Nature and Causes of the Euro crisis by José Carlos Díez

Nature and Causesof the Euro crisis

* José Carlos Díez is an economist who has combined his academic and corporate roles

throughout his professional career. His academic activity is linked to the University of

Alcalá, where he was an undergraduate and PhD student and now is Professor of

Fundamentals of Economic Analysis.

He is currently the Chief Economist at Intermoney, a company founded in 1979 and

leader in Spain in money market brokerage. He contributes with his forecasts to the

panel of experts of the ECB on European economy and the panel of FUNCAS on the

Spanish economy, and advises companies, financial entities and institutions both natio-

nal and international.

Summary

This work analyses the Euro crisis. It includes a review of its his-

torical background and the exchange rate theory to provide con-

ceptual arguments to help understand the nature and causes the-

reof. It is an infrequent pathology in economics, particularly in

developed countries, but with an enormous destructive capacity.

/JOSÉ CARLOS DÍEZ */

63

Summary; 1. Introduction; 2. Historical background of the Euro; 3. Natureof the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causesof the Euro Crisis; 6. Conclusions; Bibliography

Nature and Causes of the Euro crisis

For this reason, it is important to get the right diagnosis when defi-

ning the economic policy that will solve the crisis. The main cau-

ses analysed herein are financial integration, the under-assessment

of risks, local imbalances within the Eurozone and the Great

Recession.

1. Introduction

The world financial crisis, whose first symptom was the collap-

se of the subprime asset-backed securities market at the start of

2007, has been changing. It is currently focused on Europe, and is

calling into question the future viability of the Euro and the

European project itself. This work aims to classify the nature of the

Euro Crisis and to identify the main causes thereof. Although the

objective is not to analyse potential economic measures designed

to solve the crisis, without an accurate diagnosis of the origin and

dynamics of the crisis, finding the right solution would be an exer-

cise in chance.

To this end, section 2 includes the history of the European pro-

ject and the single currency. Section 3 describes the nature of the

crisis, which is a seldom seen pathology in economics but which

causes devastating damage to unemployment and public debt of

affected countries. In order to provide the conceptual arguments

required to analyse the crisis, section 4 contains a review of the lite-

rature on exchange rates. Section 5 analyses the main causes of the

crisis, which are: i) financial integration and under-assessment of

64

The Future of the Euro

risk; ii) local imbalances; and iii) the Great Recession. Finally, sec-

tion 6 includes the main conclusions reached in the article and

establishes the requirements to be met by the roadmap in order to

put an end to the Euro Crisis.

2. Historical Background of the Euro

The Euro is the first monetary experiment of the 21st century. It

is not the first in history and shall not be the last, but it affects an

economy like that of the Eurozone which accounts for 15% of the

GDP and for 40% of world exports. The European Union is a poli-

tical project designed to prevent a third world war in Europe. The

first assignment of sovereignty was control by a supranational

body of the coal and steel production in France and Germany, basic

raw materials to produce weaponry. Europe was not an optimal

monetary area; therefore, if a country suffered from an asymmetri-

cal disturbance which did not affect the rest and it saw the effects

thereof on tis unemployment rate, this could not be offset by wor-

kers migrating to other countries with lower unemployment rates.

The bubble in Spain is a good example of this. Spain created one

third of the jobs in the Eurozone during the boom years, but wor-

kers from Germany, where the unemployment rate was reaching

historical levels, did not come: instead, it was workers from outsi-

de the Eurozone who came. When the bubble burst, our unem-

ployment rate shot up, but very few Spanish workers have gone to

work in Germany.

65


The example of an optimal monetary area is always the US.

However, we tend to forget that in order to get there; they first

had to annihilate the original settlers and then have a civil war

which led to a default on payment of foreign debt. The European

project belongs to the 21st century and when in Asia, America or

Africa integration processes begin, they look to Europe for inspi-

ration. Nevertheless, the Euro was a risky headlong rush. Since the

end of the Bretton Woods agreement, Europe has tried to avoid

the unfair competition of competitive devaluations within a cus-

toms union. Germany, with the strongest currency in the system,

has always led the monetary agreements, as its companies suffe-

red the industrial delocalisation created by devaluations, mainly

that of the Italian Lira, a country a few hours away by lorry from

Bavaria. After the fall of the Berlin Wall, the acceleration of the

monetary union was decided so that it would become the striker

of the political union. However, the political union reached stag-

nation after the severe German crisis of 2000, and the single

currency project began to crack.

