Nature and Causes of the Euro crisis by José Carlos Díez

/JOSÉ CARLOS DÍEZ * /

Nature and Causes
of the Euro crisis

Summary; 1. Introduction; 2. Historical background of the Euro; 3. Nature
of the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causes
of the Euro Crisis; 6. Conclusions; Bibliography

Summary

This work analyses the Euro crisis. It includes a review of its his-
torical background and the exchange rate theory to provide con-
ceptual arguments to help understand the nature and causes the-
reof. It is an infrequent pathology in economics, particularly in
developed countries, but with an enormous destructive capacity.

* José Carlos Díez is an economist who has combined his academic and corporate roles
throughout his professional career. His academic activity is linked to the University of
Alcalá, where he was an undergraduate and PhD student and now is Professor of
Fundamentals of Economic Analysis.
He is currently the Chief Economist at Intermoney, a company founded in 1979 and
leader in Spain in money market brokerage. He contributes with his forecasts to the
panel of experts of the ECB on European economy and the panel of FUNCAS on the
Spanish economy, and advises companies, financial entities and institutions both natio-
nal and international.

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Nature and Causes of the Euro crisis

For this reason, it is important to get the right diagnosis when defi-
ning the economic policy that will solve the crisis. The main cau-
ses analysed herein are financial integration, the under-assessment
of risks, local imbalances within the Eurozone and the Great
Recession.

1. Introduction

The world financial crisis, whose first symptom was the collap-
se of the subprime asset-backed securities market at the start of
2007, has been changing. It is currently focused on Europe, and is
calling into question the future viability of the Euro and the
European project itself. This work aims to classify the nature of the
Euro Crisis and to identify the main causes thereof. Although the
objective is not to analyse potential economic measures designed
to solve the crisis, without an accurate diagnosis of the origin and
dynamics of the crisis, finding the right solution would be an exer-
cise in chance.

To this end, section 2 includes the history of the European pro-
ject and the single currency. Section 3 describes the nature of the
crisis, which is a seldom seen pathology in economics but which
causes devastating damage to unemployment and public debt of
affected countries. In order to provide the conceptual arguments
required to analyse the crisis, section 4 contains a review of the lite-
rature on exchange rates. Section 5 analyses the main causes of the
crisis, which are: i) financial integration and under-assessment of

64

The Future of the Euro

risk; ii) local imbalances; and iii) the Great Recession. Finally, sec-
tion 6 includes the main conclusions reached in the article and
establishes the requirements to be met by the roadmap in order to
put an end to the Euro Crisis.

2. Historical Background of the Euro

The Euro is the first monetary experiment of the 21st century. It
is not the first in history and shall not be the last, but it affects an
economy like that of the Eurozone which accounts for 15% of the
GDP and for 40% of world exports. The European Union is a poli-
tical project designed to prevent a third world war in Europe. The
first assignment of sovereignty was control by a supranational
body of the coal and steel production in France and Germany, basic
raw materials to produce weaponry. Europe was not an optimal
monetary area; therefore, if a country suffered from an asymmetri-
cal disturbance which did not affect the rest and it saw the effects
thereof on tis unemployment rate, this could not be offset by wor-
kers migrating to other countries with lower unemployment rates.
The bubble in Spain is a good example of this. Spain created one
third of the jobs in the Eurozone during the boom years, but wor-
kers from Germany, where the unemployment rate was reaching
historical levels, did not come: instead, it was workers from outsi-
de the Eurozone who came. When the bubble burst, our unem-
ployment rate shot up, but very few Spanish workers have gone to
work in Germany.

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The example of an optimal monetary area is always the US.
However, we tend to forget that in order to get there; they first
had to annihilate the original settlers and then have a civil war
which led to a default on payment of foreign debt. The European
project belongs to the 21st century and when in Asia, America or
Africa integration processes begin, they look to Europe for inspi-
ration. Nevertheless, the Euro was a risky headlong rush. Since the
end of the Bretton Woods agreement, Europe has tried to avoid
the unfair competition of competitive devaluations within a cus-
toms union. Germany, with the strongest currency in the system,
has always led the monetary agreements, as its companies suffe-
red the industrial delocalisation created by devaluations, mainly
that of the Italian Lira, a country a few hours away by lorry from
Bavaria. After the fall of the Berlin Wall, the acceleration of the
monetary union was decided so that it would become the striker
of the political union. However, the political union reached stag-
nation after the severe German crisis of 2000, and the single
currency project began to crack.

