While especially the peripheral countries with large housing market booms i. 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 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 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, 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. 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.
External assistance only came after extreme market stress. The eurozone wide crisis response was severely handicapped by the lack of supranational economic institutions.
For instance, Portugal was once a textile producing country. Nowadays cheap clothes are produced in Asia and high-quality wear in countries like Italy. Thus, some European economies lack a viable business model. This leads to further problems. Among these problems are labour market distortions which will be discussed in the next section.
The deep recession in Europe had a severe impact on labour markets, too. Increasing unemployment is a typical feature of banking crises see e. This applies to Europe. Figure 4 shows unemployment rates of selected countries and the average among all Euro members. According to Brada and Signorelli , differences in labour market performance after recessions can mainly be explained by the quality of institutions, the flexibility of labour markets, and structural factors.
We have already seen some economies with structural problems Portugal. To add another example, at the peak of the real estate bubble in Spain around one in four employees was working in the building sector. The whole sector was under pressure once the bubble burst. A second explanation comes from standard neoclassical theory. Thus, we must look at unit labour costs of some Euro countries figure 5.
Figure 5 shows unit labour costs on an index basis. Spain's and Portugal's unit labour costs increased over the full time range. Italy's unit labour costs went up until Germany's unit labour costs, on the other hand, increased until and then decreased slightly.
Ireland is the most impressive case as their unit labour costs went down all the time. But how can the increase in labour costs in Spain and Portugal be explained? Unit labour costs remain constant if nominal wages increase by just the sum of inflation and productivity gains.
So why did those countries not achieve productivity gains? Nominal wages increased by much more, forcing unit labour costs up. In addition, labour demand increased as a result of the rise in aggregate demand. However, since capital imports were mainly used for consumption, not investment, productivity only increased modestly. Therefore, these countries lost competitiveness.
It should be emphasized that the figure does not tell anything about the absolute differences of unit labour costs between countries. Germany's unit labour costs are still well above those of countries like Greece. However, it is not just costs that matter. One of the competitive advantages of Germany is that it produces high-quality products like engineering products.
This explains why Germany performs very well even though real wages are relatively high. Wage bargaining might give an explanation for different wage trends. According to Calmorfs and Driffill , real wages and unemployment are low if wage bargaining takes place either in a decentralized way or centrally.
Countries in which wages are negotiated in each sector have, on average, higher unemployment rates due to higher real wages. Trade union density, which might be used as a proxy for centralisation in wage bargaining, is high in Finland while it is slightly above OECD average in Germany, Portugal, and the Netherlands and above average in Spain. Greece, Italy, and Ireland can be considered as countries with trade union density that is neither high nor low. In Germany it is also pretty high.
This shows that these data alone cannot explain different labour market developments. However, dismissal protection together with minimum wages are two main factors for high youth unemployment rates in countries like Spain.
Lastly, labour market institutions play an important role in explaining unemployment differences. According to the model of Diamond, Mortensen, and Pissarides, there are search frictions on labour markets. Thus, vacancies and unemployment exist at the same.
The Beveridge curve figure 6 illustrates the relation between vacancy v and unemployment rates u. Simultaneous decreases in the vacancy and unemployment rate require improvement of matching efficiency.
Matching efficiency can be increased if regional and qualification mismatches fall, i. Thus, the German labour market "miracle" can be explained by several factors. One of the results was that the matching process was improved. The same reform had also intended to force the unemployed to accept low-wage jobs if necessary. Thus, the entitlement period for unemployment benefits was drastically shortened.
These reforms taken together caused a remarkable improvement of the situation on the German labour market. Finally, the Beveridge curve was sifted inwards and structural unemployment was reduced. Most importantly, regional and qualification mismatches have to be reduced by active labour market policy. The sovereign debt crisis is sometimes regarded as the main problem in Europe.
It is also used as a synonym for the Euro crisis. Some aspects of this crisis have already been covered in section "Causes of the Euro Crisis". In some cases, public debt was already high before countries introduced the Euro, while in others it increased as a result of the financial crisis. On the one hand, large public deficits in the aftermath of the crisis can be explained by rescue measures for banks and companies. On the other hand, public expenditures increased as governments fought the recession for instance with expansionary fiscal policy and mandated social expenditures e.
