RaboResearch - Economic Research

The eurozone (debt) crisis – causes and crisis response

Economic Report

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To the Eurzone (debt) crisis overview page 

  • 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 after extreme market stress. The implicit promise of the ECB to act as a lender of last resort countries and government was necessary to re-establish market access.
  • Program countries in particular had to push through reforms and severe austerity measures.
  • By definition, crisis countries 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 report, we outline how the eurozone crisis has evolved, with a special 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 countries would have been better off outside the euro area (for information on the benefits and costs of membership see for example Baldwin et al., 2008; Mongelli, 2010Rabobank, 2013)). For more detailed information about the specific causes and resolution of the crisis for each crisis country please see Eurozone (debt) crisis: Country profiles Cyprus, Greece, Ireland, Italy, Portugal and Spain

The Causes

The eurozone (debt) crisis was caused by (i) the lack of a(n) (effective) mechanisms / institutions to prevent the build-up of macro-economic and, in some countries, fiscal imbalances and (ii) the lack of common eurozone institutions to effectively absorb shocks (also 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 also 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 countries, irresponsible fiscal policies (figure 1). Meanwhile, partially as a result, the competitiveness of most Southern eurozone member states deteriorated substantially in the years after euro entry vis-à-vis their Northern counter parts, especially relative to Germany, which undertook wage moderation in this period (figure 2). Accordingly, most peripheral countries ran large current account deficits (figure 3) and experienced a (further) deterioration in their external investment positions. 

Figure 1:Fiscal stance prior to the crisis varies strongly between countries
Figure 1:Fiscal stance prior to the crisis varies strongly between countriesSource: Macrobond, Eurostat
Figure 2: Loss of competitiveness in most peripheral member states
Figure 2: Loss of competitiveness in most peripheral member statesSource: Macrobond, European Commission
Figure 3: Peripheral countries ran large current account deficits
 Figure 3: Peripheral countries ran large current account deficitsSource: Macrobond, IMF

While especially the (peripheral) countries with large housing market booms (i.e. Ireland and Spain) were already seriously affected by the Great Recession, a severe sovereign debt crisis started when the Greek government was no longer able to finance its debt 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 countries on external capital and interlinkages between governments and banks worsened these problems. As intra-eurozone capital flows fell sharply, the peripheral countries 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 countries from a collapse. Other eurozone member states also benefitted, as a collapse would have had a severe, and possibly fatal, impact on the monetary union as a whole (Rabobank, 2013).

Access to other sources of finance was more constrained. Financial support packages in the form of official intra-eurozone and IMF-loans[1] also helped accommodate the balance of payments, banking and sovereign debt crises that the peripheral countries fell prey to. However, sovereign bond yields, which had risen to elevated levels in all countries, only fell to more sustainable levels after 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 countries and governments gradually regained market access.   

In contrast to more 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 more difficult. External support in the form of loans together with a strong reluctance among eurozone member states to allow sovereign defaults to take place, resulted in a further build-up of (external) public debt, particularly in Greece (figure 5).

Figure 4: Government bond yields have fallen to below pre-crisis rates
Figure 4: Government bond yields have fallen to below pre-crisis ratesSource: Macrobond
Figure 5: Large external public debt increases
Figure 5: Large external public debt increasesSource: Macrobond, World Bank

…but only after heightened market stress…

External assistance only came after 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 countries. 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 debt as well as the possibility of a euro area break up. This severely constrained liquidity, especially in Greece, Ireland, Portugal, Italy, Spain and Cyprus. Ultimately, 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 countries (Greece, Ireland, Portugal, Spain and Cyprus) had to push through reforms and severe austerity measures. Italy never 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 countries, austerity strongly contributed to high unemployment (figure 6) and a sharp and protracted contraction of GDP (figure 7).

Figure 6: Unemployment rates have increased significantly
Figure 6: Unemployment rates have increased significantlySource: Macrobond, Eurostat
Figure 7: GDP volume still below pre-crisis peak in most crisis countries
Figure 7: GDP volume still below pre-crisis peak in most crisis countriesSource: Macrobond, Eurostat

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

While fiscal profligacy was one of the main causes of the crisis in some countries, 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 countries to employ monetary and exchange rate policy

As members of a currency union, individual eurozone countries were by definition unable to individually employ exchange rate or monetary policy to address competitiveness problems and stimulate growth. As a result, countries 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 countries’ external debt challenges. Furthermore, euro exit would have created chaos, both for exiting countries themselves and for the other member states, as an exit would have increased uncertainty about the future of the (remainder of the) eurozone.

Footnotes

[1] Union wide financial support funds (first EFSF and later ESM) were set up to prevent sovereign defaults and related contagion risk. Greece, Ireland, Portugal, Spain and Cyprus received financial support via these funds.

[2] Afterwards, the launch of quantitative easing by the ECB in March 2015 has resulted in further downwards pressure on yields.

[3] Since the introduction of the Outright Monetary Transactions (OMT, 2012), and especially since the formal approval of its existence by the European Constitutional Court (2015), the ECB can also buy government bonds in unlimited quantities. The main difference between monetary financing of government debt within and outside the EMU is that support via the OMT is conditional on an austerity and reform programme. This is important as structural reforms tend to increase the sustainability of government debt in the long term and this could help to reduce moral hazard risks. Outside the EMU, a Central Bank is unlikely to be able to request the government to push through reforms in exchange for government bond purchases. That said, the conditionality makes the emergency backstop subject to political risk.

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