The Crisis in the Eurozone

6. The road to financial integration in Europe began in early 1957, when under the so-called European directives most countries began to lift capital controls and deregulate interest rates, with a view to creating a single market in banking and financial services. However, only by the late 1980s and early 1990s did most countries embark definitively on a financial liberalization strategy, spurred by the single European Act of 1987 (Table 1).

Table 1: Financial liberalization and integration in Europe
	Lifting of capital controls	Interest rate deregulation	First Banking Directive	Second Banking Directive
Belgium	1991	1990	1993	1994
Denmark	1982	1988	1980	1991
France	1990	1990	1980	1992
Germany	1967	1981	1978	1992
Greece	1994	1993	1981	1992
Ireland	1985	1993	1989	1992
Italy	1983	1990	1985	1992
Luxembourg	1990	1990	1981	1993
Netherlands	1980	1981	1978	1992
Portugal	1992	1992	1992	1992
Spain	1992	1992	1987	1994
United Kingdom	1979	1979	1979	1993

7. In 1999, the adoption of a five-year financial harmonization program – the Financial Services Action plan (FSAP) – brought about a new level of financial integration. The FSAP's main objectives were (i) the development of a single market for wholesale financial services; (ii) the creation of open and secure retail markets; (iii) the establishment of clear, efficient, prudential rules and supervision of financial services; and (iv) the establishment of the conditions for an optimal single financial market. The Lisbon agenda and the re-launching of the Lisbon strategy further reinforced the goal of creating a single financial market. These reforms resulted in a fully integrated financial market. Using the Chinn-Ito index which measures openness in capital account transactions the table below shows that countries reached the status of full liberalization after the adoption of the euro in 2002 (Table 2).

Table 2: Chinn-Ito Index of capital account liberalization for selected groupings
	1990–1994	1995–1999	2000–2004	2005–2009
Core Countries	83.2	96.1	97.4	100.0
Non-Core Countries	19.5	80.5	96.6	100.0
Other Euro Countries	-37.9	-9.5	24.7	81.3
Non-Euro Countries	8.8	39.0	66.9	87.9

Note: The Chinn-Ito Index is expressed in terms of its highest value for all countries considered in their sample.

Thus, a value of 100 means complete liberalization.

Core countries include Austria, Belgium, France, Germany, and the Netherlands. Non-Core countries include Greece, Ireland, Italy, Portugal, and Spain. Other Euro countries include Estonia, Malta, the Slovak Republic, and Slovenia. Non-Euro countries are comprised of Sweden and the United Kingdom.

8. Financial integration resulted in a sharp increase in cross-border capital flows with claims by core countries on non-core countries' banking systems dominating the increase. Lending by German and French banks to non-core countries' banks was by far the most important factor in this increase.

Figure 2: Core bank claims in Non-Core countries

Note: Non-Core countries are Greece, Ireland, Italy, Portugal, and Spain.

9. Financial integration was also promoted by greater economic alignment among Euro Zone countries, resulting from the observance of convergence criteria for inflation, fiscal balances, exchange rate and interest rates that had been established as pre-conditions for the adoption of the euro. However, it was the adoption of the euro itself in 2002 which brought about a marked increase in financial integration. Table 3 shows the substantial growth in balance sheets in particular in non-core countries, following the adoption of the euro.

Table 3: Growth in balance sheets in European Union measured by external position vis-à-vis all sectors as percentages of GDP
Assets
Period	Core countries	Non-Core countries	Non-Euro
1990–1995	47.40	22.52	58.97
1996–2001	61.96	55.74	76.40
2002–2010	118.31	96.15	131.37
Liabilities
Period	Core countries	Non-Core countries	Non-Euro
1990–1995	41.79	19.89	63.26
1996–2001	63.40	60.31	84.35
2002–2010	102.44	107.22	148.44

Note: Core countries include Austria, Belgium, France, Germany, and the Netherlands. Non-Core countries include Greece, Ireland, Italy, Portugal, and Spain. Non-Euro countries include Sweden and the United Kingdom.