Moreover, public revenues decreased as a result of lower income and corporate tax payments as well as lower social welfare contributions. This is, however, only one part of the story. For the other, we should look at government bond yields of selected European countries figure 7. Note that government bonds yields were different before the Euro was introduced.
The nearer the Euro came, the lower the spreads were between German and French government bonds and Italian, Spanish, Portuguese, and Greek government bonds. From or on, differences were only marginal. This means that investors trusted Greece just as much as Germany or France. The turning point came in the second half of From then on, German and French government bond yields fell while they were rising for Greek, Italian, Spanish and Portuguese bonds.
Portugal and Greece seem to be the most drastic examples. The spreads between those countries' bond yields and those of Germany changed from 0. This does not bolster confidence that investors were entirely rational and took all relevant information into consideration. The same doubts arise if we take a look at ratings. This raises the question whether the rating of A was "correct". This is not to blame rating agencies; it is rather to show that most people believed that none of the Euro countries could get in such trouble or that they would be rescued if they did.
Now that public debt has increased due to the financial crisis, countries need to reduce their indebtedness. One problem is private debt see figure 2. Public and private debt can hardly be reduced at the same time. Countries like the US decided to reduce private debt first. Several European countries conducted austerity measures to reduce public debt.
Thus, private debt kept on growing. The latter option seems to be inferior because neither public nor private debt could be substantially decreased. Another issue for reducing debt can be exemplified with the following equation:. In this equation b t is the debt-to-GDP ratio in year t, r is the interest rate, g is GDP growth and d t is the primary balance in year t. The primary balance is the difference between public revenues and expenditures without interest rate payments.
The problem for PIGS countries is that those countries' interest rates are relatively high. We cannot say that they had to pay the interest rates that are illustrated in figure 7 because these are yields and not interest warrants. However, it shows us quite plainly why countries like Greece and Portugal needed help. Let's take the case of Portugal: in GDP went down by 3. However, Portugal had a primary deficit according to the table 5. Table 5 shows primary balances of some Euro countries.
Bold numbers indicate primary deficits. Portugal had primary deficits in every year. The only reason why the debt-to-GDP ratio did not increase much more before was that there was some GDP growth up to then.
So why did those countries with debt problems not cut spending much more than they did? The problem is simply that they are caught in a dilemma. If a country reduces spending and increases taxes, the primary balance might turn into a surplus.
However, these measures also cause GDP to plummet by a higher factor remember the Keynesian multiplier. In the end, the debt-to-GDP ratio b t might even increase due to this policy. Thus, it is essential for those countries to have GDP growth so that they can grow out of the crisis. GDP growth, however, cannot be the result of increased public spending. It can be caused by expenditure by countries without huge debt problems e. According to the International Monetary Fund [IMF], , debt reduction is especially successful if there is a policy mix and if monetary policy is loose.
Thus, fiscal consolidation should focus on structural problems rather than on temporary austerity measures. As fiscal repression is not likely to be an option for Euro countries, debt has to be reduced cautiously.
For instance, primary budget improvements used to be sustainable only if the annual change was around one percentage point. Furthermore, belt tightening can amplify banking problems Lane, This all shows that Europe has to accept that it will take a long time to get rid of public debt problems. Austerity measures that focus on short-term debt reductions are not a panacea. Up to now we have only seen problems that are located in single countries.
However, Euro countries trade with each other, leading to mutual dependencies. This refers to the problem of increased imbalances in current accounts of Euro member countries. It is instructive to look at the development of current account balances of selected Euro countries table 6. Table 6 shows the current account balances of some Euro countries.
There are two countries with relatively large current account surpluses, Germany and the Netherlands. Note that Germany ran deficits in and Afterwards, the surplus has grown and reached a peak of 7. The surplus of the Netherlands is even larger. On the other hand, Portugal, Greece, and Spain run current account deficits.
The data are quite worrying as they show massive imbalances in the Euro zone. How can these be explained? Prices and wages increased much more in deficit countries than in surplus countries.
Thus, countries like Greece and Spain were faced with real appreciations while Germany "depreciated" against other Euro countries. As imports depend on domestic income, this provided a further impetus for imports. These deficits and surpluses have further consequences. For euro zone countries the foreign exchange balance is balanced. Thus, current account surpluses are tantamount to capital account deficits and vice versa.
Table 7 shows the financial accounts of selected countries. These are the counterpart of the current account balances. Germany and the Netherlands, which have current account surpluses, have financial accounts deficits. Thus, money is transferred from Germany and the Netherlands to other countries mainly via credits, portfolio investment, and direct investment.
