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Rebooting the Eurozone: Step 1 – Agreeing a Crisis narrative

The Eurozone needs fixing, but it is impossible to agree upon the steps to be taken without agreement on what went wrong. This column introduces a new CEPR Policy Insight that presents a consensus-narrative of the causes of the EZ Crisis. It was authored by a dozen leading economists from across the spectrum. The consensus narrative is supported by a long and growing list of economists. 

By Richard Baldwin, Thorsten Beck, Agnès Bénassy-Quéré, Olivier Blanchard, Giancarlo Corsetti, Paul de Grauwe, Wouter den Haan, Francesco Giavazzi, Daniel Gros, Sebnem Kalemli-Ozcan, Stefano Micossi, Elias Papaioannou, Paolo Pesenti, Christopher Pissarides, Guido Tabellini and Beatrice Weder di Mauro.

The Eurozone Crisis broke out in May 2010; it is a long way from finished. Although some positive signs have emerged recently, EZ growth and unemployment are miserable and expected to remain miserable for years.

  • A large slice of Europe’s youth have been or will be jobless during the critical, formative years of their working lives;
  • The economic malaise is feeding extremist views and nationalistic tendencies just when Europe needs to pull together to deal with challenges ranging from the migration crush to possible new financial shocks.

Worse yet, many of the fragilities and imbalances that primed the monetary union for this crisis are still present.

  • Many of Europe’s banks face problems of non-performing loans;

  • Many are still heavily invested in their own nation’s public debt – a tie that means problems with banks threaten the solvency of the government and vice versa;
  • Borrowers across the Continent are vulnerable to the inevitable normalisation of interest rates that have been near-zero for years.

As a first step to finding a broad consensus on what needs to be done to fix the Eurozone, we have written what we consider to be a consensus narrative of the Eurozone Crisis. It is published today as CEPR Policy Insight 85, which can be downloaded for free from:

Rebooting the Eurozone: Step 1 – agreeing a crisis narrative

Although the authors hark from diverse backgrounds, we found it surprisingly easy to agree upon a narrative and a list of the main causes of the EZ Crisis. We say “surprisingly” since EZ policymakers remain attached to very diverse narratives of the Eurozone crisis.

The need for a consensus narrative

Formulating a consensus on the causes of the EZ Crisis is essential. When terrible things happen, the natural tendency is to fix the immediate damage and take steps to avoid similar problems in the future. It is impossible to agree upon the steps to be taken without agreement on what went wrong. Absent such agreement, half-measures and messy compromises are the typical outcome. But this will not be good enough to put the EZ Crisis behind us and restore growth.

This is why formulating a consensus narrative of the EZ Crisis matters so much. Eurozone decision-makers will never agree upon the changes needed to prevent future crises unless they agree upon the basic facts that explain how the Crisis got so bad and lasted so long.

The EZ Crisis was a ‘sudden stop’ crisis

The core reality behind virtually every crisis is the rapid unwinding of economic imbalances. In the case of the EZ crisis, the imbalances were extremely unoriginal – too much public and private debt borrowed from abroad. From the euro’s launch till the Crisis, there were big capital flows from EZ core nations like Germany, France, and the Netherland to EZ periphery nations like Ireland, Portugal, Spain and Greece.

Importantly, the EZ Crisis should not be thought of as a government debt crisis in its origin – even though it evolved into one.

  • Apart from Greece, the nations that ended up with bailouts were not those with the highest debt-to-GDP ratios.
  • Belgium and Italy sailed into the Crisis with public debts of about 100% of GDP and yet did not end up with Troika programmes;
  • Ireland and Spain, with ratios under 40%, needed bailouts.

The real culprits were the large intra-EZ capital flows that emerged in the decade before the Crisis.

These imbalances baked problems into the EZ ‘cake’ that would explode in the 2010s. All the nations stricken by the Crisis were running current account deficits. None of those running current account surpluses were hit.

When the EZ crisis started, there was a ‘sudden stop’ in cross-border lending. Investors became reluctant to lend – especially to banks and governments in other nations. The special features of a monetary union meant that the ‘sudden stop’ was not precipitous (as it was, for example, in Iceland).

Rather this ‘sudden stop with monetary-union characteristics’ showed up in rising risk premiums. The abrupt end of capital flows raised concerns about the viability of banks and governments in nations dependent on foreign lending, i.e. those running current account deficits. Slowing growth produced big deficits and rapidly increasing public debt ratios. When things got bad enough, several governments had to take on some of their banks’ debt, thus increasing national debt ratios even further. This is how a balance of payments crisis became a public debt crisis.

Why EZ membership mattered: Crisis amplifiers

Monetary union mattered since it allowed the cross-border imbalances to get so large with such little notice before the Crisis struck. It also mattered since the incomplete institutional infrastructure amplified the initial loss of trust in the deficit nations in several ways.

  • EZ governments who got into trouble had no lender of last resort.

Absent a lender of last resort, a small sustainability shock could be amplified without bound due to the deadly helix of rising risk premiums and deteriorating budget deficits stemming from higher debt servicing costs. This debt-default-risk vortex caught Portugal and came close to catching Italy, Spain and Belgium. Even France and Austria floated into the penumbra of debt vortexes at the height of the Crisis.

  • The other classic crisis response – devaluation – was impossible for euro-using nations. W1

Taken together, these two features meant their euro-denominated borrowing was akin to foreign currency debt in a traditional, developing nation ‘sudden stop’ crisis.

  • The close links between EZ banks and national governments greatly amplified and spread the Crisis.

This is the so-called ‘doom loop’ – the potential for a vicious feedback cycle between banks and their government. It was one of the key reasons that a single surprise in Greece could swell into a systemic crisis of historic proportions.