3. Nature of the Euro Crisis

The nature of the crisis which is hitting the European Union is

a classical debt deflation crisis (Fischer, 1933). Since the Great

Depression, this type of crisis had mainly taken place in emerging

countries and was associated with countries with financial vulne-

rability, with little tradition of macroeconomic stability and insti-

66


tutional fragility. Japan had suffered a crisis of this kind in the

nineties and its economy is today trapped under deflation and

liquidity, but it was viewed as an exotic case in the Far East. In

2008, the Great Recession led to an abrupt disruption of the paths

of growth in developed economies, and the ghost of the Great

Depression began to haunt the world. By contrast, the decisive and

coordinated action of global economic policies prevented another

Great Depression (Eichengreen, 2010). Since then, world trade and

industrial production are 10% higher to levels prior to the Great

Recession, although the MSCI world stock index continues to be

20% below the levels of spring 2008.

Nonetheless, the crash of Lehman Brothers led to the collapse of

world trade, and all countries and areas entered abruptly into reces-

sion, which favoured policy coordination. But the recovery from

2009 was asymmetric, and the coordination of world economic

policies was conspicuously absent. In the Eurozone, from summer

of 2008 to spring of 2009, the euphoria in support of an interven-

tion to avoid a depression gave way to exit strategies in autumn of

that same year and to begin implementing these in spring of 2010.

The debt crisis affected a country with huge imbalances in the

balance of payments and high level of indebtedness such as

Greece, which accounts for 2% of the GDP and population of the

Eurozone, and has extended first to Ireland, then to Portugal, and

now to Italy and to Spain. One third of the GDP of the area is alre-

ady affected, and it has thus become a systemic and global pro-

blem. This is a crisis in the balance of payments, but the existence

67

of a currency and the high level of indebtedness mean the lack of

any comparable historical precedents, which in turn makes the

diagnosis and the search for policies to solve it much harder. For

this reason, we must carry out a review of classical literature on

exchange rates in order to establish the conceptual bases for the

explanation of the crisis, without which the search for a solution

would become a random wander.

4. Fixed exchange rates versus flexible exchange rates: a review

An exchange rate is a relative price between two hypothetical

shopping baskets of two countries. However, exchange rates are

closely related to interest rates (Keynes, 1992), and we are therefo-

re speaking of a relative price which is essential when explaining

economic development. Probably for this reason and as a result of

the advance of globalisation, both commercial and financial since

the fifties, in recent decades economists have paid special attention

to exchange rates. Exchange rates can be:

i. Free floating: the exchange rate is set freely in the market on the

basis of supply and demand, without the intervention of the

central bank or the government of a country. The Euro and the

Dollar are the closest free floating currencies.

ii. Dirty or managed float: the government or central bank suppo-

sedly does not intervene but there are verbal interventions or


68

changes in monetary policy which attempt to alter the bases of

supply and demand in the currency market. At times of maxi-

mum volatility both the US government and the European ones

verbally intervene in the market. During the Great Recession,

the Federal Reserve, without expressly acknowledging this, has

applied a monetary policy which has significantly weakened the

dollar. The ECB has always followed in the footsteps of the Fed

but in 2011 it managed to exceed its action by weakening the

Euro, also without express recognition thereof. Japan is without

question the best example of dirty flotation. The country sup-

posedly enjoys free exchange rates but when there is tension in

the markets and the savers repatriate capital, the central bank

intervenes massively in the currency market to counteract the

pressures of appreciation on its currency, which would have a

very negative repercussion on activity and employment.

iii. Fluctuation bands: the European Monetary System or EMS, the

predecessor of the Euro, was the clearest example of this system.

A central parity and fluctuation bands were established. Whilst

the exchange rate in the market fluctuated within the bands,

the system behaved like a flexible currency rate, but if it reached

the bands then the central bank intervened to prevent these

being exceeded, therefore becoming a fixed Exchange rate.

iv. Fixed on a currency basket: equal to a fixed rate, but instead of

fixing the anchor on one single currency it is fixed on a basket.