To put it in simple terms: German and Dutch savings are partly used to finance other countries' consumption and investments. The mirror of the financial account deficits of Germany and the Netherlands are financial account surpluses of countries which ran current account deficits. Thus, money flowed from surplus countries to deficit countries like Greece and Portugal.
One could also say that these financial account surpluses were necessary to finance those countries' current account deficits. It has to be emphasized that a capital account deficit is synonymous to an increase in external debt if the foreign exchange balance is balanced. Thus, we take a look at the development of external indebtedness which is illustrated in the figure 8. Figure 8 shows the international investment positions of selected Euro countries. What is evident from that figure is that Germany's and Netherlands' current account surpluses led to a massive increase in account receivables against other countries.
Germany's claims add up to more than one trillion Euros. These are, of course, not just claims against other Euro countries. At the same time liabilities of countries with current account deficits increased. In the case of Spain the increase is tremendous, around 0. This has far-reaching consequences for most countries. For a country which wants to leave the Euro, Euro-denominated obligations would increase in value in the new domestic currency.
This could trigger sovereign default or at least a massive debt restructuring. If Germany introduced the old D-Mark, its value would doubtless skyrocket. Thus, claims issued in Euro would decline in in D-mark value. This shows why Germany cannot have an interest in a breakdown of the Euro area. Equally, Italy could relatively easily leave the currency without ill effects, since government bonds are mainly hold by domestic savers.
Thus, leaving the Euro zone would not be tantamount with an Italian insolvency. It might seem odd that countries with public debt problems managed to have capital account surpluses even after We would expect investors to withdraw their portfolio investments because of concern about bankruptcies of banks and companies.
If they have serious doubts about the solvency of their debtors, this ought to lead to capital flight. Eventually, this would cause a capital account deficit. According to table 7 , large financial account deficits were not a major problem for PIGS countries. To understand why, we have to look at the Euro zone payment system. If a Spanish consumer wants to buy a Roquefort cheese from a French cheesemonger, he tells his house bank to transfer the money from his account to the account of the cheese trader.
However, this is not how the system works. The Bank of Spain just places an order for crediting this money into the account of the French central bank Banque de France.
The Banque de France then creates new money and credits the amount to the bank of the cheesemonger. Finally, the French bank credits the amount on the cheesemonger's bank account. The result is that money vanished in Spain and new money was issued on France. The same would happen if an Italian saver wanted to invest money in Ireland. Before the crisis liabilities and claims against the ECB balanced out as current account deficits were financed by capital imports.
However, after the outbreak of the Euro crisis, European banks and investors were not willing to lend as much money to banks and consumers of countries with trade deficits. Moreover, savers and investors withdrew money from troubled countries and invested their money in "safe havens" e. The effects on the so called Target-balances are presented in the figure 9.
Such views had resonance in northern Europe because they conformed to the modes of macroeconomic management that worked best there. In coordinated market economies operating an export-led growth strategy based on high levels of inter-sectoral wage coordination to hold down unit labor costs, a restrained macroeconomic stance is desirable because it reduces the incentives of trade unions and employers to exceed desirable wage norms.
In their case, economic growth depends more heavily on the expansion of domestic demand. Accordingly, economic growth is returning to Ireland, whose liberal market economy, oriented toward foreign direct investment, which is attracted by favorable tax treatment and a skilled, English-speaking population, has been buoyed by a resurgence in global demand.
But growth remains elusive in southern Europe where multiple years of austerity have taken a toll on productive capacity and levels of investment. Spain is growing again but at rates not yet high enough to reduce an unemployment rate close to 25 percent, and growth remains sluggish in Portugal where the unemployment rate is close to 15 percent.
In Greece, 26 percent of the workforce is still unemployed despite a decline in nominal wages of 25 percent since The bailout program has left it floundering in political as well as economic terms. In retrospect, it looks as if it would have been better if the country had been allowed to restructure its debt in and given aid designed to ease its transition toward a primary surplus rather than focused on paying back lenders. Such an approach would have imposed a larger share of the adjustment costs on European financial institutions and those who invest in them but potentially lower levels of suffering on the Greek people.