10. Kalemli-Ozcan et al investigate in greater detail the impact of the euro on financial integration. They find that following the adoption of the euro bilateral bank holdings and transactions increased by roughly 40 percent among the Euro Area countries. The significance of the euro for this result is underscored by comparing the increase in bank holdings in the 12 countries that first adopted the euro with the three EU 15 countries (Denmark, Sweden and United Kingdom) that have not joined the currency union.

11. After quantifying the total effect of the euro, Kalemli-Oczan also analyze the deeper roots of the impact of the euro on financial integration. Specifically, they ask whether the euro promoted financial integration by (i) reducing the currency risk and eliminating exchange rate fluctuations, (ii) through legal harmonization or (iii) through higher trade. They find that the euro's impact on capital flows was largely driven by the elimination of the currency risk. In addition, they confirm that the 27 directives of the FSAP had a major impact on financial integration and on the intensity of capital flows across member states.

12. They also investigate the hypothesis of whether cross-border banking integration is driven by an increased volume of transactions in international trade. As goods and assets move in tandem and currency unions raise bilateral trade, the positive impact of the single currency on financial integration may partly be coming from goods trade. Kalemli-Oczan et al. establish econometrically, though, that trade cannot explain any part of the effect of the euro on financial integration.

13. The elimination of the currency risk and the easier access to international capital markets that followed EMU membership led to convergence of interest rates in periphery countries to the level of core countries. The resulting fall in lending rates on commercial bank loans as well as on the cost of sovereign debt in periphery countries was perhaps the single most important effect of the adoption of the euro and had profound implications for the financial system in Europe and the structure of European economies (Figure 3).

Figure 3: Convergence in inflation rates and long-term bond yields

Note: Core countries are Austria, Belgium, France, Germany, and the Netherlands. Periphery countries are Greece, Ireland, Italy, Portugal, and Spain.

14. As pointed out by Perez-Caldentey and Vernengo, interest rate convergence also lowered interest rate margins especially in noncore countries. Between 1990–95 and 1996–2001, interest rate margins – as a percentage of total earning assets – declined from 3.9 percent to 2.8 percent, while they remained roughly constant in core countries. This translated into a decline in the rate of return over assets in noncore countries from 0.8 percent to 0.5 percent between 1990- 95 and 1996-2001. In the face of a decline in ROA (as in the case of noncore countries between 1990-95 and 1996-2007) or for a roughly constant ROE (as in the case of both core and noncore countries between 1996-2001 and 2002-2007) the levels of profitability (ROE) of the financial system can be maintained or increased by higher levels of leverage (or indebtedness). Available evidence on Germany (Bloomberg) shows that leverage for the major banks increased on average from 27 to 45 percent between 1996 and 2007 (Table 4).

Table 4: Selected indicators of the performance of the banking system in the European Union
Core Countries
Period	Financial deepening	Costs/Income	Interest margins	ROA	Concentration	Z-Score
1990–1995	92.5	72.8	2.3	0.3	67.2	15.4
1996–2001	103.5	67.8	2.5	0.9	67.2	9.4
2002–2007	108.2	70.2	2.1	1.0	68.2	7.3
Non-Core Countries
Period	Financial deepening	Costs/Income	Interest margins	ROA	Concentration	Z-Score
1990–1995	56.8	67.6	3.9	0.8	72.1	23.9
1996–2001	73.3	70.8	2.8	0.5	66.7	25.6
2002–2007	112.8	66.5	2.2	0.4	68.9	15.8
Eurozone Countries
Period	Financial deepening	Costs/Income	Interest margins	ROA	Concentration	Z-Score
1990–1995	77.0	65.8	3.1	0.6	73.7	18.1
1996–2001	77.3	69.9	2.7	0.7	68.8	12.7
2002–2007	101.3	67.6	2.4	0.8	70.8	10.4

Note: Core countries include Austria, Belgium, France, Germany, and the Netherlands. Non-Core countries include Greece, Ireland, Italy, Portugal, and Spain. "Financial deepening" is measured by private credit, deposit money banks, and other financial institutions. "Cost/Income" is measured as total costs, as a share of total income of all commercial banks. "Interest margins" equals the accounting value of a bank's net interest revenue, as a share of its interest-bearing (total earning) assets. ROA equals "rate of return over assets". "Concentration" refers to assets of three largest banks as a share of assets of all commercial banks. "Z-Score" is estimated as ROA+equity/assets/sd(ROA); the standard deviation of ROA, sd(ROA), is estimated as a 5-year moving average.

