The Eurozone Crisis: Contributors to the Vulnerability of Crisis

Written in April, 2021

Abstract: This essay explores the Eurozone crisis, emphasizing the initial imbalances in lending and borrowing, loose lending practices leading to a housing bubble, overinvestment, and deficit spending, as well as factors like contagion, institutional shortcomings, and policy failures contributing to the crisis.

Eurozone is an economic and monetary union consisting of seventeen countries that collectively adopt euro as their currency. These establishments were aimed to simplify intra-zone trading and borrowing. Within the eurozone, there are some originally more developed and economically more stable countries such as Germany, France, the Netherland. In comparison, there are weaker countries such as GIPS. The fact that all EZ countries were able to access financial market at “almost identical yields (page.22)” regardless of their imbalanced macroeconomic background fueled the EZ crisis.

With that being said, one of the most important factors leading up to the crisis, as identified by the authors, is the immense initial imbalances of intra-eurozone lending and borrowing. Peripheral countries such as and especially as Greece has too much of both private and public debt(page.31) from abroad that its domestic government revenue could not support to pay them back.

After the creation of EZ, weaker countries have access to both lower interest rate of borrowing and higher quota of the amount to borrow. At first, it creates the benefit for them to increase their domestic spending by adjusting fiscal policy. However, according to the article, the borrowed money was not used to pay off the original debt. Rather, it is used to increase economic development such as “housing and government services/consumption.” Consequently, loose lending conditions and cheap credits result in housing bubble and huge loan.

Moreover, GIPS tend to overinvest than to save(page.27.) Investment rates were relatively in high in GIPS while lower in core countries. In comparison, saving rates were relatively low in GIPS while relatively high in core countries. The over inflow of money into the market creates loss of price competitiveness, and high inflation for GIPS. Too much of investment also consolidates their trade deficits. Because GIPS has too small of domestic savings to support the domestic investment, and because GIPS attracts investors from abroad(page.28) at the same time, the countries would require foreign savings to make up the difference, and thereby creating a deficit. With this and the housing bubble, the deficit and debt are further deepened.

Back to the “government services,” the Greek government also uses the money to create more job, and therefore needs to borrow even more money to pay the wages. Therefore, Greece embarks on a huge deficit spending that it needs to repay the debt with more debt. It faces the debt trap where it must keep on taking out new loans in order to pay back the old ones. The cascade accounts for what the author argued as the “further worthening of their current accounts. (page.24)”

The basic concepts underlying such cascade is related to the theory of balance of payments. A budget deficit is defined as when the government expenditure is larger than its tax revenue. Such expenditure usually covers wage, capital and current investments. In order to finance and balance out such excess of expenditures over revenue, the government sources borrowing from abroad. The accumulation of borrowing, or the deficits minus budget surplus, becomes the public government debt. In short, EZ crisis is how imbalance of payments turned into public debt. And in terms of intertemporal balance of payments, which means the building of debt over periods, because the inflow of investment is in non-tradable sector, this does not help payback of debts either.

Contagion, another theory in regards of financial crisis plays a role in amplifying the EZ crisis. It is defined as the case that crises that begin in one country spread to other countries. After Greek’s severe current deficit and huge debt burden, it triggers the chain reaction and causes problem for all EZ countries. The final result is that it caused the “sudden stop” of capital inflow that no country would lend to Greece to repay the debt.

Lastly, apart from the imbalance lending and borrowing, the authors also argued some amplifiers such as lack of institutional infrastructure, failures in crisis management and some monetary and fiscal policy failures in terms of controlling the debt.