Revisiting the Euro Crisis

The euro crisis of the 2010s is well in the past now, but it remains one of the central macroeconomic events of our time.  But the nature of the crisis remains widely misunderstood, not only by the mainstream but also — and more importantly from my point of view — by economists in the heterodox Keynesian tradition. In this post, I want to lay out what I think is the right way of thinking about the crisis. I am not offering much in the way of supporting evidence. For the moment, I just want to state my views as clearly as possible. You can accept them or not, as you choose. 

During the first 15 years of the euro, a group of peripheral European countries experienced an economic boom followed by a crash, with GDP, employment and asset prices rising and then falling even more rapidly. As far as I can tell, there are four broad sets of explanations on offer for the crises in Greece, Ireland, Italy, Portugal and Spain starting in 2008. 

(While the timing is the same as the US housing bubble and crash, that doesn’t mean they are directly linked — however different they are in other respects, most of the common explanations for the European crisis I’m aware of locate its causes primarily within Europe.s)

The four common stories are:

1. External imbalances. The fixed exchange rate created by the euro, plus some mix of slow productivity growth in periphery and weak demand growth in core led to large trade imbalances within Europe. The financial expansion in the periphery was the flip side of a causally prior current account deficit.

2. Monetary policy. Both financial instability and external imbalances were result of Europe being far from an optimal currency area. Trying to carry out monetary policy for the whole euro area inevitably produced a mix of stagnation in the core and unsustainable credit expansion in the periphery, since a monetary stance that was too expansionary for Greece, Spain etc. was too tight for Germany.

3. Fiscal irresponsibility. The root of the crisis in peripheral countries was the excessive debt incurred by their own governments. The euro was a contributing factor since it led to an excessive convergence of interest rates across Europe, as markets incorrectly believed that peripheral debt was now as safe as debt of core countries.

4. Banking crises. The booms and busts in peripheral Europe were driven by rapid expansions and then contractions of credit from the domestic banking systems, with dynamics similar to that in credit booms in other times and places. The specific features of the euro system did not play any significant role in the development of the crisis, though they did importantly shape its resolution. 

In my view, the fourth story is correct, and the other three are wrong. In particular, trade imbalances within Europe played no role in the crisis. In this post, I am going to focus on why I think the external balances story is wrong, since that’s the one that people who are on my side intellectually seem most inclined toward.

As I see it, there were two distinct causal chains at work, both starting with a credit boom in the peripheral countries.

easy credit —> increased aggregate spending —> increased output and income —> increased imports —> growing trade deficit —> net financial inflows

easy credit —> rising asset prices —> bubble and/or fraud —> asset price crash —> insolvent banks —> financial crisis

That the two outcomes — external imbalances and banking crisis — went together is not a coincidence. But there is no causal link from the first to the second. Both rather are results of the same underlying cause. 

Yes, in the specific conditions of the late-2000s euro area, a credit boom led to an external deficit. But in principle it is perfectly possible to have a a credit-financed asset bubble and ensuing crisis in a country with a current account surplus, or one with current account balance, or in a closed economy. What was specific to the euro system was not the crisis itself, but the response to it. The reason the euro made the crisis worse because it prevented national governments from taking appropriate action to rescue their banking systems and stabilize demand. 

This understanding is, I think, natural if we take a “money view” of the crisis, thinking in terms of balance sheets and the relationship between income and expenditure. Here is the story I would like to tell.

Following the introduction of the euro in 1998, there were large credit expansions in a number of European countries. In Spain, for example, bank credit to the non-financial economy increased from 80 percent of GDP in 1997 to 220 percent of GDP in 2010. Banks were more willing to make loans, at lower rates, on more favorable terms, with less stringent collateral requirements and other lending standards. Borrowers were more willing to incur debt. The proximate causes of this credit boom may well have been connected to the euro in various ways. European integration offered a plausible story for why assets in Spain might be valued more highly. The ECB might have followed a less restrictive policy than independent central banks would have (or not — this is just speculation). But the euro was in no way essential to the credit boom. Similar booms have happened in many other times and places in the absence of currency unions — including, of course, in the US at roughly the same time.

In most of these countries, the bulk of the new credit went toward speculative real estate development. (In Greece there was also a big increase in public-sector borrowing, but not elsewhere.) The specifics of this lending don’t matter too much. 