  • The predominance of bank financing transmitted bank problems to the wider economy.

As the ‘doom loop’ and slowing economy raised uncertainty, investment suffered much more than in countries where bank financing is less central, such as the US. This weakened economies in ways that worsened the sustainability outlook for nations and banks.

  • The rigidity of factor and product markets made the process of restoring competitiveness slow and painful in terms of lost output.

The whole situation was made much worse by poor crisis management. Mistakes were made, but above all there was nothing in the EZ institutional infrastructure to deal with a crisis on this scale. EZ leaders faced the dual challenge of fire-fighting and institution-building – all in a situation where the interests of debtors and creditors diverged sharply and European electorates were closely following developments.

Judging from market reactions, each policy intervention ‘saved the day’ but made things worse from the next day on. The corner was only turned in the summer of 2012 with the decision to set up a banking union and the “whatever it takes” assertion by ECB President Mario Draghi.

The following leading economists have agreed to support the consensus-narrative. If you are an economist and would like to support the consensus-narrative this, please email [email protected] stating your support and attaching a CV showing you are an economist (business, media, academics, think tanks, etc.).

Academic supporters of the Consensus Narrative on the Eurozone Crisis (in order of replying)

Silvana Tenreyro, LSE, Sir Charles Bean, LSE (Ex-Deputy Governor Bank of England), Philippe Bacchetta, University of Lausanne, Jorge Braga de Macedo, Universidade Nova de Lisboa, Lars E O Svensson, Stockholm School of Economics (ex-Deputy Governor of Sveriges Riksbank), Andrew Rose,UC Berkeley, László Halpern, Hungarian Academy of Sciences, Refet S. Gürkaynak, Bilkent University, Giorgio E Primiceri, Northwestern University, Peter Bofinger, Universität Wurzburg, Jürgen von Hagen, Universität Bonn, Tryphon Kollintzas, Athens University of Economics and Business, Patrick Honohan, Trinity College Dublin (Ex-Governor of Central Bank of Ireland), Charles A Goodhart, LSE, David Vines, University of Oxford, Fabrizio Coricelli, University of Paris I, Stephanie Schmitt-Grohé, Columbia University, Pierre-Olivier Gourinchas, UC Berkeley, Evi Pappa, EUI, Cédric Tille, The Graduate Institute, Geneva (Member of the Swiss National Bank Council), Stephen G. Cecchetti, Brandeis International Business School (ex chief economic adviser for Bank of International Settlements), Carmen Reinhart, Harvard, Ugo Panizza, Graduate Institute, Geneva, Tommaso Monacelli, Bocconi, Donato Masciandaro, University of Bocconi,Tony Yates, University of Birmingham, Francisco Torres, LSE European Institute, Annette Bongardt, LSE European Institute, Yannis M. Ioannides, Tufts University, Paolo Giudici, University of Pavia, John Hassler,Institute for International Economic Studies in Stockholm, Dirk Schoenmaker, Rotterdam School of Management, Erasmus University, Guillaume Daudin, Université Paris-Dauphine, Jesper Stage, Luleå University of Technology, Manos Matsaganis, Athens University of Economics and Business, Athanasios Orphanides, MIT (Ex-Governor of Central Bank of Cyprus), Anthony Elson, Sanford School of Public Policy, Duke University, Barry Eichengreen, UC-Berkeley, Charles Wyplosz, Graduate Institute Geneva,Cecilio Tamarit, University of Valencia, Arnoud Boot, University of Amsterdam, Panagiotis Petrakis, National and Kapodistrian University of Athens, Augusto Schianchi, University of Parma, Ed Westerhout, University of Amsterdam, John Muelbauer, University of Oxford, Panos Tsakloglou, Athens University of Economics and Business, Harald Fadinger, University of Mannheim, Karl Morasch, Bundeswehr University Munich, Bas Jacobs, Erasmus University Rotterdam, Antonio Fatas, INSEAD, Erik Jones, SAIS JHU Bologna, Laura Parisi, University of Pavia,Manuel Pinho, Columbia  University (Former Minister of Economy of Portugal, 2005- 09), Andrea Salanti, Università degli Studi di BergamoGeorges Siotis, Universidad Carlos III de Madrid, Marios Zachariadis, University of Cyprus, Fabio Ghironi, University of Washington, António Mendonça, ISEG - Lisboa School of Economics & Management (Former Minister of Public Works, Transport and Communications), Mark Allen, Fellow CASE Research Warsaw (ex Director of Policy Development and Review, IMF), Simon Wren-Lewis, University of Oxford, Rafael Domenech, University of Valencia, Roger Farmer, UCLA, Samuel Bentolila, CEMFI Madrid

Economists from private sector

Eric Chaney, Chief Economist AXA, Marco Mazzucchelli, Managing Director at Bank Julius Baer in Zurich, Vitor Bento, Chairman of SIBS, SGPS and SIBS, FP and CEO of SIBS Pagamentos, Jordi Gual, Chief Economist and Chief Strategy Officer, CaixaBank, Rafael Domenech, Chief Economist for Developed Economies, BBVA, Gus Garita, IMA Asia, Christian Kopf, Spinnaker Capital

Economists from public sectors, think tanks, etc are:

Orkun Saka Shalva Mkhatrishvili Marta Götz Daniel Angel Urdaneta Zoubalevitch Miguel Otero-Iglesias Roger Wessman Dubravko Radosevic Erwan Mahe Filipe Moreira Alves Alexandre Schwarstman Paul Temperton Frederico Aragão Morais Sotiria Theodoropoulou  André ten Dam Andre Silva Anis Chowdhury Laurent Franckx Mark Allen Gustav A. Horn Jean Wanningen

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