The response to the Euro crisis also laid bare a series of political paradoxes consequential for the future of European integration. In the context of coping with the crisis, the heads of government of the Eurozone met together or with other EU leaders an extraordinary fifty-four times between January and August On the one hand, these high-level meetings reflected unprecedented levels of consultation and cooperation among the member states.
On the other, this modus operandi sidelined the Parliament and Commission, institutions that were supposed to gain influence under the Treaty of Lisbon, in the name of advancing European democracy. The crisis years have also been marked by the ascendance of Germany to a position of virtual hegemony with the councils of the EU, a paradoxical result given that France initiated the move to EMU partly in order to reduce German influence over European economic affairs. Although it was inevitable that a reunified Germany would gradually become more willing to assert its national interests because it paid the largest share of the bailout bills, the Euro crisis rapidly thrust it to prominence and power, arguably before the German government had time to reflect carefully about how to balance national and European interests.
In many respects, Germany is a reluctant hegemon—less willing to pay the costs of providing public goods for a large number of states than the U. In the coming years, much will depend on what Germans think their leadership role in Europe entails.
In another paradoxical result, a crisis that ultimately called forth intensive cooperation among the political elites of the member states has ended up fostering hostility among the citizenry at large. Political leaders bear some responsibility for this state of affairs.
The initial response of many northern European politicians was to treat the crisis not as the existential dilemma that it was for Europe, but as a moral issue about whether the citizens of other countries had been adequately self-disciplined. When Syriza took office in Greece, it was repaid by accusations that the Germans were behaving like Nazis.
Sentiments such as these have eroded the sense of transnational solidarity on which electoral support for effective cooperation within the EU depends. The extensive conditions attached to its bailout agreements, and policed by the troika, have often been forced on reluctant national governments, notably in Ireland, which was forbidden from imposing a haircut on the holders of bonds in its failing banks, and in Greece, where the troika dictated highly-detailed sets of spending, tax, and industrial policies.
The reasoning, of course, is that European officials know better than their national counterparts how to secure the growth necessary to pay back substantial European loans, and there are precedents in the conditions imposed by the IMF on debtor countries.
But the European Union has pretensions to democratic governance that the IMF does not, and many wonder why it could not have negotiated a required level for budget surpluses in the debtor countries while leaving the decisions about how to meet those levels to elected governments. This new assertiveness is gradually altering the relationship between the EU and its constituent states.
In this context, the most pressing issue is whether the single currency can endure and operate successfully without deeper political integration. Among the European political elites, there is currently a strong impetus to centralize economic power in Brussels.
Many in the north want to give the EU more substantial powers over national budgets in order to avoid a repeat of the fiscal foibles that brought Greece to the brink of bankruptcy.
Politicians from the south are more likely to argue for an economic government equipped with new sources of funding and the capacity to promote reflation in Europe. They are supported by many economists who argue that the single currency will survive only if the Eurozone moves toward this type of fiscal union with supervisory powers over national budgets and ideally with a budget of its own to provide the social insurance benefits that might cushion the member states facing recession from such shocks.
It is difficult to see where the popular support necessary to alter the European treaties so as to build new European institutions would come from. The capacities to decide whom to tax and how to allocate the proceeds, however, are the most important powers of a democratic state.
Accordingly, many observers have argued that a Eurozone authority equipped with such powers must be democratically governed, and diverse sets of schemes for doing so have been produced, including proposals to elect the President of the Commission and to strengthen greatly the powers of the European Parliament. On this view, deeper fiscal union requires a political union based on the development of more democratic European institutions.
However, none of these schemes for turning the European Union or its Eurozone into a supranational democracy are really viable. In the absence of effective competition among genuinely European political parties, even the most ambitious schemes for making European institutions more democratic offer, at best, highly tenuous lines of electoral accountability, and, in the wake of the Euro crisis, popular support for passing more powers to Brussels is at a low ebb.
Majorities in most European electorates continue to favor the Euro and membership in the EU, but enthusiasm for further political integration has declined, and radical right parties opposed to European integration are on the rise across Europe.
Moreover, the torturous negotiations accompanying the Euro crisis have worn away the sense that the single currency is a positive-sum enterprise offering manifest benefits to all. Because those negotiations have been dominated by a search for national advantage, as well as endemic conflict between the ECB and European governments about which would bear the risks associated with new initiatives, the response to the Euro crisis has looked like a zero-sum enterprise in which the risks or costs of new initiatives are borne more heavily by some actors than others.