3. Nature of the Euro Crisis

The nature of the crisis which is hitting the European Union is
a classical debt deflation crisis (Fischer, 1933). Since the Great
Depression, this type of crisis had mainly taken place in emerging
countries and was associated with countries with financial vulne-
rability, with little tradition of macroeconomic stability and insti-

66


tutional fragility. Japan had suffered a crisis of this kind in the
nineties and its economy is today trapped under deflation and
liquidity, but it was viewed as an exotic case in the Far East. In
2008, the Great Recession led to an abrupt disruption of the paths
of growth in developed economies, and the ghost of the Great
Depression began to haunt the world. By contrast, the decisive and
coordinated action of global economic policies prevented another
Great Depression (Eichengreen, 2010). Since then, world trade and
industrial production are 10% higher to levels prior to the Great
Recession, although the MSCI world stock index continues to be
20% below the levels of spring 2008.

Nonetheless, the crash of Lehman Brothers led to the collapse of
world trade, and all countries and areas entered abruptly into reces-
sion, which favoured policy coordination. But the recovery from
2009 was asymmetric, and the coordination of world economic
policies was conspicuously absent. In the Eurozone, from summer
of 2008 to spring of 2009, the euphoria in support of an interven-
tion to avoid a depression gave way to exit strategies in autumn of
that same year and to begin implementing these in spring of 2010.
The debt crisis affected a country with huge imbalances in the
balance of payments and high level of indebtedness such as
Greece, which accounts for 2% of the GDP and population of the
Eurozone, and has extended first to Ireland, then to Portugal, and
now to Italy and to Spain. One third of the GDP of the area is alre-
ady affected, and it has thus become a systemic and global pro-
blem. This is a crisis in the balance of payments, but the existence

67


of a currency and the high level of indebtedness mean the lack of
any comparable historical precedents, which in turn makes the
diagnosis and the search for policies to solve it much harder. For
this reason, we must carry out a review of classical literature on
exchange rates in order to establish the conceptual bases for the
explanation of the crisis, without which the search for a solution
would become a random wander.

4. Fixed exchange rates versus flexible exchange rates: a review

An exchange rate is a relative price between two hypothetical
shopping baskets of two countries. However, exchange rates are
closely related to interest rates (Keynes, 1992), and we are therefo-
re speaking of a relative price which is essential when explaining
economic development. Probably for this reason and as a result of
the advance of globalisation, both commercial and financial since
the fifties, in recent decades economists have paid special attention
to exchange rates. Exchange rates can be:

i. Free floating: the exchange rate is set freely in the market on the
basis of supply and demand, without the intervention of the
central bank or the government of a country. The Euro and the
Dollar are the closest free floating currencies.

ii. Dirty or managed float: the government or central bank suppo-
sedly does not intervene but there are verbal interventions or

68


changes in monetary policy which attempt to alter the bases of
supply and demand in the currency market. At times of maxi-
mum volatility both the US government and the European ones
verbally intervene in the market. During the Great Recession,
the Federal Reserve, without expressly acknowledging this, has
applied a monetary policy which has significantly weakened the
dollar. The ECB has always followed in the footsteps of the Fed
but in 2011 it managed to exceed its action by weakening the
Euro, also without express recognition thereof. Japan is without
question the best example of dirty flotation. The country sup-
posedly enjoys free exchange rates but when there is tension in
the markets and the savers repatriate capital, the central bank
intervenes massively in the currency market to counteract the
pressures of appreciation on its currency, which would have a
very negative repercussion on activity and employment.

