Saturday, 12 November 2011

Eurozone crisis – analysis of causes and consequences (part 2)

The second part observes problems inflicted to the eurozone economies from abroad. It then looks at how foreign capital inflows (due to large CA deficits shown in part 1) were used in domestic economies. 

(Regarding the current affairs, the economist offers its own short history of the eurozone crisis, worth reading. In addition, its Free Exchange blog offers two good texts on the current eurozone affairs, one on Spain, the other on ItalyTyler Cowen offers an interesting summary on what we learned from the euro crisis on his blog Marginal Revolution.)

Instabilities from abroad

Problems with a CA deficit and the common currency

When one country runs a current account deficit, this implies that it runs a surplus in its capital account. A capital account surplus means an inflow of foreign capital (investments) into a country, which is essentially a good thing since money will always flow to where it expects the highest and safest returns. However, the question is where is the money from abroad being transferred to domestically? If it is used to finance investment (into manufacturing or any other wealth creating activity) instead of consumption, then the deficit can carry on rising as the country is using the inflow of capital to boost its production facilities and increase growth. If it is used to finance consumption and government expenditures focused on politically popular policies, then the outcome might be an asset price boom or an unsustainable fiscal position of the government who is becoming dependent on foreign capital to finance its over-exaggerated expenditures. Ireland, Spain and to some extent the US suffered from the first, while Greece, Portugal and Italy suffered from the former. 

Foreigners with high savings rates (China, Japan, Germany) choose where to invest their savings, and they usually choose the US, considered to be a safe haven for investments due to many factors. In Europe, savings from the core eurozone countries was channelled to the peripheral countries after introducing the euro, which explains the high CA deficits experienced by all the peripheral countries, pointed out in the previous post.

Before the euro unification Greece had a history of debt defaults, financial contagion, inflation crises and banking crises (see Reinhart and Roggof). This was usually reflected in its higher bond yields, a sort of a risk premium for investing in its debt. The spread between Greek and German bonds was always high. However, once the euro was introduced, its yields and the spread started decreasing making the Greek debt as safe an investment (financially) as the German debt. The reasoning behind it was that the ECB would make sure inflation will never again be the problem of Greece or any other peripheral country. Soon enough, every eurozone peripheral bond on the market traded as the German Bund – the spreads were smaller and the risks were perceived as non-existent (Basel I and II recognized their debt as zero risk-weighted assets).  

This meant one thing; all these countries could borrow at cheap rates, while the politicians had no need to be fiscally responsible and could resort to populist policies that would keep them in power. Borrowing cheaply meant that credit from abroad was used to fuel domestic consumption which led to a rapid increase in GDP above its potential levels (see graph from last post). The bubbles did not affect the same markets – Ireland (like the US) experienced a housing bubble (180% increase since 1998), Greece’s government increased its debt in order to support its public sector and win elections by populist policies, Spain in addition to the housing bubble had a construction bubble and so on. 

The following graphs observe how the inflow of capital was used in the peripheral economies. It compares growth of consumption and investment and government expenditures and investment for all the peripheral economies to see what really drove the GDP far above its potential level, and whether the CA deficit was unsustainable. 

Source: St Louis Fed, FRED economic data. (Note: consumption is everywhere depicted by the blue line, while fixed capital formation is the red line)

From the graphs it can be inferred that in all these countries, except Ireland, consumption was growing much faster than fixed capital formation (investments). In Ireland they grew simultaneously right about two years before the crisis, when the housing prices started to fall and the construction industry started deteriorating - the same effect can be noticed in Spain. 
Greece, Italy and Portugal saw particularly rising gaps between consumption and investment, implying that much more funds were guided into consumption than into investment. 

The next set of graphs shows the relationship between government expenditures and fixed capital formation. 

Source: St Louis Fed, FRED economic data. (Note: government expenditures are everywhere depicted by the blue line, while fixed capital formation is the red line)

Even thought the relationship isn't as straightforward as it is in the previous graphs, it does show a rising trend in each country's government expenditures (represented by the blue line). Even for Greece, government expenditure doubled over the past 10 years, while its investments rose by a third before the crisis, and are now approaching the level they were at 10 years ago. Italy saw its government expenditures rise the same level as investments, while Portugal experienced a significant decrease of the gap between investments and government expenditures after the introduction of the euro. 
Observe also the two spikes of investments in Ireland and Spain which show even better on the new set of graphs, pointing out to an asset price bubble and burst of the bubble. 

Summary of outside contagion 

Interest rates were low across the eurozone, and investors in the core countries seized this opportunity to invest in periphery countries. In Germany lack of domestic demand was suppressed by a rise of foreign investments. It became more attractive for investors to invest in the periphery as the risk of default was diminished by the fact that euro was backed up by all eurozone nations, including the most important ones like Germany and France. Capital outflows came mainly from the core as it was available now for German and French investors to broaden their portfolio onto new, and yet stable markets. The system of borrowing to fuel domestic asset bubbles worked as long as the asset prices kept rising. Borrowers could pay off their loans simply by borrowing more even cheaper. However, the sudden stop in credit flows put an end to this mechanism and made room for the recession.

In essence the idea of euro was to increase and smoothen convergence in the eurozone. Adoption of the euro made it easier for capital to flow into the peripheral countries. Their CA deficits prove this. However, this was an anticipated reaction and a welcomed move from the eurozone policymakers. It indeed helped fuel and sustain economic growth way above its potential level for some of these countries. The problem arose when the inflow of capital suddenly stopped due a spread of financial contagion across the globe spilled-over from the US. Investor confidence rapidly declined worldwide and the peripheral eurozone countries faced the same fate of the Latin American countries in the 90s. They were given the status of emerging market economies since they were no longer able to issue debt in their own currency. Investors didn’t react well to this. The sudden stop in 2009 made it difficult for these countries to roll over their debts which increased the European crisis of confidence and led the peripheral economies into recession. 

The underlying graphs show what was the driver of high growth above its potential level explained in the previous post. Consumption and government expenditures (and an asset price bubble in Ireland and Spain), rather than investments, were fueling growth creating dependency on foreign capital to service current liabilities. Local instabilities combined with an increase of systemic risk and outside shock that led to a stop of credit exaggerated the existing instabilities in the peripheral eurozone countries.

The next post looks at how the collapse came about and how the banks got involved and increased their risk exposure to peripheral debt. 


  1. excellent post and excellent blog!
    I like the international perspective you offer here and your explanation in how it affected the instabilities of the eurozone as a whole.
    I completely agree with your argument on inefficient distribution of capital inflows and the irresponsible way some of the politicians in the eurozone used its ability to borrow cheeper.
    Looking forward to the next post

  2. thank you and thanks for joining the blog

  3. Thank you for such a nice blog, it is very helpful.