As a result, it has become more difficult to argue that further European integration is an enterprise from which all the member states will gain. The Eurozone may become locked into a deflationary macroeconomic stance that condemns some of its member states to slow rates of economic growth for years to come.
Therefore, the EU finds itself on the horns of a dilemma. Influential figures are arguing that the single currency will survive only if the Eurozone has an economic government of its own.
But, since there seems no way of making such a government truly democratic, moves in this direction threaten to replace embryonic democratic institutions with a new technocracy.
Caught between Scylla and Charybdis, the member states are currently temporizing. With a fiscal compact committing the member states to budgetary balance and new regulations for the supervision of national budgets, the European authorities have acquired unprecedented powers of purview over national budgets, but it remains unclear whether those powers will ever really be exercised.
As I have noted, because the political economies of the member states are organized in different ways, they cannot all emulate the export-led growth strategies of Germany. Some can prosper only via demand-led growth strategies that require more relaxed fiscal policies. The clear-cut danger is that the Eurozone may become locked into a deflationary macroeconomic stance that condemns some of its member states to slow rates of economic growth for years to come.
The important issue is what sorts of decisions would emerge from any new set of European institutions, and those decisions will depend on the relative power and positions of the national states represented there. A new set of institutions dominated by a German government convinced that the budgets of every member state should always be balanced and that trade surpluses reflect virtue while deficits result from vice might yield policies no more conducive to growth than the current ones.
Macroeconomic coordination at the European level will not be successful until those supervising it realize that there is more than one route to economic success.
Does this mean that, if the member states of the Euro do not move closer to fiscal and political union, the single currency is doomed to disintegrate? Not necessarily. The Eurozone does not yet have robust institutional mechanisms for economic adjustment. But it is arguable that, with a slightly more-developed institutional exoskeleton built on recent practice, the single currency may be able to endure. One key condition for economic success is a robust banking union capable of identifying and winding down insolvent banks so as to maintain transnational financial flows.
Although stalled on the issue of cross-national deposit insurance and equipped with a bank resolution fund that is currently too small, plans for such a banking union are proceeding.
Another condition underlined during the Euro crisis is the presence of a European central bank with the capability to act as a lender of last resort both to banks and to sovereigns in order to deter speculative attacks in the financial markets. Much depends on whether these practices are accepted as legitimate modes of operation going forward, and it is conceivable that they might be.
From my perspective, the key issue is whether the single currency can be sustained even if some member states run endemic deficits on their current account while others run persistent surpluses, since the presence of multiple varieties of capitalism inside the Euro makes that likely. For that to be possible, investors in the states that acquire funds by running surpluses must be willing to invest some of those funds in states running deficits.
A banking union offering reassurance about the solvency of counterparties helps make that possible. However, the growth prospects of the states running deficits must also look good enough to justify such investment. Thus, the fate of the Euro hangs to some extent on future prosperity in southern Europe. In previous decades, a catch-up process that leads countries at lower levels of economic development to converge toward the standard of living of those at higher levels of development has provided incentives for investment in southern Europe.
The Euro crisis has disrupted that process, and investors will be more wary about the types of asset booms that appeared over the last ten years. Therefore, much will depend on the capacity of the states on the southern and eastern boundaries of Europe to generate growth in new ways and, in particular, to move towards the production of higher value-added commodities in the context of global markets where the comparative advantages for low-cost production lie elsewhere.
That will require, in turn, that these countries adjust to the modalities of an emerging knowledge economy.
To date, the record of southern Europe on these fronts is spotty. Except in some regions, levels of vocational training and tertiary education lag behind those of northern Europe, and spending on research and development is at relatively low levels. But there is opportunity for improvement to be found here. The larger lesson is that the survival of the Euro and the prosperity of much of the continent will depend not simply on the short-term decisions taken about how to survive the crisis, but on the decisions that are made in the countries of southern and eastern Europe about how to invest in the levels of human capital and infrastructure that will position them for effective long-term growth.
In this regard, the future of Europe lies as much in the hands of national governments as it does in extended European cooperation. In many parts of Europe, the public evinces lower levels of trust in national governments than it does in the European Union, and there is corresponding turmoil in national politics.
But, provided Europe gives its member states adequate room for maneuver, this is not an impossible dream. Click Enter. Login Profile. Es En. Economy Humanities Science Technology. Scientific Insights. Multimedia OpenMind books Authors. Featured author.
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