iii. Fluctuation bands: the European Monetary System or EMS, the
predecessor of the Euro, was the clearest example of this system.
A central parity and fluctuation bands were established. Whilst
the exchange rate in the market fluctuated within the bands,
the system behaved like a flexible currency rate, but if it reached
the bands then the central bank intervened to prevent these
being exceeded, therefore becoming a fixed Exchange rate.

iv. Fixed on a currency basket: equal to a fixed rate, but instead of
fixing the anchor on one single currency it is fixed on a basket.
It has been speculated for some time that China wants to apply

69


this system. It makes more sense that just fixing it against the
dollar, as the basket should replicate the composition of the
current account and financial balance and would allow for bet-
ter stabilisation of real exchange rates, which are the ones
which determine the impact on activity and employment.

v. Fixed adjustable: this is a fixed exchange rate which allows
for adjustments. These may be discretionary or else subject
to rules such as in the Bretton Woods system, or periodically
adjustable. The latter were used in emerging countries which
had sustained soaring inflation rates in the eighties and
nineties during their stabilisation programmes, especially in
Latin America.

vi. Non-adjustable or true fixed rate: the country fixes a nominal
anchor with a fixed rate relative to another currency with no
possibility of change. Middle Eastern countries have fixed
exchange rates against the dollar, which is justified by income
from oil being collected in dollars. China had a fixed exchange
rate against the dollar until 2005, when it moved onto daily
fluctuation bands which it has recently broadened to +/- 1%
daily.

vii. Cash conversion: the monetary supply of a country is determi-
ned by the level of currency reserves, and thus monetary sove-
reignty is subject to capital flows. This was the exchange system
in Argentina until 2001.

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viii.Exchange Union: the countries waive their national sove-
reignty and assume a new currency. This may be a dollarization
as has been proposed in some Latin American countries, or else
a Euroization where the dollar would be adopted but without
representation in the central bank. Or else a monetary and
exchange union such as the Eurozone, where countries assume
the same currency and are represented in the central bank and
in monetary and exchange decision making processes.

The debate on fixed or floating exchange rates is as old as macroe-
conomics. During the happy twenties and then during the Great
Depression, capital movements were accused of being speculative due
to the extreme volatility of exchange (Nurkse 1942). Subsequently,
another school of thought argued that the volatility was caused by
destabilising economic policies and that freedom and speculation had
stabilising effects (Friedman 1953). Rudiger Dornsbush opened up a
new avenue of research according to which, even with investors with
rational expectations, there was volatility in exchange rates. An incre-
ase in the money in circulation by the central bank would increase
inflation expectations and lead to a depreciation in the exchange rate.
However, for investors to buy once again there should be expectations
of appreciation; the exchange rate should therefore over-react and
exceed its level of equilibrium to enable capital flows to return to the
country.

The truth is that neither the theory nor the empirical evidence
are conclusive in this debate. The problem facing the countries is

71


threefold: exchange rate stability, monetary independence and
financial aperture. Conceptually speaking, flexible exchange rates
are the optimal solution, but for these to be stable the country
must have monetary credibility. Flexible exchange rates provide
leeway to the central bank in terms of fiscal policy, whereas the
fixed exchange rate means this is lost and it becomes dependent on
the decisions made by the central bank to which it has anchored
its currency. The problem is that credibility takes a long time to
achieve and takes very little time to lose. Moreover, it cannot be
imposed; it is the society of the country in question which must
understand stability to be a public asset and to accept sacrifices and
limitations in order to preserve it.

Countries lacking monetary credibility have hardly any leeway in
monetary policy, and this reduces the costs of accepting a fixed
exchange rate. If the country has suffered from hyperinflation or a
spiralling inflation, a nominal anchor on a stable currency allows for
stabilisation of the prices of imported goods in the shopping basket
and, combined with a stabilisation plan, proves to be highly effecti-
ve to get the economy out of hyperinflation. This is what happened
in Argentina in 1990, but then the fixed exchange rate allowed imba-
lances to go beyond what was sustainable and ended up by explo-
ding in mid-air and amplifying the effects of the severe crisis of 2001.

