Theoretical background to the European Crisis

The origins of the European debt crisis can be directly traced back to the global financial crisis of 2007–2009, which spilled over into a sovereign debt crisis in several euro area countries in early 2010. To offset sharp falls in output, euro area governments (as governments in the rest of the world) responded with counter-cyclical fiscal policies that increased fiscal deficits. Moreover, fiscal positions worsened as tax revenues declined and transfer payments grew larger due to rising unemployment during the crisis. In many countries, government bailouts of banking systems also contributed to an increase in public debt. Private debt became public debt, be it through banking crises or the burst of housing bubbles, leading to sovereign crisis. The debt crisis in several member states of the euro area has raised doubts about the viability of the European Economic and Monetary Union (EMU) and the future of the euro. The crisis has highlighted the problems and tensions that will inevitably arise within a monetary union when imbalances build up and become unsustainable.

As far as banking crises are concerned, it had been understood that they could occur also within EMU. But what was not understood was that the combination of strong interdependence between banks and sovereigns and the absence of a lender of last resort for sovereigns made euro area countries particularly prone to such crises. The potential severity of what would become known as the ‘doom loop’ was not foreseen. Furthermore, the EU relied on a rather loose framework of cooperation between national authorities, and lacked a comprehensive template for dealing with cross-border issues. The generally prevailing view was that sovereign debt crises – also because of the prohibition of monetary financing – could occur. A substantial body of literature had emphasized that sovereign solvency would be a concern in a monetary union and that crises had to be prevented through fiscal surveillance. But no framework existed for such an eventuality and its potentially serious consequences. In setting up the EU policy framework, the focus was on crisis prevention mainly through the Stability and Growth Pact and other surveillance mechanisms. No thought was given to crisis management. In addition, until 2010, interpretations of the meaning of Article 125 of the EU Treaty (the no-bail out clause) differed in different countries and institutions, but these interpretations were not discussed, let alone reconciled. Finally, balances of payments (BOP) crises were deemed impossible since solvent agents within a country would always retain access to private funding. BOP crises were in fact ruled out by most authors.

An important element that much contributed to the European crisis was the mispricing of sovereign risk by capital markets and an ensuing misallocation of capital in the decade before the outbreak of the crisis. This had the effect of giving wrong incentives to policymakers. In fact, during the boom years, when financial markets were blind to the sovereign risks, no incentives were given to policy makers to reduce their debts, as the latter were priced so favorably. Since the start of the financial crisis, financial markets driven by panic overpriced risks and gave incentives to policymakers to introduce excessive austerity programmes. A high level of public debt is not a problem per se, as long as the government is able to refinance itself and roll over its debt. This requires public debt and the interest burden to grow more slowly than the economy and the tax base. This is not the case in many peripheral European countries. Therefore, today’s debt crisis is not merely a debt crisis; it is first and foremost a competitiveness and growth crisis that has led to structural imbalances within the euro area. In fact, below the surface of the sovereign public debt and banking crises lies a balance of payments crisis, caused by a misalignment of internal real exchange rates.

Since the European Monetary Union (EMU) has been built as a union of sovereign states, each state has retained its own national central bank, which has become a member of the so-called Eurosystem with the European Central Bank (ECB) at the top. National interbank payment systems have been merged into a euro area interbank payment system (TARGET2), where national central banks have assumed the role of the links between countries. So, TARGET2 plays a key role in ensuring the smooth conduct of monetary policy, the correct functioning of financial markets, and banking and financial stability in the euro area, by substantially reducing systemic risk. The settlement of cross-border payments between participants in TARGET2 results in intra-Eurosystem balances – that is, positions on the balance sheets of the respective central banks that reflect claims/liabilities on/to the Eurosystem. They are reported on the National Central Banks’ (NCB) balance sheets as TARGET2 claims, if positive, or TARGET2 liabilities, if negative, vis-à-vis the ECB as the central counterpart. TARGET2 balances reflect funding stress in the banking systems of crisis-hit countries, which must be interpreted with caution as they also reflect transactions among multi-country banking groups. Interpretations of the role assumed by TARGET2 balances fall into two camps. The first is that these balances correspond to current account financing, which can be labeled the flow interpretation. The second camp interprets TARGET2 balances as a “capital account reversal”, that is they see this as one symptom of a balance of payments crisis. Someone argues that the Eurosystem full allotment refinancing operations should be seen as financing the reversal of an outstanding stock of cross-border claims, while the TARGET2 payments system merely records the results. This corresponds to the stock interpretation of TARGET2 balances.

The tensions in sovereign debt markets and within the banking sector have fed each other, creating severe funding problems for many borrowers. These developments have also led to the fragmentation of the financial system along national borders, with a retrenchment of financial activities to national domestic markets. The resulting limited or costly access to funding for many businesses and households wishing to invest has been a major obstacle to recovery across Europe. At the same time, high levels of indebtedness mean that many economic actors need to reduce their financial exposure or increase their savings. Such “deleveraging” can also hamper recovery in the short term. The problems are particularly acute in the vulnerable euro area member states.