The Crisis in the Eurozone

The crisis in the Euro Zone

Did the euro contribute to the evolution of the crisis?

1. The global financial crisis that erupted with the collapse of Lehman Brothers in September 2008 ushered in a period of recovery in 2010 and 2011 driven primarily by growth in emerging markets. Yet, the simmering sovereign debt crisis in the Euro Zone represents a looming threat to the recovery of the world economy and could lead to a renewed global financial crisis. The purpose of this paper is to analyze the root causes of the crisis in Europe and assess the extent to which it was driven by the global financial crisis and by factors internal to Europe, notably the adoption of the common currency.

2. The crisis in Europe reflects primarily the reaction of financial markets to over-borrowing by private households, the financial sector and governments in periphery countries of the Euro Zone. In many analysts' views, the European debt crisis – which led to economic adjustment programs sponsored by the EU and the IMF in Greece, Ireland and Portugal – was caused by fiscal profligacy on the part of noncore countries driven primarily by the expansion of a welfare state model and rising public sector wages. Proponents of this view argue that if countries had balanced their budgets and avoided the temptation to create a welfare state, excessive private spending would not have occurred and investors and banks would have been more aware of the risks involved. Consequently, noncore countries must adopt a realistic position regarding their fiscal policy stance and renounce their welfare objectives. The generalized 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 G-20 Toronto summit in June 2010 established fiscal consolidation as the new policy priority.

3. This paper will argue that – in the peculiar policy and regulatory environment of the Euro Zone – the adoption of the euro itself was a major factor in bringing about excess consumption and exacerbating weak competitiveness in periphery countries in the Euro Zone. The euro was a crucial factor in promoting financial integration and lowering interest rates in periphery countries. While financial integration itself would have been a desirable outcome, it triggered large inflows of capital from core into non-core countries that financed rising consumption, partly encouraged by rising wages, as well as a real estate boom. In addition, much like in the United States, financial deregulation prompted the development of new financial instruments and derivatives which further spurred the real estate boom. Rising wages and the real estate boom initially helped increase fiscal revenue and allowed deficits to remain in line with the Maastricht criteria (except for Greece), in spite of government expenditure that rapidly rose due to increasing government wage bills and social transfers. Yet, with 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.

4. The global financial crisis since September 2008 led to a recession in Europe and triggered the burst of the real estate bubble; both resulted in a ballooning of fiscal deficits and a massive deterioration of debt indicators that set the stage for the sovereign debt crisis in the Euro Zone that began with the Greek crisis in early-2010.

Figure 1: Euro Zone growth: Projections and reality

Note: Projection data from previous year of actual GDP growth.

5. The dynamics between core countries, especially Germany, and non-core countries in the Euro Zone appear analogous to those between East Asian surplus economies and the United States in the run-up to the global financial crisis. Excess consumption in the United States brought about by a real estate boom and low interest rates allowed East Asian countries to expand their exports, until the burst of the real estate bubble and the ensuing crisis of the financial sector triggered a global recession. The consumption boom in the United States went hand in hand with a decline in the competitiveness of the US economy, in particular in the manufacturing sector.