During the nineties the debate in Europe prior to the creation of
the Euro was very intense (Rodríguez Prada, 1994). Most econo-
mists did not call into question the fact that Europe was an opti-

72


mal monetary area (Meade 1957 and Mundell 1961). Although
much progress has been made in the freedom of movements of
capital and people, the labour markets continue to be segmented,
mainly due to language and cultural differences, and when a region
suffers an asymmetric disturbance with an increase in unemploy-
ment, this is not offset by transferring workers from another region
as they do, for example, in the US. In this scenario, the country
needs to transfer capital and work to the sector of non-corporate
goods to the corporate goods sector and needs to depreciate the real
exchange rate. Without the capacity to devaluate the nominal
exchange rate, all the adjustment must be made via inflation or
productivity. When the central country has inflation rates close to
2% the strategy must be deflationist, which is where the problems
start, as many economists warned prior to the creation of the Euro
and has been proven since the Great Recession (Obstfeld 1998).

Nevertheless, the lack of an optimal monetary union is clearly a
downside to the creation of the euro, but in the nineties it was the
benefits that were highlighted (De Grauwe 2009). The main bene-
fit is that we Europeans already had a customs union and high
level of commercial integration. Nowadays, approximately 70% of
the Spanish exports are concentrated in the European Union and
60% of what we import comes from our partners. Therefore, natio-
nal exchange policies were very destabilising in this scenario, put-
ting the European project at risk.

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The main benefits were concentrated in the financial area.
Integration would enable the removal of currency risk and risk pre-
miums, leading to a drop in real interest rates and therefore incre-
asing the potential growth of the Eurozone and of each of the
countries therein, in turn allowing for convergence in income per
inhabitant with the US, which experience a sharp boom in pro-
ductivity in the nineties. Chart 1 shows how the introduction of
the euro did not achieve the desired convergence, except in the
case of Spain.

Chart 1
Gross Domestic Product per inhabitant

Source: Eurostat structural indicators and own work

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In the debate of costs and benefits prior to the creation of the Euro,
many economists warned of institutional problems in the design of
the monetary union. The main ones were the absence of a fiscal
union which would offset the asymmetric disturbances that might
take place in some states and, that in the absence of exchange rates
and monetary policy, the country would be left without economic
policy leeway to counteract them (Eichengreen 1998). The other
main limitation was the absence of a true lender of last resort which
the statutes imposed on the ECB (Obstfeld 1998).

5. Causes of the Euro Crisis

The Euro crisis is extremely complex like all debt deflation cri-
ses in history (Díez 2012), which is why we shall now review the
main events to enable us to understand the fundamentals of the
over-indebtedness without which we shall not be able to come up
with appropriate economic policies to help digest this.

5.1. Financial integration and under-assessment of risk

When a country adopts a fixed exchange rate and investors con-
sider it sustainable in the future, the risk premium drops. A rational
investor must choose between an infinite variety of international
assets in which to invest his savings, but his yield estimates are
made in local currency as the objective of purchasing financial
assets is to protect against the impairment of purchasing power

75


caused by inflation during the investment period. If an investor
purchases an asset in another currency that then appreciates
during the investment period, his yield will increase in the local
currency, but if it depreciates it will drop, which explains the direct
relationship between interest and exchange (Dornbusch 1976).

In the case of the Euro we are dealing with the exchange rate
with the largest commitment and greatest exit costs; therefore its
added credibility is also greater, just as the drop in risk premiums is
also highly intense. Chart 2 shows the intense process of financial
integration which took place in Europe following the creation of
the single currency. Investment funds and financial institutions in
the Eurozone went from having 20% of assets from other countries
in the region in their portfolios in 1998, to 45% and 40% respecti-
vely in 2007. This means a huge transfer of capitals from countries
with a savings surplus, mainly Germany, to countries with savings
deficits and especially those with higher risk premiums.

This arrival of capital flows, along with the credibility granted
by the investors to the Euro since its inception, help to explain the
intense convergence of interest rates between the public debt of the
various member countries that can be observed in Chart 3.
However, as is the case with all bubbles, at the beginning there are
fundamentals which justify investor behaviour, but usually, follo-
wing such sharp changes in financial flows, there is usually and
over-reaction and asset prices move away from the fundamentals.