Now for the key point. What happens when a a Spanish bank makes a loan? In the first step the bank creates two new assets – a deposit for the borrower, and the loan for itself. Notice that this does not require any prior “saving” by a third party. Expansion of bank credit in Spain does not require any inflow of “capital” from Germany or anywhere else.

Failure to grasp is an important source of confusion. Many people with a Keynesian background talk about endogenous money, but fail to apply it consistently. Most of us still have a commodity money or loanable-funds intuition lodged in the back of our brains, especially in international contexts. Terms like “capital flows” and “capital flight” are, in this respect, unhelpful relics of a gold standard world, and should probably be retired.

Back to the story. After the deposits are created, they are spent, i.e. transferred to someone else in return, in return for title to an asset or possession of a commodity or use of a factor of production. If the other party to this transaction is also Spanish, as would usually be the case, the deposits remain in the Spanish banking system. At the aggregate level, we see an increase in bank credit, plus an increase in asset prices and/or output, depending on what the loan finances, amplified by any ensuing wealth effect or multiplier.

To the extent that the loans finance production – of beach houses in Galicia say — they generate incomes. Some fraction of new income is spent on imported consumption goods. Probably more important, production requires imported intermediate and capital goods. By both these channels, an increase in Spanish output results in higher imports. If the credit boom leads Spain to grow faster relative to its trade partners — which it will, unless they are experiencing similar booms — then its trade balance will move toward deficit.

(That changes in trade flows are primarily a function of income growth, and not of relative prices, is an important item in the Keynesian catechism.)

Now let’s turn to the financial counterpart of this deficit. A purchase of a German good by a Spanish firm requires a bank deposit to be transferred from the Spanish firm to the German firm. Since the German firm presumably doesn’t hold deposits in a Spanish bank, we’ll see a reduction in deposits in the Spanish banking system and an equal increase in deposits in the German banking system. The Spanish banks must now replace those deposits with some other funding, which they will seek in the interbank market. So in the aggregate the trade deficit will generate an equal financial inflow — or, better said, a new external liability for the Spanish banking system. 

The critical thing to notice here is that these new financial positions are generated mechanically by the imports themselves. It is simply replacing the deposit funding the Spanish banks lost via payment for the imports. The financial inflow must take place for the purchase to happen — otherwise, literally, the importer’s check won’t clear. 

But what if there is an autonomous inflow – what if German wealth owners really want to hold more assets in Spain? Certainly that can happen. These kinds of cross-border flows may well have contributed to the credit boom in the periphery. But they have nothing to do with the trade balance. By definition, autonomous financial flows involve offsetting financial transactions, with no implications for the current account. 

Suppose you are a German pension fund that would like to lend money to a Spanish firm, to take advantage of the higher interest rates in Spain. Then you purchase, let’s say, a bond issued by Spanish construction company. That shows up as a new liability for Spain in the international investment position. But the Spanish firm now holds a deposit in a German bank, and that is an equal new asset for Spain. (If the Spanish firm transfers the deposit to a Spanish bank in return for a deposit there, as I suppose it probably would, then we get an asset for Spain in the interbank market instead.) The overall financial balance has not changed, so there is no reason for the current account to change either. Or as this recent BIS paper puts it, “the high correlations between gross capital inflows and outflows are overwhelmingly the result of double-entry bookkeeping”. (The importance of gross rather than net financial positions for crises is a pint the bIS has emphasized for many years.)

It may well happen that the effect of these offsetting financial transactions is to raise incomes in Spain (the contractor got better terms than it would at home) and/or banking-system liquidity (thanks to the fact that the Spanish banking system gets the deposits without the illiquid loan). This may well contribute to a rise in incomes in Spain and thus to a rise in the trade deficit. But this seems to me to be a second-order factor. And in any case we need to be clear about the direction of causality here — even if the financial inflows did indirectly cause the higher deficit, they did not in any sense finance it. The trade balances of Germany and Spain in no way affect the ability of German institutions to buy Spanish debt, any more than a New Yorker’s ability to buy a house in California depends on the trade balance between those states.

At this point it’s important to bring in the TARGET2 system. 

