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The Crisis in the Eurozone

By Justin Yifu Lin & Volker Treichel

Four years after the beginning of the global financial crisis, the protracted sovereign debt crisis in the eurozone is a looming threat to the recovery of the world economy and could lead to a renewed global financial crisis. While fiscal profligacy on the part of periphery countries has been viewed by many analysts as the root of the ongoing crisis, this paper argues that the impact on capital flows within the eurozone of financial deregulation and liberalization and of the adoption of the common currency was critical in exacerbating a growing competitiveness gap between core and periphery countries and explaining the evolution of the crisis.

The collapse of Lehman Brothers about four years ago marked the beginning of the most severe economic crisis since the Great Depression. While the sluggish recovery in 2010 and 2011—driven primarily by growth in emerging markets—seemed to promise a silver lining on the horizon, stubbornly high unemployment and weak housing markets in many advanced countries have dampened demand and underscore risks to achieving a self-sustained recovery. Most importantly, the protracted sovereign debt crisis in the eurozone is a looming threat to the recovery of the world economy and could lead to a renewed global financial crisis. What have been the root causes of the crisis in Europe?  How important has the global financial crisis been for the evolution of the crisis relative to factors internal to Europe, especially the adoption of the Euro? 

The crisis in Europe began when financial markets lost confidence in the creditworthiness of Greece and other periphery countries and interest rates on government bonds soared to levels that forced the governments of these countries to seek bailouts from the international community, including the European Community and the IMF. Rising risk premia on government bonds reflected the reaction of financial markets to over-borrowing by private households, the financial sector and governments in periphery countries of the eurozone. As fears of government default were the main trigger of the crisis, many analysts came to the conclusion that the crisis itself was caused by fiscal profligacy in periphery countries, driven by the construction of an elaborate welfare state and rising public sector wages. Consequently, these analysts argue, periphery countries’ commitment to fiscal discipline will allow Europe’s currency to regain strength, without further need for fiscal stimulus. Among European countries, Germany is a particularly strong proponent of the view that fiscal austerity is crucial to addressing the crisis, and under its influence, the G20 Toronto summit in June 2010 established fiscal consolidation as the new policy priority.

Yet, a deeper analysis of the dynamics underlying the current Euro crisis shows that financial deregulation and liberalization was a major cause of the crisis in periphery countries in the eurozone. Much like in the United States, financial deregulation and liberalization encouraged the development of new financial instruments and derivatives and allowed banks in core eurozone countries to increase leverage and boost loanable funds, spurring a real estate and consumption boom. This boom was also made possible by the adoption of the Euro in the context of greater European financial and economic integration, which lowered the currency risk in periphery countries and permitted interest rates to converge towards the much lower level in core countries. Both financial deregulation and the fall in interest rates contributed to large inflows of capital from core countries into periphery countries and led to housing bubbles and excess consumption. Increased lending from core eurozone countries also occurred in countries outside the eurozone, such as Iceland, Hungary and other countries in Eastern Europe. Abundant credit from core countries triggered an economic boom in the periphery countries, driven largely by rising consumption. Given that the boom initially helped increase fiscal revenue, deficits could remain in line with the Maastricht criteria (except for Greece), in spite of the fact that government expenditure rose rapidly due to increasing government wage bills and social transfers. Yet, with rising wages and growth increasingly driven by unsustainably high domestic consumption, periphery countries lost export competitiveness and the manufacturing sector declined. At the same time, core countries’ competitiveness and their external surpluses improved, as a result of wage restraint and the relative undervaluation of the Euro compared to the earlier national currencies.

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