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Chart 2
Financial integration

Source: European Central Bank

Chart 4 shows how not only did convergence take place in
public debt interest rates, but that the process was more intense in
private debt. Covered bonds are the assets with the least likelihood
of default following the public debt of a country and it might even
be the case, in extreme cases, of default on Treasury bonds but not
on covered bonds, as has happened in Greece. The covered bond is
a bond with a senior guarantee from the financial institution that
issues it, but which also has a second guarantee. The issuing entity
selects its highest credit quality mortgages, those for the main resi-
dence, with a debt under 80% of appraisal and a monthly instal-
ment below 35% of the household income, and these are attached
as bond guarantees. Therefore, in the event of bankruptcy of the

77


Chart 3
10 years Public debt spread v. Germany

Source: Bloomberg and own data

entity, the buyers of the covered bond would prevail over the rest
of creditors to collect on such mortgages until recovery of their
investment, irrespective of whoever purchases the bankrupt entity.
This is what distinguishes them from asset-backed securities where
the investor assumes the direct default of the mortgages. In the
case of the covered bond, the risk belongs to the entity and, second
to the default of the mortgages, and thus they have a dual guaran-
tee and lesser likelihood of default. Moreover, the rating agencies
require the over-collateralisation of the issue, so that if an institu-

78


tion issues a covered bond worth 1000 million euros, they would
be required to provide between 1300 and 1500 in mortgage portfo-
lio as a guarantee. Hence, the entity would first have to be declared
bankrupt and then it should have to have a default in the mortga-
ge portfolio of over 50% for the investor not to recover 100% of his
investment. This helps one to understand that since 2007 no cove-
red bond issued by a European entity has experienced default.
These types of assets do not exist in the US, as the Fannie Mae and
Freddy Mac played the same role, but evidence has shown that the
European system, by maintaining the risk in each institution, was
more efficient and, in fact, there are legislative proposals under way
to develop a covered bond market in the US.

Until 1997, the companies of peripheral countries such as Spain
found it difficult to issue bonds on the international markets. The
Peseta was a currency which had experienced several devaluations
over the last few decades, its financial markets were very narrow
and were practically taken over in full by public debt. The entry of
the Euro enabled Spanish financial entities to access an organised
market of covered bonds with a longstanding tradition and depth
in Germany, which rapidly spread to all other countries in the area.
As we shall explain shortly, this coincided with a deep and complex
debt crisis in Germany, as a result of the excesses of its Unification,
which increased the savings rate in a structural way, and thus the
supply of top quality credit assets for its financial institutions, insu-
rance companies and pension funds, which in turn boosted the
rapid growth of this market as well as its (Díez 2012b).

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Chart 4
Spanish covered bonds spreads

Source: Bloomberg and own data

In Chart 5 we can see how such structural changes in the fun-
damentals led to a credit boom in the Spanish economy. The ori-
gin of the boom was justified by the fundamentals, but in the end
the only fundamentals were the self-realisable expectations, lea-
ding to the bubble. In 1995, when the likelihood assigned by inves-
tors that Spain would form part of the founder members of the
Euro was very low, practically all of the Spanish bonds in the hands
of non-residents were public. Since then, the percentage of public
debt over GDP had become constant, but when our incorporation

80


into the single currency was approved in 1998, the international
issues market opened up for the private sector and grew exponen-
tially until it doubled that of public debt in terms of GDP. The hea-
ding “other resident sectors” includes the asset-backed securities
funds, rendering most of debt as pertaining to banks.

