European Union: The eurozone (debt) crisis – causes and crisis response

The eurozone crisis could develop due to lack of mechanisms to prevent the build-up of macro-economic imbalances. Given limited access to other sources of finance and limited fiscal transfers, the ECB played a crucial role in the crisis response.
External assistance only came next extreme market stress. The implicit promise of the ECB to act as a lender of last resort nations and government was necessary to re-establish market access. Program nations in particular had to push through reforms and severe austerity measures.
By definition, crisis nations were not able to use monetary and exchange rate policy, but, given the chaos that it would likely have resulted in, euro-exit remained an unappealing alternative.

Introduction

In this statement, we outline how the eurozone crisis has evolved, with a appropriate focus on peripheral member states, i.e. Greece, Ireland, Portugal, Italy, Spain and Cyprus. We discuss how European Monetary Union (EMU) membership shaped both the economic crisis itself and the crisis response. As this study does not provide a counterfactual, the conclusions do not necessarily imply that crisis hit nations would have been better off outside the euro sector(for data on the benefits and costs of membership 

The Causes

The eurozone (deficit) crisis was caused by (i) the lack of a(n) (effective) mechanisms / institutions to prevent the build-up of macro-economic and, in some nations, fiscal imbalances and (ii) the lack of common eurozone institutions to entirely absorb shocks (as well see Rabobank, 2012; Rabobank, 2013).

Lower borrowing costs following the entry into the euro area led to large intra-eurozone capital flows, primarily in the form of banks loans, resulting in significant increases of primarily private, and in some cases as well public sector indebtedness in peripheral member states. Cheap (foreign) credit was often not used for productive investment . Instead it was to a large extent used to finance consumption, an oversupply of housing and, in some nations, irresponsible fiscal policies (figure 1). Meanwhile, partially as a result, the competitiveness of most Southern eurozone member states deteriorated substantially in the years next euro entry vis-à-vis their Northern counter parts, particularly relative to Germany, which undertook wage moderation in this period (figure 2). Accordingly, most peripheral nations ran large current account deficits (figure 3) and experienced a (further) deterioration in their external investment positions.
 

While particularly the (peripheral) nations with large housing market booms (i.e. Ireland and Spain) were by presently seriously affected by the Great Recession, a severe sovereign deficit crisis started at the same time as the Greek government was no longer able to finance its deficit on the markets in 2010. Rising concerns about Greece’s fiscal problems spread rapidly to the other peripheral member states due to the lack of common eurozone wide institutions to absorb shocks and growing uncertainty about the interpretation of the EU’s ‘non-bailout’ clause and the willingness of eurozone member states to support weaker member states and the currency union itself. Strong reliance in peripheral nations on external capital and interlinkages between governments and banks worsened these problems. As intra-eurozone capital flows fell sharply, the peripheral nations were confronted with a sudden stop of capital inflows and a strong tightening of financial conditions for sovereigns, banks, companies and households. Below we discuss how euro membership has had an impact on the crisis response.

The Crisis response

External assistance provided as part of eurozone membership…

The ECB played a crucial role in the crisis response. From the start of the crisis, particularly through its longer-term refinancing operations (LTRO) programs, the ECB mitigated the negative effects of rapidly reversing cross-border private capital flows. Growing divergence in Target II balances within the Eurosystem substituting for private intra-eurozone loans reflected this assistance. By providing cheap credit the ECB has thus saved the banking sectors in, and thereby the economies of, the crisis-hit nations from a collapse. Other eurozone member states as well benefitted, as a collapse would have had a severe, and possibly fatal, impact on the monetary union as a whole.

Access to other sources of finance was additional constrained. Financial support packages in the form of official intra-eurozone and IMF-loans[1] as well helped accommodate the balance of payments, banking and sovereign deficit crises that the peripheral nations fell prey to. However, sovereign bond yields, which had risen to elevated levels in all nations, only fell to additional sustainable levels next Mario Draghi’s promise in July 2012 to do “whatever it takes” to preserve the euro and the subsequent announcement of Outright Monetary Transactions[2] (figure 4). As a result, most crisis nations and governments gradually regained market access.

In contrast to additional regular, politically integrated currency areas, due to the limited size of the budget of the European Commission and the fact that support was given in the form of loans and not grants, the size of fiscal transfers within the euro area was and is very small. This made the adjustment process for peripheral eurozone members additional difficult. External support in the form of loans together with a strong reluctance part eurozone member states to allow sovereign defaults to take place, resulted in a further build-up of (external) public deficit, particularly in Greece

…but only next heightened market stress…

External assistance only came next extreme market stress. The eurozone wide crisis response was severely handicapped by the lack of supranational economic institutions. For a long time, it was not clear to what extent other eurozone members and the ECB and other European institutions were willing to support the crisis nations. Within the eurozone, there was initially no central bank that could act as a lender of last resort for sovereigns (De Grauwe, 2011)[3]. As a result, investors got concerned about the ability of peripheral member states to service their public deficit inclunding the possibility of a euro area break up. This severely constrained liquidity, particularly in Greece, Ireland, Portugal, Italy, Spain and Cyprus. From presently on, it was the intense market pressure that moved fellow Eurozone members and institutions like the IMF and the ECB to extend financial assistance..

…accompanied by austerity and reforms…

In return for financial support from other eurozone members, programme nations (Greece, Ireland, Portugal, Spain and Cyprus) had to push through reforms and severe austerity measures. Italy at no time requested a support programme, but implemented austerity measures to comfort financial markets and to live up to Europe’s budget rules. In all the crisis nations, austerity strongly contributed to high unemployment (figure 6) and a sharp and protracted contraction of GDP (figure 7).
 

On top of the conditions tied to financial support programmes, EU budget rules as well constrained non-crisis eurozone nations from supporting domestic request through fiscal policy. The fact that core member states as well tightened their budgets during the crisis years, made the adjustment process for peripheral eurozone members even additional difficult.

While fiscal profligacy was one of the major causes of the crisis in some nations, particularly Greece, a slower pace of fiscal adjustment could have reduced the negative impact of the adjustment process. Moreover, eurozone wide contractionary fiscal policy limited the effectiveness of expansionary monetary policy.

… and EMU membership did not allow nations to employ monetary and exchange rate policy

As members of a currency union, individual eurozone nations were by definition unable to individually employ exchange rate or monetary policy to address competitiveness problems and stimulate increase. As a result, nations had to resort to internal devaluation, i.e. reducing labour costs, at the cost of a further contraction of the economy and higher unemployment. However, currency devaluation via euro-exit would only have increased the peripheral nations’ external deficit challenges. Furthermore, euro exit would have created chaos, both for exiting nations themselves and for the other member states, as an exit would have increased uncertainty about the next of the (remainder of the) eurozone.