized shock.
Unsustainable Economic Structure
When economic imbalances unwind, they tend to hit nations with different balance sheet characteristics in different ways. In this case, the nations that were most affected were those that relied on foreign capital to cover their savings-investment gap – Ireland and Portugal. Their borrowing costs soared in the wake of Greece’s bailout.
This is because investors started to lose faith in their government’s ability to finance their debts – leading them to demand higher risk premiums and thus push borrowing costs up inexorably. The domino effect that followed put Belgium, Cyprus and even France at risk. This was Europe’s Lehman moment and Buti is in no doubt that it must not be repeated. To avoid such a crisis, EU-level decisions must be insulated as much as possible from domestic political economy considerations, which typically take a moralistic line on demanding creditors be held to account.
Microeconomics is essential to understanding the Eurozone problem. “Understanding Supply and Demand – The Basics of Microeconomics” explains economic system fundamentals. Supply and demand explain the Eurozone crisis. Microeconomic principles expose trade and fiscal policy imbalances and currency union effects. Microeconomics can help us comprehend the Eurozone issue and find answers.