It has been speculated for some time that China wants to apply


69

this system. It makes more sense that just fixing it against the

dollar, as the basket should replicate the composition of the

current account and financial balance and would allow for bet-

ter stabilisation of real exchange rates, which are the ones

which determine the impact on activity and employment.

v. Fixed adjustable: this is a fixed exchange rate which allows

for adjustments. These may be discretionary or else subject

to rules such as in the Bretton Woods system, or periodically

adjustable. The latter were used in emerging countries which

had sustained soaring inflation rates in the eighties and

nineties during their stabilisation programmes, especially in

Latin America.

vi. Non-adjustable or true fixed rate: the country fixes a nominal

anchor with a fixed rate relative to another currency with no

possibility of change. Middle Eastern countries have fixed

exchange rates against the dollar, which is justified by income

from oil being collected in dollars. China had a fixed exchange

rate against the dollar until 2005, when it moved onto daily

fluctuation bands which it has recently broadened to +/- 1%

daily.

vii.Cash conversion: the monetary supply of a country is determi-

ned by the level of currency reserves, and thus monetary sove-

reignty is subject to capital flows. This was the exchange system

in Argentina until 2001.


70

viii.Exchange Union: the countries waive their national sove-

reignty and assume a new currency. This may be a dollarization

as has been proposed in some Latin American countries, or else

a Euroization where the dollar would be adopted but without

representation in the central bank. Or else a monetary and

exchange union such as the Eurozone, where countries assume

the same currency and are represented in the central bank and

in monetary and exchange decision making processes.

The debate on fixed or floating exchange rates is as old as macroe-

conomics. During the happy twenties and then during the Great

Depression, capital movements were accused of being speculative due

to the extreme volatility of exchange (Nurkse 1942). Subsequently,

another school of thought argued that the volatility was caused by

destabilising economic policies and that freedom and speculation had

stabilising effects (Friedman 1953). Rudiger Dornsbush opened up a

new avenue of research according to which, even with investors with

rational expectations, there was volatility in exchange rates. An incre-

ase in the money in circulation by the central bank would increase

inflation expectations and lead to a depreciation in the exchange rate.

However, for investors to buy once again there should be expectations

of appreciation; the exchange rate should therefore over-react and

exceed its level of equilibrium to enable capital flows to return to the

country.

The truth is that neither the theory nor the empirical evidence

are conclusive in this debate. The problem facing the countries is


71

threefold: exchange rate stability, monetary independence and

financial aperture. Conceptually speaking, flexible exchange rates

are the optimal solution, but for these to be stable the country

must have monetary credibility. Flexible exchange rates provide

leeway to the central bank in terms of fiscal policy, whereas the

fixed exchange rate means this is lost and it becomes dependent on

the decisions made by the central bank to which it has anchored

its currency. The problem is that credibility takes a long time to

achieve and takes very little time to lose. Moreover, it cannot be

imposed; it is the society of the country in question which must

understand stability to be a public asset and to accept sacrifices and

limitations in order to preserve it.

Countries lacking monetary credibility have hardly any leeway in

monetary policy, and this reduces the costs of accepting a fixed

exchange rate. If the country has suffered from hyperinflation or a

spiralling inflation, a nominal anchor on a stable currency allows for

stabilisation of the prices of imported goods in the shopping basket

and, combined with a stabilisation plan, proves to be highly effecti-

ve to get the economy out of hyperinflation. This is what happened

in Argentina in 1990, but then the fixed exchange rate allowed imba-

lances to go beyond what was sustainable and ended up by explo-

ding in mid-air and amplifying the effects of the severe crisis of 2001.

During the nineties the debate in Europe prior to the creation of

the Euro was very intense (Rodríguez Prada, 1994). Most econo-

mists did not call into question the fact that Europe was an opti-


72

mal monetary area (Meade 1957 and Mundell 1961). Although

much progress has been made in the freedom of movements of

capital and people, the labour markets continue to be segmented,

mainly due to language and cultural differences, and when a region

suffers an asymmetric disturbance with an increase in unemploy-

ment, this is not offset by transferring workers from another region

as they do, for example, in the US. In this scenario, the country

needs to transfer capital and work to the sector of non-corporate

goods to the corporate goods sector and needs to depreciate the real

exchange rate. Without the capacity to devaluate the nominal

exchange rate, all the adjustment must be made via inflation or

productivity. When the central country has inflation rates close to

2% the strategy must be deflationist, which is where the problems

start, as many economists warned prior to the creation of the Euro

and has been proven since the Great Recession (Obstfeld 1998).

Nevertheless, the lack of an optimal monetary union is clearly a

downside to the creation of the euro, but in the nineties it was the

benefits that were highlighted (De Grauwe 2009). The main bene-

fit is that we Europeans already had a customs union and high

level of commercial integration. Nowadays, approximately 70% of

the Spanish exports are concentrated in the European Union and

60% of what we import comes from our partners. Therefore, natio-

nal exchange policies were very destabilising in this scenario, put-

ting the European project at risk.