15. Where did the increase in lending go? The sharp fall in interest rates led to a very significant increase in consumer lending; and in Ireland and Spain, and to an extent in Greece, much of it was channeled into real estate (Figure 4). As a result, from 1997 to 2007, housing prices rose at an average annual rate of 12.5 percent in Ireland and 8 percent in Spain, compared to 4.6 percent in the United States during its bubble. Over the same period, construction as a share of gross output rose from 9.8 to 13.8 percent in Spain, and from 7.9 to 10.4 percent in Ireland. In the United States, the same figure only increased from 4.6 to 4.9 percent. Yet, the channeling of funds into real estate allowed bubbles to emerge in Ireland and Spain whose burst was at the core of the economic crisis.

Figure 4: Growth rate of mortgage loans for selected European countries

16. Like in the United States, financial deregulation encouraged the creation of derivatives whose risk profile could not be properly assessed. At the same time, risk management was weakened through the shadow banking system that was only marginally under the supervision of bank regulatory authorities. This was especially the case in Spain where securitization (mortgage-backed securitization and asset-based securitization (MBS and ABS onwards)) may have had a large and lasting effect on housing prices.

17. Fahri and Tirole link securitization as a major contributing factor to incentives towards leverage and the building up of systemic risks. Securitization allowed banks to turn traditionally illiquid claims (overwhelmingly in the form of bank loans) into marketable securities which enabled banks to off-load part of their credit exposure to other investors, thereby lowering regulatory pressures on capital requirements and allowing them to raise new funds and expand lending to the private sector. The massive development of the private securitization market experienced in recent years coincided with a period of low risk aversion and scant defaults. This so-called – Great Moderation resulted in a number of shortcomings in firms' risk management tools and models which often used default figures from this period and tended to underestimate default and liquidity risks.

18. Recent research empirically assesses the impact of securitization. Mian and Sufi show that securitization played an important role in the expansion of the supply of credit. Dell'Arriccia et al. suggest that lending standards declined more in those areas in the United States experiencing larger credit booms, housing price increases and higher mortgage securitization rates. Furthermore, results from Keys et al. show that existing securitization practices adversely affected the screening incentives. There is also evidence that securitization has quantitatively increased the amount of credit granted making it less dependent on specific banking or monetary policy condition. There is also considerable evidence that securitization makes further acquisition of risks more attractive for banks.

19. What was the impact of securitization on the housing market in Spain? Carbó Valverde, and Rodríguez Fernández, using cointegration and vector-error-correction models on a sample covering the 1988Q4 to 2008Q4 period, find that housing prices and mortgage credit interact in the short and the long run. Their results also suggest that there was a regime shift in mortgage lending in Spain starting in 2001 when mortgage credit securitization grew substantially. In the development of the credit boom from 2007 to 2010, the use of ABS and MBS grew significantly. The outstanding values of these securities gives an idea of the significant potential risk transferring associated with them. In particular, the outstanding values of Spanish ABS grew from 42 billion euros in 2008Q1 to 81 billion euros in 2009 Q4, declining to 75 billion euros in 2010 Q1. As for the MBS, the outstanding values changed from 112 billion euros in 2008 Q1 to 172 billion euros in 2009 Q2, falling afterwards to 164 billion euros in 2010Q1. So, overall securitization was a very important factor in the Spanish real estate bubble.

20. Convergence of interest rates within the Euro Zone also created a gap between the interest rates that would have been desirable from the point of view of a member country's individual circumstances and those that prevailed, thus underscoring the fact that the Euro Zone was not an optimal currency area. In fact, a recent study by the OECD finds that, using the Taylor rule, policy interest rates over 2001-2006 were approximately 500 basis points too high for Germany, but between 300 and 400 basis points too low for Spain, Greece and Ireland, and that these relatively low interest rates are correlated with increases in asset prices. They argue that accommodating monetary policy over the period 2002-2005 in combination with rapid financial market innovation seems to have been in retrospect among the factors behind the run-up in asset prices and consequent financial imbalances.

