July 10, 2017    5 minute read

Eurozone Finance and The Origins of the European Crisis

Chapter 4: Playing Detective    July 10, 2017    5 minute read

Eurozone Finance and The Origins of the European Crisis

The prolonged European crisis of the past years and the “Great Recession” that followed were due to a number of structural weaknesses of the peripheral European economies and to the “vices” of a number of local governments (i.e. lack of structural reforms, lower productivity levels, limited and unproductive investments, lack of liberalizations, lack of true competition, high taxation, high tax evasion, bureaucracy, corruption) which increased the divergence among the economies.

2008 Financial Crisis

But the crisis was also due to the devastating impact of the global financial crisis of 2008 and its aftermath, namely the sudden and disruptive freeze in the financial markets and liquidity markets; the sudden capital flight from the peripheral countries, when the crisis peaked; the severe and prolonged credit crunch that followed the financial crisis due also to undercapitalized banks, and a tougher prudential regulation.

But most of all, it was due to the lack of an immediate access to a single European crisis resolution mechanism – a backstop fund that would have helped stabilize the weaker economies after the crisis.

The ECB, somehow, has done the impossible after the crisis with the Troika, playing the role of the central bank but also a “political” role, and providing unconventional policies and support to states and banks.

How It All Started

When the peripheral European countries joined the euro in the late 1990s (the European Monetary Union), the interest rates they paid fell sharply as market participants judged that the value of investments in these countries would no longer be vulnerable to erosion through currency depreciation (competitive devaluations aimed at boosting exports).

Thus, since the interest rates in the peripheral countries were still higher and more attractive than those of the core European countries, massive inflow of funds arrived in these countries from the core ones.

Low real interest rates spurred heavy foreign borrowing by both the public and private sectors in the countries and triggered bubbles and severe imbalances/debt crises.

The problem was that foreign capital was used to support domestic consumption or housing booms rather than productivity enhancing investments. Thus, these countries engaged in substantial foreign borrowing for a number of years.

In other words, in spite of the fact that the economic fundamentals and business environment were not particularly brilliant (e.g. moderate GDP growth rates in some countries, or higher ones, but driven mainly by the housing and lending bubbles; high sovereign debts, and in some countries also high budget deficits; low productivity/higher unit labour costs in manufacturing, low investments in innovation, and decreasing competitiveness; current accounts imbalances and stronger exchange rates which eroded competitiveness; bureaucracy, red tape, and local elites defending their status quo), these Eurozone states had a wide availability of very cheap interest rates for long time, closer to the ones of the “core” Central and Northern European countries.

Shortsighted Investors

This was because investors and financial markets had limited perception of a potential underlying higher sovereign risk (risk premium), which could be triggered by severe and prolonged financial and economic shocks (e.g. the global financial crisis), without a lender of last resort (ECB), or without a fiscal and banking union, and solidarity mechanisms among member states.

This has led, in a number of peripheral countries, to the “Easy Credit” euphoria and to heavy borrowing engagements from foreign private investors, which have ultimately allowed domestic spending to outpace incomes.

Then, as it is well known, there was the perceived debt crisis/imbalances (e.g. “Grexit”) which reflected a loss of investor confidence in the sustainability of these countries’ finances and caused a spike in domestic interest rates, and capital flight towards “safer havens” (i.e. AAA rated bonds – German Bunds/cheaper funding costs).

Lower Interest Rates

The lower real interest rates available in the peripheral European countries, unwisely, have not been used by local governments to improve their countries’ competitiveness; to increase productive investments, repay their huge public debts, or to encourage structural reforms.

Joining the single currency (the euro), these countries have been forced to a stricter fiscal and monetary rectitude. They have lost the opportunity to use the exchange rate as a critical cushion against unexpected shocks or to the benefit of temporary competitive devaluations of the currency to boost export and growth.

Yet, they have had the benefit of a much stronger currency (euro) to purchase commodities and energy products (oil) but also cheaper interest rates to increase capital investment and improve firms’ profitability or to reduce the high public debts.


In many circumstances, however, these more favorable conditions were not used wisely to invest in innovative sectors but rather used to support domestic consumption or to invest in old economy activities (i.e. real estate), as it has happened in the U.S.A prior to the global financial crisis through the massive growth of the subprime mortgage segment and housing market.

The euro has not been the root cause of the demise of the weaker Eurozone countries since a number of these economies were not growing significantly even prior to joining the euro, and their level of productivity has actually decreased after joining the euro.


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