There was an extraordinary international bank-intermediated credit boom among the advanced economies during 2003-2007. There is considerable evidence that financial crises are often preceded by credit booms (Gourinchas and Obstfeld 2012), so the Eurozone crisis was out of line with experience. One distinctive features was the way that cross-border flows amplified differences in loan growth across surplus and deficit countries (Lane and McQuade 2014).
Given the role of credit on the way up, the unravelling of the credit booms and a contraction in cross-border flows have been central features of the subsequent Global Financial Crisis and Eurozone crisis. While global factors certainly played a critical role in this boom-bust cycle, the role of cross-border flows was especially intense inside the Eurozone due to the much higher scale of intra-zone cross-border integration of banking and bond markets (Lane 2013a, 2015a).
Rather, the evidence indicates that the 2003-2007 period can be characterised as a ‘credit supply’ shock by which the global financial system was more willing to tolerate large net debt flows to these advanced economies. There is a large literature that debates the sources of this credit shock, with the low policy rates adopted by advanced central banks, financial innovations (such as new types of securitisation), and shifting beliefs about risk levels and risk absorption capacity combined to foster an extraordinary boom in international capital flows (Lane 2013a).
Role of the euro
The common currency facilitated cross-border financial flows, since euro-denominated debt transactions within the Eurozone could be viewed as having zero currency risk. In addition, the deep swap markets between the euro and the major currencies also allowed Eurozone banks to obtain foreign-currency funding (especially dollar funding in US money markets) and hedge the currency risk at low cost (Lane 2015b). The low risk nature of this funding was further underpinned by access to Eurosystem liquidity to banks in all member countries, which was additionally secured by the ECB collateral policy of treating the sovereign bonds of all member countries as low risk.
The debt inflows took different forms across the various European peripheral countries.
- For Ireland and Spain, the debt inflows helped to fuel large-scale domestic property booms; and,
- For Greece and Portugal, it was the sovereign (or quasi-fiscal) institutions that were at the forefront of issuing international debt.
Among these countries, the motivations underlying the willingness to absorb a large increase in external debt liabilities also varied. Optimistic types extrapolating continued appreciation in property prices played a role in Ireland and Spain. Governments and private-sector entities possibly seeking to delay adjustment, along with downshifts in long-term growth projections, played a role in Greece and Portugal (Lane and Pels 2012).
Where the private sector incurred the debt liabilities:
- Governments were insufficiently wary of the possible contingent risk exposures (both direct bailout costs and the indirect impact of financial crises on fiscal balances);
- Fiscal policy was not sufficiently counter-cyclical (vis-à-vis the financial cycle), with the required scale of prudential fiscal surpluses above historical norms or politically-feasible levels; and,
- Macro-prudential measures to cool the expansion in domestic credit were not sufficiently aggressive and/or implemented too late in the boom phase.
The Eurozone crisis has also vividly highlighted the tensions involved in resolving external funding crises when creditors and debtors share a common currency and are deeply intertwined in terms of economic and political linkages (Lane 2013b). There are clear conflicts of interest between creditors and debtors in terms of the design of bailout programmes and the potential role of debt restructuring mechanisms (both vis-à-vis banks and sovereigns), while financial stability spillovers are plausibly more intense inside a common currency area. Moreover, private-sector debt funding is arguably more fragile in a monetary union, since risk-averse investors can quickly shift out of riskier countries towards safer countries without taking on currency risk, which was reflected in the emergence of large Target 2 imbalances during the crisis, as peripheral banks replaced cross-border private funding with Eurosystem funding.
Ending the ‘doom loop’: Delinking banks and sovereigns
These considerations reinforce the importance of delinking banks and sovereigns, through the formation of a deep banking union, the imposition of limits on the domestic sovereign bond holdings of banks and the introduction of efficient sovereign debt restructuring mechanisms (Corsetti et al 2015). In related fashion, the fragility of cross-border financial flows within a monetary union call for the formation of a common area-wide ‘safe asset’, along the lines of the European Safe Bonds (ESBies) advocated by Brunnermeier et al (2011).
While there have been multiple factors influencing the propagation of the European crisis, it is striking that there is a very strong correlation between the pre-crisis level of external imbalances and macroeconomic performance since 2008 (Lane and Milesi-Ferretti 2012, 2015). Sorting out the relative contributions of current account reversals and fiscal austerity (each also interacting with domestic credit contractions) in determining post-crisis output dynamics is a high priority for the research agenda of international macroeconomists.
Lessons for the future
Given the very painful experience with external adjustment, the lesson for the future is that macro-financial policies (including macro-prudential measures and the cyclically-adjusted stance of fiscal policy) should proactively seek to manage the risks attached with excessive net international debt flows. While this principle is recognised in the new ‘macroeconomic imbalances procedure’’ (MIP), the identification of risk triggers and the design of appropriate interventions remains to be worked out.
More deeply, a greater degree of economic convergence among member countries should be associated with less financial divergence in terms of external imbalances and asymmetries in credit growth. To this end, the aspiration of the recent Five Presidents’ Report is to promote economic convergence. Whether Europe has the political appetite to follow the agenda laid out in this report is a major question for the coming years.
Author's note: This article is based on research funded by the Irish Research Council.
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