Chart 5
Spanish bonds in the hands of non-residents

Source: Bank of Spain, INE and own data

Covered bonds are purely a bank product, despite carrying a
second mortgage guarantee, and are accounted for as bank debt. The
most developed covered bond market in the world was the German

81


one of Pfandbrife but in Chart 6 one can see how in 2006 the
Spanish banks issued 70,000 million euros in covered bonds, 30%
less than the German banks which had a balance three times as
large as that of Spanish banks. In summer 2007, before the start of
the financial crisis, the outstanding balance of covered bonds issued
by Spanish banks exceeded 300,000 million euros, 30% of the GDP
and an amount equal to the outstanding balance of Spanish public
debt. In 2006, the issues of covered bonds and asset-backed securi-
ties by Spanish banks comfortably exceeded the current account
deficit which was approaching 100,000 million and were the main
financing instrument of our economic, without which it is not pos-
sible to explain the credit and real estate bubble.

The dynamics were straightforward. The Spanish banks used the
loans granted in retail banking as a guarantee for new issues which
allowed the granting of new credits. The issues of covered bonds
were carried out at variable interest rates of Euribor plus 10 basis
points and the mortgages were granted at Euribor plus 50 basis
points. A strong growth in credit, low rate of default and spreads
between stable asset and liability rates constituted the basis of the
demand for funds of Spanish banks. What were the fundamentals
of the supply of funds? The key lay in the Shadow Banking System
(FSB 2011, European Commission 2012). This consisted mainly of
vehicles created by international banks, based in tax havens and
not consolidated in their balance sheets and thus outside the peri-
meter of oversight by the central banks. The vehicles purchased
assets, mainly of high credit quality and were funded by the com-

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Chart 6
Issues of Covered Bonds

Source: International Monetary Fund

mercial paper market using those assets as guarantees. Let us assu-
me that the vehicle bought a covered bond at Euribor plus 10 basis
points and was funded by Euribor commercial paper. This resulted
in a profit of 10 basis points per transaction. If the vehicle only had
5% of capital and 95% of debt, this meant a 20-fold leverage, such
that the yield over equity was Euribor plus 200 basis points.

The growth of the shadow banking system was exponential and
in 2007 in the US reached 20 billion dollars, whereas the non-sha-
dow banking system supervised by the Federal Reserve amounted

83


to 16 billion dollars. The asset-based leverage which used mortgage
guarantees already granted enabled the banking system to generate
liquidity in an endogenous manner without having to resort to the
central bank, leading to the loss of monopoly by the monetary aut-
horities of the issue of money in circulation. When in February
2005 Alan Greenspan, then President of the Federal Reserve,
announced that there was an enigma in the behaviour of the bond
market, he was responsible for this for allowing the development of
the shadow banking system. Until 2009, no statistics were publis-
hed on the shadow banking system but, once they became public,
it was much easier to understand the causes of the largest global cre-

Chart 7
Current account balance

Source: International Monetary Fund

84


dit bubble burst since the Great Depression and which was parti-
cularly severe in some Eurozone countries, including Spain.

5.2. Local imbalances:

Over the last few decades, the economic paradigm has analysed
the real economy and the financial economy separately. The Great
Recession has proven the failure of the paradigm and, as we were
shown by Luca Paciolo in the 13th century, when an economy is
analysed, the assets and liabilities cannot be separated. Therefore,
although it is evident that the hurricane began in the financial
realm, there are imbalances in the real economy which also help
to explain the crisis. Chart 7 shows the divergence between
current account balances among developed and emerging coun-
tries in the last decade. Several causes help explain this phenome-
non which the literature has called “global imbalances” (Caballero
2009).

The main cause was the aftermath of the Asian crisis of 1997.
The affected countries had large current account deficits and low
levels of currency reserves before the crisis, and subsequently they
geared their economic policy towards exports. This led to current
account surpluses and high currency reserves, and the ensuing
structural increase of the world savings rate (Bernanke 2005). The
accumulation of reserves was concentrated on sovereign funds and
central banks with a conservative approach, which significantly
increased the demand for fixed income funds of top credit quality,

85


known as AAA. Without understanding the Asian crisis and its con-
sequences it is not possible to understand the intense development
of the shadow banking system and the strong increase in leverage
in the world banking system which has been analysed in the pre-
vious section (Caballero 2008).