73

The main benefits were concentrated in the financial area.

Integration would enable the removal of currency risk and risk pre-

miums, leading to a drop in real interest rates and therefore incre-

asing the potential growth of the Eurozone and of each of the

countries therein, in turn allowing for convergence in income per

inhabitant with the US, which experience a sharp boom in pro-

ductivity in the nineties. Chart 1 shows how the introduction of

the euro did not achieve the desired convergence, except in the

case of Spain.


74

Chart 1Gross Domestic Product per inhabitant

Source: Eurostat structural indicators and own work

In the debate of costs and benefits prior to the creation of the Euro,

many economists warned of institutional problems in the design of

the monetary union. The main ones were the absence of a fiscal

union which would offset the asymmetric disturbances that might

take place in some states and, that in the absence of exchange rates

and monetary policy, the country would be left without economic

policy leeway to counteract them (Eichengreen 1998). The other

main limitation was the absence of a true lender of last resort which

the statutes imposed on the ECB (Obstfeld 1998).

5. Causes of the Euro Crisis

The Euro crisis is extremely complex like all debt deflation cri-

ses in history (Díez 2012), which is why we shall now review the

main events to enable us to understand the fundamentals of the

over-indebtedness without which we shall not be able to come up

with appropriate economic policies to help digest this.

5.1. Financial integration and under-assessment of risk

When a country adopts a fixed exchange rate and investors con-

sider it sustainable in the future, the risk premium drops. A rational

investor must choose between an infinite variety of international

assets in which to invest his savings, but his yield estimates are

made in local currency as the objective of purchasing financial

assets is to protect against the impairment of purchasing power


75

caused by inflation during the investment period. If an investor

purchases an asset in another currency that then appreciates

during the investment period, his yield will increase in the local

currency, but if it depreciates it will drop, which explains the direct

relationship between interest and exchange (Dornbusch 1976).

In the case of the Euro we are dealing with the exchange rate

with the largest commitment and greatest exit costs; therefore its

added credibility is also greater, just as the drop in risk premiums is

also highly intense. Chart 2 shows the intense process of financial

integration which took place in Europe following the creation of

the single currency. Investment funds and financial institutions in

the Eurozone went from having 20% of assets from other countries

in the region in their portfolios in 1998, to 45% and 40% respecti-

vely in 2007. This means a huge transfer of capitals from countries

with a savings surplus, mainly Germany, to countries with savings

deficits and especially those with higher risk premiums.

This arrival of capital flows, along with the credibility granted

by the investors to the Euro since its inception, help to explain the

intense convergence of interest rates between the public debt of the

various member countries that can be observed in Chart 3.

However, as is the case with all bubbles, at the beginning there are

fundamentals which justify investor behaviour, but usually, follo-

wing such sharp changes in financial flows, there is usually and

over-reaction and asset prices move away from the fundamentals.


76

Chart 4 shows how not only did convergence take place in

public debt interest rates, but that the process was more intense in

private debt. Covered bonds are the assets with the least likelihood

of default following the public debt of a country and it might even

be the case, in extreme cases, of default on Treasury bonds but not

on covered bonds, as has happened in Greece. The covered bond is

a bond with a senior guarantee from the financial institution that

issues it, but which also has a second guarantee. The issuing entity

selects its highest credit quality mortgages, those for the main resi-

dence, with a debt under 80% of appraisal and a monthly instal-

ment below 35% of the household income, and these are attached

as bond guarantees. Therefore, in the event of bankruptcy of the


77

Chart 2Financial integration

Source: European Central Bank

entity, the buyers of the covered bond would prevail over the rest

of creditors to collect on such mortgages until recovery of their

investment, irrespective of whoever purchases the bankrupt entity.

This is what distinguishes them from asset-backed securities where

the investor assumes the direct default of the mortgages. In the

case of the covered bond, the risk belongs to the entity and, second

to the default of the mortgages, and thus they have a dual guaran-

tee and lesser likelihood of default. Moreover, the rating agencies

require the over-collateralisation of the issue, so that if an institu-


78

Chart 310 years Public debt spread v. Germany

Source: Bloomberg and own data

tion issues a covered bond worth 1000 million euros, they would

be required to provide between 1300 and 1500 in mortgage portfo-

lio as a guarantee. Hence, the entity would first have to be declared

bankrupt and then it should have to have a default in the mortga-

ge portfolio of over 50% for the investor not to recover 100% of his

investment. This helps one to understand that since 2007 no cove-

red bond issued by a European entity has experienced default.