21. The abundance of capital flows throughout Europe, substantially lower borrowing costs, easy access to liquidity via leveraging and as a result of growing lending from core banks to noncore banks, and no exchange rate risk provided an illusionary sense of prosperity in a lowrisk environment. The sense of prosperity was illusionary because it was not matched by improvements in productivity or the business environment that would have laid the foundation for sustained long-term growth. In fact, the sudden abundance of financial flows in non-core countries resulting from the adoption of the euro exacerbated weak competitiveness that had already adversely affected these countries before the adoption of the common currency.

22. One of the factors contributing to this loss of competitiveness was the sharp rise in wages in non-core countries. Between 2001 and 2011 per unit labor costs in Greece rose by 33 percent, 31 percent in Italy, 27 percent in Spain and 20 percent in Ireland, while they grew by only 11 percent in the United States and by only 0.9 percent in Germany (Table 5). This increase in wages was primarily driven by increases in public sector wages – aimed at swaying the electorate towards the ruling parties – which then also triggered increases in private sector wages. Expenditure increases were considered to be manageable, though, owing to the substantially lower borrowing costs for sovereigns in the aftermath of the adoption of the euro and rapidly rising revenue reflecting the increase in economic activity and the real estate boom (Table 6 and Figures 3, 5 and 6).

Table 5: Percent increase in unit labor costs, Q1 2001–Q1 2011
Greece	33.2%
Italy	30.7%
Spain	26.6%
Ireland	20.0%
United States	11.5%
Germany	0.9%

Table 6: General government deficit, percentage of GDP
	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
Greece	-3.7	-4.5	-4.8	-5.6	-7.5	-5.2	-5.7	-6.5	-9.8	-15.6	-10.3	-9.1
Ireland	4.7	0.9	-0.4	0.4	1.4	1.7	2.9	0.1	-7.3	-14	-31.2	-13.1
Italy	-0.8	-3.1	-3.1	-3.6	-3.5	-4.4	-3.4	-1.6	-2.7	-5.4	-4.6	-3.9
Portugal	-3.3	-4.8	-3.4	-3.7	-4.0	-6.5	-4.6	-3.1	-3.6	-10.2	-9.8	-4.2
Spain	-0.9	-0.5	-0.2	-0.3	-0.1	1.3	2.4	1.9	-4.5	-11.2	-9.3	-8.5
France	-1.5	-1.5	-3.1	-4.1	-3.6	-2.9	-2.3	-2.7	-3.3	-7.5	-7.1	-5.2
Germany	1.1	-3.1	-3.8	-4.2	-3.8	-3.3	-1.6	0.2	-0.1	3.2	-4.3	-1.0

Figure 5: Annual growth of government expenditure, percent average for 1997–2007

Figure 6: Annual growth of government revenue, percent average 1997–2007

23. Bibow argues that one of the core reasons behind the current crisis of the Euro Zone is the lack of wage coordination which is normally critical in preventing asymmetric shocks and sustaining a monetary union. In fact, since 1996, Germany established its own new lower norm of zero nominal unit labor cost inflation resulting from a consensus between the trade unions, workers' representatives and employers that wage restraint was pivotal to preserve Germany's competitiveness, reduce unemployment and prevent further relocation of labor to Eastern Europe and other low-wage countries. Most European countries, especially on the periphery, found themselves unable to emulate German wage restraint, reflecting the political economy in their countries that resulted in pressure to increase wages at a time when the adoption of the euro seemed to herald a new era of prosperity.

24. Wage increases and growth in government spending in non-core countries led to large increases in aggregate demand. In Greece, for example, aggregate demand grew between 2002 and 2007 by an average of 4.2 percent compared to a growth of only 1.8 percent in the Euro Area. This increase was financed by foreign borrowing and resulted in higher inflation with consumer prices in Greece rising since 1997 by 47 percent compared to an increase of only 27 percent in the Euro Area. Only over the past four years, the real effective exchange rate appreciated by 17 percent eroding Greece's competitiveness and resulting in a widening current account deficit.