Chart 8 shows how the Eurozone was hardly affected by the
phenomenon of Global Imbalances, with a current account balan-
ce close to equilibrium since the Asian crisis. However, Chart 8
shows that there have indeed been huge differences between the
countries within the Euro and, for this reason, the phenomenon
has now been called Local Imbalances. In 2001 Germany suffered a
debt crisis similar to the one suffered at present in Spain, although
it hardly translated into a current account or foreign debt deficit.
Germany, as was the case in Japan in the eighties, suffered from a
problem of over-indebtedness of households and businesses, with
real estate bubble, burst and depression all thrown in to the packa-
ge. Following the burst of the bubble in 2000, German households
were reluctant to take on debt and structurally increased their
savings rate to reduce such a debt. Private consumption plumme-
ted and businesses sought the supply that was absent in the domes-
tic market in the export market. The fiscal revenue dropped dra-
matically and Germany failed to meet the Stability Pact and wat-
ched its public debt increase significantly until 2005.

The birth of the euro and the credit boom in peripheral coun-
tries enabled Germany to overcome the severe recession thanks to

86


the strength of its exports. Moreover, German savings found an
easy path without assuming exchange rate risk with its partners in
the Eurozone. The causes of the Euro crisis are focused on the
analysis of the imbalances of debtor countries, but it is not possi-
ble to understand and explain the crisis without analysing the
saver countries, particularly Germany. Debtor countries are facing
a prolonged period of debt reduction, which will ensure a weak
internal demand, and shall be obliged to show a current account
surplus as was the case in Asia in 1998 and in Germany in 2001.
But this will not be possible if the creditor countries reduce their
current account surpluses and boost internal demand.

Chart 8
Current account balance

Source: International Monetary Fund and own data

87


5.3. The Great Recession:

The European Monetary Union was born with institutional pro-
blems but these did not become evident and to put its viability at
risk until 2009. Chart 9 shows how the Great Recession which rava-
ged the world and Europe in 2008 has been the worst for seventy
years, although it did not reach the depth and length of the Great
Depression, which it is being called the Great Recession. Without
an earthquake of this force, it is possible that the institutional flaws
of the European project could have endured for longer, but the cri-
sis has highlighted them and the Euro is now at a crossroads.

In 2007 it was financial disturbances which anticipated the
recession. Chart 6 shows how the covered bond market practically
dried up for Spanish banks as well as for all other indebted coun-
tries. This brought the credit boom to a halt and acted as the trig-
ger for the recession. In 2008 the disorderly collapse of Lehman led
to the worst global run since the Great Depression. The investors
quickly resorted to short term public debt of the internal reserve
currencies, the money markets dried up as did the currency mar-
kets, and world trade collapsed in a matter of weeks. The coordi-
nated reaction of the G20 with the most expansive monetary, fis-
cal and financial policy in history prevented the world from ente-
ring into a depression and enabled a V-shaped recovery of world
economy and trade in 2009.

88


Chart 9
GDP EU 15

Source: Angus Maddison. University of Groningen

Economics is an empirical science but it is difficult to find
homogeneous experiments to compare policies, but this crisis has
provided one. The Great Recession was synchronized and most
countries entered into recession at the same time. However, the
recovery since 2009 has been disparate and the economic policies
have been very different between the US and the Eurozone, which
enables a comparison of its effects to be drawn. Europe began fis-
cal consolidation at the beginning of 2010, despite the boost
given in 2008 to get out of the recession, whereas the US has con-
tinued to renew its fiscal incentive plans. The ECB has been reluc-
tant to intervene and has only done so when the markets have
been on the edge of collapse and it even took the liberty of incre-

89


asing the interest rated in July 2011, making the same mistake as
in July 2008, anticipating the recession. The Federal Reserve has
kept its rates at 0% and has renewed its quantitative policies.