These types of assets do not exist in the US, as the Fannie Mae and

Freddy Mac played the same role, but evidence has shown that the

European system, by maintaining the risk in each institution, was

more efficient and, in fact, there are legislative proposals under way

to develop a covered bond market in the US.

Until 1997, the companies of peripheral countries such as Spain

found it difficult to issue bonds on the international markets. The

Peseta was a currency which had experienced several devaluations

over the last few decades, its financial markets were very narrow

and were practically taken over in full by public debt. The entry of

the Euro enabled Spanish financial entities to access an organised

market of covered bonds with a longstanding tradition and depth

in Germany, which rapidly spread to all other countries in the area.

As we shall explain shortly, this coincided with a deep and complex

debt crisis in Germany, as a result of the excesses of its Unification,

which increased the savings rate in a structural way, and thus the

supply of top quality credit assets for its financial institutions, insu-

rance companies and pension funds, which in turn boosted the

rapid growth of this market as well as its (Díez 2012b).


79

In Chart 5 we can see how such structural changes in the fun-

damentals led to a credit boom in the Spanish economy. The ori-

gin of the boom was justified by the fundamentals, but in the end

the only fundamentals were the self-realisable expectations, lea-

ding to the bubble. In 1995, when the likelihood assigned by inves-

tors that Spain would form part of the founder members of the

Euro was very low, practically all of the Spanish bonds in the hands

of non-residents were public. Since then, the percentage of public

debt over GDP had become constant, but when our incorporation


80

Chart 4Spanish covered bonds spreads

Source: Bloomberg and own data

into the single currency was approved in 1998, the international

issues market opened up for the private sector and grew exponen-

tially until it doubled that of public debt in terms of GDP. The hea-

ding “other resident sectors” includes the asset-backed securities

funds, rendering most of debt as pertaining to banks.

Covered bonds are purely a bank product, despite carrying a

second mortgage guarantee, and are accounted for as bank debt. The

most developed covered bond market in the world was the German


81

Chart 5Spanish bonds in the hands of non-residents

Source: Bank of Spain, INE and own data

one of Pfandbrife but in Chart 6 one can see how in 2006 the

Spanish banks issued 70,000 million euros in covered bonds, 30%

less than the German banks which had a balance three times as

large as that of Spanish banks. In summer 2007, before the start of

the financial crisis, the outstanding balance of covered bonds issued

by Spanish banks exceeded 300,000 million euros, 30% of the GDP

and an amount equal to the outstanding balance of Spanish public

debt. In 2006, the issues of covered bonds and asset-backed securi-

ties by Spanish banks comfortably exceeded the current account

deficit which was approaching 100,000 million and were the main

financing instrument of our economic, without which it is not pos-

sible to explain the credit and real estate bubble.

The dynamics were straightforward. The Spanish banks used the

loans granted in retail banking as a guarantee for new issues which

allowed the granting of new credits. The issues of covered bonds

were carried out at variable interest rates of Euribor plus 10 basis

points and the mortgages were granted at Euribor plus 50 basis

points. A strong growth in credit, low rate of default and spreads

between stable asset and liability rates constituted the basis of the

demand for funds of Spanish banks. What were the fundamentals

of the supply of funds? The key lay in the Shadow Banking System

(FSB 2011, European Commission 2012). This consisted mainly of

vehicles created by international banks, based in tax havens and

not consolidated in their balance sheets and thus outside the peri-

meter of oversight by the central banks. The vehicles purchased

assets, mainly of high credit quality and were funded by the com-


82


83

mercial paper market using those assets as guarantees. Let us assu-

me that the vehicle bought a covered bond at Euribor plus 10 basis

points and was funded by Euribor commercial paper. This resulted

in a profit of 10 basis points per transaction. If the vehicle only had

5% of capital and 95% of debt, this meant a 20-fold leverage, such

that the yield over equity was Euribor plus 200 basis points.

The growth of the shadow banking system was exponential and

in 2007 in the US reached 20 billion dollars, whereas the non-sha-

dow banking system supervised by the Federal Reserve amounted

Chart 6Issues of Covered Bonds

Source: International Monetary Fund

to 16 billion dollars. The asset-based leverage which used mortgage

guarantees already granted enabled the banking system to generate

liquidity in an endogenous manner without having to resort to the

central bank, leading to the loss of monopoly by the monetary aut-

horities of the issue of money in circulation. When in February

2005 Alan Greenspan, then President of the Federal Reserve,

announced that there was an enigma in the behaviour of the bond

market, he was responsible for this for allowing the development of

the shadow banking system. Until 2009, no statistics were publis-

hed on the shadow banking system but, once they became public,

it was much easier to understand the causes of the largest global cre-


84

Chart 7Current account balance

Source: International Monetary Fund


85

dit bubble burst since the Great Depression and which was parti-

cularly severe in some Eurozone countries, including Spain.