Under normal conditions, when someone wants to take a cross-border position within the euro systems the other side will be passively accommodated somewhere in the banking system. But if a net position develops for whatever reason, central banks can accommodate it via TARGET2 balances. Concretely, let’s say soon in Spain wants to make a payment to someone in Germany, as above. This normally involves the reduction of a Spanish bank’s liability to the Spanish entity and the increase in a German bank’s liability to the German entity. To balance this, the Spanish bank needs to issue some other liability (or give up an asset) while the German bank needs to acquire some asset. Normally, this happens by the Spanish bank issuing some new interbank liability (commercial paper or whatever) which ends up, perhaps via various intermediaries, as an asset for a German bank. But if foreign banks are unwilling to hold the liabilities of Spanish banks (as happened during the crisis) the Spanish bank can instead borrow from its own central bank, which in turn can create two offsetting positions through TARGET2 — a liability to the euro system, and a reserve asset (a deposit at the ECB). Conceptually, rather than the transfer of the despot being offset by a liability fro the Spanish to the German bank the interbank market, it’s now offset by a debt owed by the Spanish bank to its own national central bank, a debt between the central banks in the TARGET2 system, and a claim by the German bank against its own national central bank.

In this sense, within the euro system TARGET2 balances stand at the top of the hierarchy of money. Just as non financial actors settle their accounts by transfers of deposits at commercial banks, and banks settle their balances by transfers of deposits at the central bank, central banks settle any outstanding balances via TARGET2. It plays the same role as gold in the old gold standard system. Indeed, I sometimes think it would be better to describe the euro system as the “TARGET2 system.” 

There is however a critical difference between these balances and gold. Gold is an asset for central bank; TARGET2 balances are a liability. When a payment is made from country X to country Y in the euro area, with no offsetting private payment, the effect on central bank balance sheets is NOT a decrease in the assets of the central bank of X (and increase in the assets of the central bank of Y) but an increase in the liabilities of the central bank of X. This distinction is critical because assets are finite and can be exhausted, but new liabilities can be issued indefinitely. The automatic financing of payments imbalances through the TARGET2 system seems like an obscure technical detail but it transforms the functioning of the system. Every national central bank in the euro area is in effect in the situation of the Fed. It can never be financially constrained because all its obligations can be satisfied with its own liabilities. 

People are sometimes uncomfortable with this aspect of the euro system and suggest that there must be some limit on TARGET2 balances. But to me, this fundamentally misunderstands the nature of a single currency. What makes “the euro” a single currency is not that it has the same name, or that the bills look the same in the various countries, or even that it trades at a fixed ratio of one for one. What makes it a single currency is that a bank deposit in any euro-area country will settle a debt in any other euro-area country, at par. TARGET2 balances have to be unlimited to guarantee the this will be the case — in other words, for there to be a single currency at all.

(In this sense, we should not have been so fixed on the question of being “in” versus “out” of the euro. The relevant question is the terms on which payments can be made from one bank account another, for settlement of which obligations.)

The view of the euro crisis in which trade imbalances finance or somehow enable credit expansion is dependent on a loanable-funds perspective in which incomes are fixed, money is exogenous and saving is a binding constraint. It’s implicitly based on a model of the gold standard in which increased lending impossible without inflow of reserves — something that was not really true in practice even in the high gold standard era and isn’t true even in principle today. What’s strange is that many people who accept this view would reject those premises – if they realized they were applying them.

Meanwhile, on the domestic side, abundant credit was bidding up asset prices and encouraging investment that was, ex post, unwise (and in some case fraudulent, though I have no idea how important this was quantitatively). When asset prices collapsed and the failure of investment projects to generate the expected returns became clear, many banks faced insolvency. There was a collapse in activity in the real-estate development and construction activity that had driven the boom and, as banks tightened credit standards across the board, in other credit-dependent activity; falling asset values further reduced private spending; all these effects were amplified by the usual multiplier. The result was a steep fall in output and employment.

I don’t believe there’s any sense in which a sudden stop of cross-border lending precipitated the crisis. Rather, the “nationalization” of finance came after. Banks tried to limit their cross-border positions came only once the crisis was underway, as it became clear that there would be no systematic euro-wide response to insolvent banks, so that any rescues or bailouts would be by national governments for their own banks.

Credit-fueled asset booms and crashes have happened in many times and places. There was nothing specific to the euro system about the property booms of the 2000s. What was specific to the euro system was what happened next. Thanks to the euro, the affected governments could not respond as developed country governments have always responded to financial crises since World War II — by recapitalizing insolvent banks and shifting public budgets toward deficit until private demand recovers. 

The constraints on euro area governments were not an inevitable feature of system, in this view. Rather, they were deliberately imposed through discretionary choices by the authorities in order to use the crisis to advance a substantive political agenda.