After two years of experimenting, what has the result been? The
growth in the US has been twice that of Europe, its inflation has
also doubled and its unemployment rate has reduced to 8.5%,
whereas in Europe it has exceeded 10%. In the US, several states,
among them California and Florida, burst their real estate bubbles
and California defaulted on payments and created its own
currency, what was known in Argentina as Patacones. Therefore,
the Euro crisis is not the cause of the problems in Europe but
simply the result of mistakes made in economic policy in Europe
since 2009. Neither is the argument of the greater rigidity of
European labour markets and the mobility problems between
countries valid. In the US, the unemployment rate increased with
equal intensity in states which did not have a real estate bubble,
thus confirming that the cause of the growth in unemployment
was a sharp drop in demand caused by an intense banking crisis
and credit restriction. But the most spectacular result of the expe-
riment is probably what happened with public finances. The US,
without resorting to raising taxes, without great cuts and simply by
freezing public expenditure has managed to increase fiscal revenue
by 12% and has reduced the deficit by four percentage points of
GDP. Europe, by raising taxes and cutting costs has managed a
revenue increase of 6% and a reduction of the deficit of two points
of GDP.

90


The emergence of almost ten points of public deficit in a new
Government in Greece was the spark which ignited the Euro crisis
which we currently face. The Greek Tragedy spread first to Portugal,
then to Ireland, and currently threatens Spain and Italy, thus
having affected one third of the GDP of the Eurozone, (Díez, 2012).
Chart 2 shows how the Great Recession began a process of finan-
cial disintegration in the Eurozone which was intensified by the
Greek Tragedy and the contagion of all other economies. In a
monetary union, the outflow of capital is equal to a contractive
monetary policy and, on the contrary, the inflow of capital is
expansive. This helps us to understand why the countries subjected
to financial tension entered once again into deep recession in 2011
whereas Germany, the main receiver of capital flows, has continued
to grow.

6. Conclusion

The European project is a political one and it is born out of the
need to end wars and conflicts which had ravaged Europe in the
20th century. The Euro was an attempt to accelerate the political
union but has ended up being a headlong flight.

· The Euro is the most extreme version of a fixed exchange rate.
Indeed, it is reinforced and with high cost of departure, which
renders it more credible, but while it lacks a political union there
will always be doubts as to whether it will be a single currency.

91


· In the nineties the benefits – and there were some which have
been clearly demonstrated – of the creation of the euro were
overvalued. But at the same time there was an under-assessment
of the costs which reality has proven were also there. The two
main institutional problems which must be solved are: i) the
absence of a fiscal union to complement the monetary union
and ii) the absence of a lender of last resort due to the limita-
tions imposed on the ECB in its bylaws.

· Financial integration and the undervaluation of risk, both glo-
bal phenomena, are essential to explain the credit boom and the
problem of over-indebtedness which are the origin of the Euro
Crisis. The case of the covered bonds is a good example that not
only were credit risks undervalued, but liquidity risk was likewi-
se under-assessed.

· The Local Imbalances, the high current account surplus in
Germany and the deficits in Spain and other countries forced
the transfer of financial flows and boosted the credit boom and
over-indebtedness. Countries subjected to financial tension are
implementing sharp reductions in their current accounts, but
Germany has hardly reduced its foreign surplus since 2007.

· The institutional problems of the Eurozone became apparent at
the Great Recession, as a result of the sharp drop in activity and
the collapse of the financial markets and credit channels which
have rendered many debts unsustainable and unpayable.

92


Without such a deep recession, the problems would have taken
longer to appear.

· The aim of this article was not to discuss solutions, but from the
analysis of the nature and causes of the Euro crisis, we can con-
clude that the solution must: i) dispel doubts as to the future via-
bility of the euro, ii) to do so we must work towards the fiscal
union and the creation of Eurobonds would be the precedent for
a future single European treasury, iii) we must change the bylaws
of the ECB so that it may act as a lender of last resort as the
Federal Reserve does in the US, iv) we must halt the process of
financial disintegration and ensure the return of part of the capi-
tal flows which have exited from peripheral countries, and v) we
must urgently reactivate growth in Europe. In order to do so, the
monetary policy must opt for quantitative strategies of debt pur-
chase, the fiscal policy must be less restrictive and the financial
institutions and countries with greater solvency problems must
be recapitalized in order to restore the credit channels as soon as
possible.

93


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