5.2. Local imbalances:

Over the last few decades, the economic paradigm has analysed

the real economy and the financial economy separately. The Great

Recession has proven the failure of the paradigm and, as we were

shown by Luca Paciolo in the 13th century, when an economy is

analysed, the assets and liabilities cannot be separated. Therefore,

although it is evident that the hurricane began in the financial

realm, there are imbalances in the real economy which also help

to explain the crisis. Chart 7 shows the divergence between

current account balances among developed and emerging coun-

tries in the last decade. Several causes help explain this phenome-

non which the literature has called “global imbalances” (Caballero

2009).

The main cause was the aftermath of the Asian crisis of 1997.

The affected countries had large current account deficits and low

levels of currency reserves before the crisis, and subsequently they

geared their economic policy towards exports. This led to current

account surpluses and high currency reserves, and the ensuing

structural increase of the world savings rate (Bernanke 2005). The

accumulation of reserves was concentrated on sovereign funds and

central banks with a conservative approach, which significantly

increased the demand for fixed income funds of top credit quality,

known as AAA. Without understanding the Asian crisis and its con-

sequences it is not possible to understand the intense development

of the shadow banking system and the strong increase in leverage

in the world banking system which has been analysed in the pre-

vious section (Caballero 2008).

Chart 8 shows how the Eurozone was hardly affected by the

phenomenon of Global Imbalances, with a current account balan-

ce close to equilibrium since the Asian crisis. However, Chart 8

shows that there have indeed been huge differences between the

countries within the Euro and, for this reason, the phenomenon

has now been called Local Imbalances. In 2001 Germany suffered a

debt crisis similar to the one suffered at present in Spain, although

it hardly translated into a current account or foreign debt deficit.

Germany, as was the case in Japan in the eighties, suffered from a

problem of over-indebtedness of households and businesses, with

real estate bubble, burst and depression all thrown in to the packa-

ge. Following the burst of the bubble in 2000, German households

were reluctant to take on debt and structurally increased their

savings rate to reduce such a debt. Private consumption plumme-

ted and businesses sought the supply that was absent in the domes-

tic market in the export market. The fiscal revenue dropped dra-

matically and Germany failed to meet the Stability Pact and wat-

ched its public debt increase significantly until 2005.

The birth of the euro and the credit boom in peripheral coun-

tries enabled Germany to overcome the severe recession thanks to


86

the strength of its exports. Moreover, German savings found an

easy path without assuming exchange rate risk with its partners in

the Eurozone. The causes of the Euro crisis are focused on the

analysis of the imbalances of debtor countries, but it is not possi-

ble to understand and explain the crisis without analysing the

saver countries, particularly Germany. Debtor countries are facing

a prolonged period of debt reduction, which will ensure a weak

internal demand, and shall be obliged to show a current account

surplus as was the case in Asia in 1998 and in Germany in 2001.

But this will not be possible if the creditor countries reduce their

current account surpluses and boost internal demand.


87

Chart 8Current account balance

Source: International Monetary Fund and own data

5.3. The Great Recession:

The European Monetary Union was born with institutional pro-

blems but these did not become evident and to put its viability at

risk until 2009. Chart 9 shows how the Great Recession which rava-

ged the world and Europe in 2008 has been the worst for seventy

years, although it did not reach the depth and length of the Great

Depression, which it is being called the Great Recession. Without

an earthquake of this force, it is possible that the institutional flaws

of the European project could have endured for longer, but the cri-

sis has highlighted them and the Euro is now at a crossroads.

In 2007 it was financial disturbances which anticipated the

recession. Chart 6 shows how the covered bond market practically

dried up for Spanish banks as well as for all other indebted coun-

tries. This brought the credit boom to a halt and acted as the trig-

ger for the recession. In 2008 the disorderly collapse of Lehman led

to the worst global run since the Great Depression. The investors

quickly resorted to short term public debt of the internal reserve

currencies, the money markets dried up as did the currency mar-

kets, and world trade collapsed in a matter of weeks. The coordi-

nated reaction of the G20 with the most expansive monetary, fis-

cal and financial policy in history prevented the world from ente-

ring into a depression and enabled a V-shaped recovery of world

economy and trade in 2009.