25. In a quasi Dutch disease-type phenomenon, this loss of external competitiveness also led to a shift away from manufacturing sectors towards service and non-tradable sectors. Table 7 shows that, between 2000 and 2007, the share of manufacturing in GDP fell by 10 percent in Ireland, 3 percent in Italy, 4 percent in Spain, and 3 percent in Portugal and 1 percent in Greece (from its already low level of 10 percent). At the same time, the share of the service and construction sectors in Spain increased by 3.4 percentage points of GDP, while it increased by 2.3 percent points of GDP in Ireland. The shares of the construction sector did not increase in Greece and Portugal.

26. Yet, the share of the manufacturing sector rose by 1 percentage point of GDP in Germany. This increase in the relative size of Germany's manufacturing sector (from its already very high level) was also reflected in a rise of Germany's overall surplus position with the Euro Zone member countries.

Table 7: Manufacturing Value Added, percent of GDP
	2007	Change since 2000
Germany	24	+1
Ireland	22	-10
Italy	18	-3
Spain	15	-4
Portugal	14	-3
Greece	10	-1

27. The emerging divergence in competitiveness between core and non-core countries was partly conditioned by countries' desire to observe Maastricht stability criteria. In fact, prior to the global financial crisis most Euro Zone countries maintained their fiscal deficits at or below 3 percent of GDP (with the notable exception of Greece and – to an extent – Portugal, although Portugal managed to substantially reduce deficits in 2007 and 2008). Several countries, such as Ireland and Spain even had surpluses. Yet with core countries able to pursue wage moderation and restraint policies and noncore countries not having the means to counteract and offset core countries' 'beggar thy neighbor' policies, a growing competitiveness gap emerged leading to widening euro imbalances.

28. And this impacted countries' external position: the current account balance for noncore countries deteriorated sharply during the finalization of the European integration process, and even more so following the adoption of the euro. Much like in the United States, this deterioration in the current account was driven by the sharp increase in housing prices. While many Northern European countries' current account positions improved, including those of Austria, Finland and the Netherlands, it was the massive increase in Germany's current account surplus by over 10 percentage points of GDP since 2000, partly because of increasing exports to periphery countries, that was at the core of the emergence of intra-European imbalances (Figure 7). Figure 8 shows the evolution of export market shares for Greece, Spain and Portugal. Growth in these countries was more and more dominated by internal consumption.

Figure 7: German trade surplus in Europe

Figure 8: Evolution of export market share

Note: This shows whether the country's exports grow faster or slower than its market, i.e., if it is experiencing market share gains or losses

29. Overall, at the heart of the crisis in the Euro zone is a balance of payments crisis caused by the large and growing gap in competitiveness between core and periphery countries. And as discussed above, the common currency was central to this outcome with its impact on interest rates (both for sovereigns and for credit to the private sector), financial integration and the encouragement of export-led growth in core countries and consumption-led growth in non-core countries.

30. The investment and consumption boom were not without (temporary) benefits. For example in Greece, after averaging an annual GDP growth rate of 1.1 percent from 1980 through 1997 – the slowest in eventual Euro Area countries – Greece's economy expanded at an average rate of 4.0 percent over the next ten years, the third-fastest rate in the Euro Area. In Spain, economic growth averaged 3.8 percent between 1997 and 2007, 1.3 percentage points higher than the average for the years between 1980 and 1997. Ireland had the highest growth during 1997 and 2007, achieving an average rate of 6.8 percent, an improvement over its already impressive growth rates of 4.6 during the years of 1980 and 1997. Only Portugal experienced slower average growth rates in the later period, with an average rate of 2.3 percent during 1997- 2007, and an average rate of 3 percent for the period 1980-97. This is due to the country's poor competitiveness. In fact, there is much evidence that Portugal's business climate is especially weak and further deteriorated following the adoption of the euro.

31. In the aftermath of the global financial crisis, most European countries entered a recession and the bubble in the real estate market burst, leading to sharp increases in nonperforming loans and subsequent government-financed bail-outs for the financial sectors. The increase in public debt resulting from these bail-outs was further compounded by the ballooning of government deficits resulting from the sharp fall in revenue as a result of the drop in output. Figures 9 and 10 show the evolution of fiscal balances and of the public debt burden following the crisis.

Figure 9: Evolution of general government deficits, percent of GDP

Figure 10: Evolution of general government gross debts, percent of GDP