The euro crisis started as a classic ‘sudden stop’ to cross-border capital inflows. As boom turned into bust, governments lost their tax base and had to assume private debt, thus creating a public debt crisis. The highly leveraged banking system of the Eurozone, tightly linked to national governments, provided a multiplier, which made the crisis systemic.
From balance of payments to public debt crisis
The Eurozone crisis is considered in official circles essentially as a sovereign debt crisis. This is partially due to the fact that the crisis started with the sovereign debt problems of Greece at the turn of 2009/10 (and Greece remains the only unresolved issue in 2015). Moreover, European policymakers had to deal mostly with the problems of member states which had problems refinancing their public debt, losing sight of the root causes of these problems.
One simple observation proves the key role of the external – or balance of payments – origin of the crisis.
- No country which had in 2008 a current-account surplus and/or a positive net external asset position had to endure lasting financial stress – irrespective of the level of its public debt.
For example, Belgium, which had at the outset of the crisis a higher (public) debt to GDP ratio than Portugal, never experienced serious financial stress and its risk premium has, on average, been over the entire period less than 90 basis points. Portugal, by contrast, had to pay such a high risk premium that it even lost market access at some point and had to be bailed out. The reason for this difference is that Belgium had run large current-account surpluses for a long time prior to the crisis, and had thus accumulated a net foreign creditor position of about 50% of GDP, whereas Portugal had run large current-account deficits, accumulating a large foreign debt in the process (close to 100% of GDP).
Figure 1. Foreign asset position and risk premia
Source: Eurostat 2015.
Note: Horizontal axis depicts the simple average of the ‘cumulated current- account from 1995-2015’ and the ‘Net international investment position of 2013’ (Excluding Luxembourg).
The underlying reason for the current deficits of the (now) so-called peripheral countries had not always been excessive public spending. In the cases of Ireland and Spain, the public sector had been running substantial surpluses before the crisis, resulting in public debt-to-GDP ratios which, at the moment the crisis started, were considerably below the European average. The underlying problems of these countries had been that domestic real estate booms had been financed by foreign capital inflows. When these inflows ended the real estate booms turned into bust and the depression of economic activity which followed led to large deficits and a rapid increase in public debt. Moreover, the public sector had to take over part of the debt incurred by the private sector, increasing public debt even further (Reinhard and Rogoff 2009).
This is how a balance of payments crisis became a public debt crisis. But the public debt which matters was that owed to foreigners. Domestic residents by and large kept financing their own government (with one exception: Greece) whereas foreign investors, especially those in the surplus countries, were selling at almost any price once they realised that public debt was no longer riskless.
Figure 1 shows the relationship between foreign asset position and risk premia. These have change over the life time of crisis. Hence this chart uses an average over 2010 2014.
The severity of the crisis = strength of preceding boom
Why was the crisis so severe? There are two elements which determine the difficulties engendered by a sudden stop. On both accounts, the euro crisis had to be severe.
- The size of the capital inflows (flow aspect).
Current-account deficits within the Eurozone had reached unprecedented proportions, topping 12% of GDP for Portugal and Greece, for example. When the inflows stopped, domestic demand in these economies had to crash because it was not possible to increase exports immediately to make up for the missing capital inflows.
- Capital inflow duration (stock aspect).
These current-account deficits lasted for a very long time, in some cases over 10 years, leading to a large build-up of debt. The legacy debt that has to be serviced when the boom ends is roughly equal to the product of the imbalances and the length of time they persisted. As the boom preceding the euro crisis had been unprecedented on both accounts, the crisis was likely to be of unprecedented proportions as well.
Was it the fault of the euro?
The introduction of the common currency had led to the illusion that current-account imbalances within the Eurozone would cease to matter. But this was by far not the only enabling factor, as it was seen in the context of a global phenomenon, namely the Great Moderation.
The success of central banks in stabilising the economy during the late 1990s and early 2000s had led to the widespread illusion that the business cycle was dead and that financial risk had been abolished. This provided the backdrop for a global credit boom of unprecedented proportions, both internally and across nations.
- The US also had a real estate boom fuelled by easy credit. It was actually the US Subprime Crisis, which started the Global Crisis in 2007/8.
- Countries outside the Eurozone were also running extraordinarily large deficits for a long time (e.g. Iceland, or (then) non-euro EU member countries like the Baltic States, whose current-account deficits topped 20% of GDP).
The large and persistent current-account imbalances and associated capital flows within the Eurozone must thus be seen as the local manifestation of a global credit boom.
Undercapitalised banks as a crisis multiplier
A bank-based financial system can make a crisis more severe. Banks usually operate on a very thin layer of capital. Prior to the crisis, their capital ratios were often less than 5%, meaning that a bank could not survive a loss of more than 5% of its assets (Gros and Micossi 2008).