88

Economics is an empirical science but it is difficult to find

homogeneous experiments to compare policies, but this crisis has

provided one. The Great Recession was synchronized and most

countries entered into recession at the same time. However, the

recovery since 2009 has been disparate and the economic policies

have been very different between the US and the Eurozone, which

enables a comparison of its effects to be drawn. Europe began fis-

cal consolidation at the beginning of 2010, despite the boost

given in 2008 to get out of the recession, whereas the US has con-

tinued to renew its fiscal incentive plans. The ECB has been reluc-

tant to intervene and has only done so when the markets have

been on the edge of collapse and it even took the liberty of incre-


89

Chart 9GDP EU 15

Source: Angus Maddison. University of Groningen

asing the interest rated in July 2011, making the same mistake as

in July 2008, anticipating the recession. The Federal Reserve has

kept its rates at 0% and has renewed its quantitative policies.

After two years of experimenting, what has the result been? The

growth in the US has been twice that of Europe, its inflation has

also doubled and its unemployment rate has reduced to 8.5%,

whereas in Europe it has exceeded 10%. In the US, several states,

among them California and Florida, burst their real estate bubbles

and California defaulted on payments and created its own

currency, what was known in Argentina as Patacones. Therefore,

the Euro crisis is not the cause of the problems in Europe but

simply the result of mistakes made in economic policy in Europe

since 2009. Neither is the argument of the greater rigidity of

European labour markets and the mobility problems between

countries valid. In the US, the unemployment rate increased with

equal intensity in states which did not have a real estate bubble,

thus confirming that the cause of the growth in unemployment

was a sharp drop in demand caused by an intense banking crisis

and credit restriction. But the most spectacular result of the expe-

riment is probably what happened with public finances. The US,

without resorting to raising taxes, without great cuts and simply by

freezing public expenditure has managed to increase fiscal revenue

by 12% and has reduced the deficit by four percentage points of

GDP. Europe, by raising taxes and cutting costs has managed a

revenue increase of 6% and a reduction of the deficit of two points

of GDP.


90

The emergence of almost ten points of public deficit in a new

Government in Greece was the spark which ignited the Euro crisis

which we currently face. The Greek Tragedy spread first to Portugal,

then to Ireland, and currently threatens Spain and Italy, thus

having affected one third of the GDP of the Eurozone, (Díez, 2012).

Chart 2 shows how the Great Recession began a process of finan-

cial disintegration in the Eurozone which was intensified by the

Greek Tragedy and the contagion of all other economies. In a

monetary union, the outflow of capital is equal to a contractive

monetary policy and, on the contrary, the inflow of capital is

expansive. This helps us to understand why the countries subjected

to financial tension entered once again into deep recession in 2011

whereas Germany, the main receiver of capital flows, has continued

to grow.

6. Conclusion

The European project is a political one and it is born out of the

need to end wars and conflicts which had ravaged Europe in the

20th century. The Euro was an attempt to accelerate the political

union but has ended up being a headlong flight.

· The Euro is the most extreme version of a fixed exchange rate.

Indeed, it is reinforced and with high cost of departure, which

renders it more credible, but while it lacks a political union there

will always be doubts as to whether it will be a single currency.


91

· In the nineties the benefits – and there were some which have

been clearly demonstrated – of the creation of the euro were

overvalued. But at the same time there was an under-assessment

of the costs which reality has proven were also there. The two

main institutional problems which must be solved are: i) the

absence of a fiscal union to complement the monetary union

and ii) the absence of a lender of last resort due to the limita-

tions imposed on the ECB in its bylaws.

· Financial integration and the undervaluation of risk, both glo-

bal phenomena, are essential to explain the credit boom and the

problem of over-indebtedness which are the origin of the Euro

Crisis. The case of the covered bonds is a good example that not

only were credit risks undervalued, but liquidity risk was likewi-

se under-assessed.

· The Local Imbalances, the high current account surplus in

Germany and the deficits in Spain and other countries forced

the transfer of financial flows and boosted the credit boom and

over-indebtedness. Countries subjected to financial tension are

implementing sharp reductions in their current accounts, but

Germany has hardly reduced its foreign surplus since 2007.

· The institutional problems of the Eurozone became apparent at

the Great Recession, as a result of the sharp drop in activity and

the collapse of the financial markets and credit channels which

have rendered many debts unsustainable and unpayable.


92

Without such a deep recession, the problems would have taken

longer to appear.

· The aim of this article was not to discuss solutions, but from the

analysis of the nature and causes of the Euro crisis, we can con-

clude that the solution must: i) dispel doubts as to the future via-

bility of the euro, ii) to do so we must work towards the fiscal

union and the creation of Eurobonds would be the precedent for

a future single European treasury, iii) we must change the bylaws

of the ECB so that it may act as a lender of last resort as the

Federal Reserve does in the US, iv) we must halt the process of

financial disintegration and ensure the return of part of the capi-

tal flows which have exited from peripheral countries, and v) we

must urgently reactivate growth in Europe. In order to do so, the

monetary policy must opt for quantitative strategies of debt pur-

chase, the fiscal policy must be less restrictive and the financial

institutions and countries with greater solvency problems must

be recapitalized in order to restore the credit channels as soon as

possible.


93

Bibliography

- Bernanke, B. (2005). “The Global Saving Glut and the U.S. Current

Account Deficit”. Federal Reserve Speech 10 March.

- Bernanke, B. (2007). “The Financial Accelerator and the Credit

Channel”. Federal Reserve Speech 15 June.

- Caballero, Ricardo J., Farhi, Emmanuel and Gourinchas, Pierre-

Olivier (2008), "An Equilibrium Model of ‘Global Imbalances' and Low

Interest Rates," American Economic Review, vol. 98 (1), pp. 358-93.

- Caballero, Ricardo J. and Krishnamurthy, Arvind (2009), "Global

Imbalances and Financial Fragility," American Economic Review:

Papers & Proceedings, vol. 99 (May), pp. 584-88.

- European Commission (2012) “El Sistema Bancario en la Sombra”.

Libro verde, Marzo.

- De Grauwe, Paul (2009) Economics of Monetary Union 9 ed.

Oxford University Press. Oxford.

- Díez, José Carlos (2012) “Crisis de la Deuda Europea: crisis de emer-

gentes o sumergidos” Papeles de Economía Española 130 January,

pag. 150-166.


94

- Díez, José Carlos (2012b) “El Sistema Bancario tras la Gran

Recesión” Mediterráneo Económico 20 January, pag. 329-345.

- Dornbusch, Rudiger. (1976) "Expectations and Exchange Rate

Dynamics." Journal of Political Economy 84: pag. 1161-76.

- Eichengreen, Barry, and Wyplosz, Charles (1998) “The Stability

Pact: Stabilizing or Destabilizing?” Economic Policy 26 April, pag. 65-

113.

- Eichengreen, Barry and O’Rourke, Kevin (2010), A tale of two

depressions: What do the new data tell us? February 2010 update,

VoxEU.org, 8 March.

- European Commission (1998) “Convergence Report 1998”,

Bruselas.

- European Monetary Institute, Convergence Report, Frankfurt am

Main, March 1998.

- FSB, Financial Stability Board (2011) Shadow Banking:

Strengthening Oversight and Regulation. October.

- Friedman, Milton (1953) The Case for Flexible Exchange Rates.

Essays in Positive Economics.


95

- Chicago: University of Chicago Press, 1953, pp. 157-203. Chicago.

- Keynes, John M. (1992) Breve Tratado sobre la Reforma Monetaria.

Fondo de Cultura Económica de España. Madrid.

- Meade, James (1957) The Balance of Payments Problems of a Free

Trade Area.

- Economic Journal, Sept. 67, 379-96.

- Mundell, Robert (1961) A Theory of Optimum Currency Areas. The

American Economic Review, Vol. 51, No. 4., pp. 657-665.

- Nurkse, Ragnar (1942). International Currency Experience. Lessons

from the Inter-War period. League of Nations, p. 188. Genova.

- Obstfeld, Maurice (1998) EMU: Ready, or Not? Working Paper.

University of California, Berkeley.

- Rodríguez Prada, Gonzalo (1994) Teoría y estrategias de la integra-

ción económica y monetaria: con aplicaciones a los casos de la UE, el

NAFTA y el MERCOSUR. Universidad de Alcalá. Alcalá de Henares.

- Torrero, A. (2006) Crisis Financieras: Enseñanzas de Cinco Episodios.

Marcial Pons. Madrid.


96

Nature and Causes of the Euro crisis by José Carlos Díez

Education

Transcript of Nature and Causes of the Euro crisis by José Carlos Díez