When all banks are thinly capitalised and they all face large losses on the credits they extended during the boom, the entire financial system is at risk. But modern economies cannot survive without the basic functions, like the payments system, which are performed by banks. This creates the potential for runs on banks where the fear of large losses can be self-validating (Diamond and Dybwig 1983).
The bank-centric nature of Europe’s financial system (ESRB 2015) thus makes it more exposed to financial crisis.
The bank-sovereign nexus
In Europe the banks and the sovereign are usually so closely linked that one cannot survive without the other. This has two elements.
- The sovereign is the ultimate guarantor of the banks; but
- The banks are often key holders of public debt.
In many countries banks hold multiples of their capital in government debt. This implies that the insolvency of a government would also wipe out the capital of the banks and bankrupt them as well. But an insolvent government would no longer be able to save its banks.
There was thus the potential for a self-reinforcing, negative feed-back loop between the banks and their government. Doubts about the solvency of the government lead to doubts about the solvency of banks, which in turn weakens the economy and thus makes the situation even worse for the sovereign whose tax revenues decline.
The key element in this feed-back loop is that banks hold large amounts of the debt of their own government. If banks were holding a diversified portfolio of the debt of all Eurozone governments, the feed-back loop would be much weaker since the insolvency of any one government would not wipe out the capital of the banks on its territory (Gros 2013).
Sovereigns without a central bank
The Eurozone is not the only area in the world where banks finance a large part of public debt. The unique aspect of the bank sovereign nexus in the Eurozone is that the sovereign can no longer rely on its central bank for emergency financing in a crisis (de Grauwe 2011).
In a country with its own currency, government debt is riskless since before going bankrupt the government will force the central bank to print the money it needs to service its debt. This will then create inflation and bond holders will lose in real terms, but in nominal terms there is no reason to doubt the ability of the government to service its debt and save its banks (Calvo 1988).
By contrast, the ECB is actually forbidden to finance governments. This interdiction was only partially, and in a limited way, overcome when the ECB created its Open Market Transactions (OMT) programme of 2012 under which it would, under strict conditions, be able to support the government debt market of individual member countries.
… and a central bank without a sovereign
Emergency liquidity provision is essential in any financial crisis as during the crisis period even solvent entities (banks and governments) tend to have liquidity problems. Ex ante, it is, of course, never certain who is solvent and faces only liquidity problems. It is nevertheless clear that ex post the cost of the crisis and thus the extent of insolvencies will be much reduced if there is a lender of last resort.
In a country with its own currency the lender of last resort will be the central bank, which not only can support the national treasury in times of need, but can also rely on the taxing power of the government to be compensated for any losses that arise if it makes losses on liquidity provision. This is also not the case in the Eurozone, where the ECB cannot rely on a single treasury to be compensated for any losses it might make on liquidity provision. The official Emergency Liquidity Assistance, which has been widely used relies instead on the guarantee of national governments, thus reinforcing the negative feed-back loop between the banks and the sovereign.
The EZ crisis is best viewed as a particular virulent manifestation of the bust that followed the global credit boom engendered by the Great Moderation.
- At the outset of the Global Crisis, it appeared that the US and the Eurozone were about even in terms of house prices increases and leverage (increase in credit relative to GDP).
- In Europe, the crisis proved much more difficult to deal with given the predominance of bank financing, thinly capitalised banks, and the absence of a common mechanism to deal with failing banks and the absence of a common lender of last resort for governments.
A global credit of similar magnitude is unlikely to return for at least a generation or two, but regional credit booms (and busts) seem unavoidable. It follows that another EZ crisis is unlikely for some time, but regional crises will recur and could still wreak havoc through the bank–sovereign feedback which has still not been really cut as this summer’s experience in Greece shows.
Calvo, G (1988), “Servicing the Public Debt. The Role of Expectations,” American Economic Review, Vol. 78, No. 4 (Sep., 1988), pp. 647-661.
Cotarelli, C, L Forni, J Gottschalk and P Mauro (2010), “Default in Today's Advanced Economies. Unnecessary, Undesirable, and Unlikely”, IMF Staff Position Note, 1 September SPN/10/12.
De Grauwe, P (2011) “Governance of a Fragile Eurozone”, CEPS Working Documents, WD 346, May 2011.
Diamond D W, and P H Dybvig (1983), "Bank runs, deposit insurance, and liquidity". Journal of Political Economy 91 (3). 401–419.
Gros, D and S Micossi (2008), “The beginning of the end game…”, VoxEU.org, 20 September.
Gros, D (2013), “Banking Union with a Sovereign Virus The self-serving regulatory treatment of sovereign debt in the Eurozone”, CEPS Policy Brief No. 289, 27 March.
Reinhart, C M and K S Rogoff (2009), This Time is Different Eight Centuries of Financial Folly, Princeton University Press.
1 Only the IMF refused to acknowledge this even in 2010 (Cotarelli et al. 2010).