How did the euro area get into trouble and

what could be done to fix it?

Francesco Giavazzi
Bocconi University and MIT
July 26, 2010 (Itaú Securities: Global connections #3)

Though the European crisis has found a channel in public
debt, its essence is not fiscal. True, it was triggered by the
sudden and unexpected discovery of a desperate fiscal
situation in Greece, verging on insolvency, but this does not
apply to other countries. Until 2007 Ireland and Spain were
model members of the euro, running surpluses, unlike most
other EU countries, and with decreasing debt ratios. Still
now, their debt/GDP ratio is relatively low by any standard.
Even Portugal did not do badly until 2009. With the
exception of Greece, those countries were incompliance
with all the Maastricht conditions, including debt.
The real origin of the crisis
Greece, Spain, Portugal and (to a lesser extent) Ireland are
special in a different way: the extent to which, once inside
the monetary union, they were allowed to borrow. The
possibility that the euro might result in the build-up of
large imbalances between the north and the south (see
Table 1) was completely overlooked when the monetary
union was created. At the time, the focus was on debt and
deficits and on the risk that fiscal dominance might
endanger the ability of the ECB to set monetary policy
independently. Ex-post overlooking external borrowing was
clearly a big mistake. (Table 1 also helps understand why
Italy has been sheltered from the crisis: its extent of
external borrowing was minusculecompared to the rest of
Southern Europe.)
Table 1: Current account deficits in the euro area,
2002-2008 (% of GDP)
Greece Ireland Portugal Spain Italy Germany
Cumulated -66,6 -19,2 -62,8 -53,9 -9,7 35,4
Yearly average -9,4 -2,7 -9,0 -6,9 -1,4 5,0
Three questions come up from observing Table 1. (i) Why
did they borrow so much? (ii) What did this borrowing
finance? (iii) From whom did they borrow?
i) Who financed the borrowing explosion in southern
Europe? The lending clearly came from northern Europe.
Table 2 shows that Germany, for instance, almost doubled
its overall (the table shows the allocation of country
portfolios) exposure to the four countries, increasing the
share invested in liabilities issued by these countries from
17% to about 30%. The same is true for France and to a
somewhat lesser extent for the Netherlands. What is
puzzling is not the fact that Germany (see Table 1) decided
to save so much. The puzzling fact is how these savings were
invested: in southern Europe with spreads that hardly
reflected the risk of those investments.
Table 2: Investments in Spain, Portugal, Ireland and Greece
as a share of total investment in the euro area
Germany France Netherlands
2001 0.17 0.19 0.12
2008 0.29 0.29 0.23
ii) How did the external borrowing happen, and how was it
channeled into higher domestic spending? The borrowing
mostly happened via domestic banks issuing
eurodenominated liabilities in other euro area countries and
using the proceeds to expand domestic credit (see Table 3).
The domestic credit expansion was dramatic in Ireland and
Spain. The case of Greece is less clear cut: one could argue
that Greece entered the euro with rather underdeveloped
financial systems (a ratio of domestic credit to GDP which
was a fraction of that of Germany) and in ten years closed
some of the gap. (The case of Portugal is somewhere in
between Spain and Greece).
Table 3: Total domestic credit (% of GDP)
Greece Ireland Portugal Spain Italy Germany
2000:01 1.6 3.6 3.9 3.3 2.9 5.2
2007:04 3.4 7.5 5.5 6.5 4.2 4.2
iii) A current account imbalance is an imbalance between a
country’s savings and investment. So, what lies behind the
large current account deficits in southern Europe? A boom
in investment or a fall in savings? There is not a single
answer. As shown in Table 4, In Spain and in Ireland the
current account deficit was mostly due to a surge in
investment (mostly construction); In Greece it was due to a
collapse in national savings which exceeded the fall in
domestic investment (although construction did increase
and what was crowded out was industrial investment.) In
Germany the surplus is explained by an increase is national
savings accompanied by a slowdown in investment. What is
important is that neither in Southern Europe nor in Ireland
there is evidence that external borrowing financed
investment in machinery and equipment or in industrial
structures thus raising the productive capacity of the
economy. Capital did flow south – as it should have since
income per capita is lower I southern Europe - but it failed
to make the south more productive.
 Table 4: What did the borrowing finance? 2000-2007 Can it be fixed?
(change in the share of GDP)
Two aspects need to be fixed: (i) divergences in
Greece Ireland Portugal Italy Spain Germany
competitiveness need to be corrected, and (ii) something
National saving -32.74 -9.65 -28.65 -2.43 -5.82 +30.2
should be done to prevent capital from flowing south to
Investment -4.72 +8.79 -19.64 +5.79 +17.87 -16.06
finance either consumption or residential investment.
of which: construction +17.65 -0.18 -36.36 +12.45 +21.99 -22.12
i) The first requires either a reduction in nominal wages or
machinery&equipment +36.38 +29.16 +11.03 +4.00 +5.94 +11.19 an improvement in productivity (both relative to Germany).
Some policies could help, for instance (as suggested by
What have been the consequences of the capital
Domingo Cavallo in a piece in Vox-eu) a reduction in the
flows within the euro area? wedge between the cost of labor to firms and the take-
A worsening of the current account can be seen from two home pay obtained by cutting social security contributions
points of view. It reflects an increase in domestic absorption and replacing the revenue with an increase in VAT.
(relative to domestic output) and, at the same time, it
reflects a worsening of domestic competitiveness. How did ii) On how to prevent infra-euro area imbalances, the
external borrowing worsen competitiveness? The channel criteria used to assess fiscal discipline within the euro area
through which this came about is a change in the relative have turned out to be flawed or irrelevant. The Irish and
price of traded to non-traded goods. The increase in Spanish cases show that the budget deficit criterion is faulty
domestic absorption raised demand for non-traded goods: or incomplete, insofar as it does not consider the structure
to increase their output, the relative price of non-traded of revenues and expenditures (in both Spain and Ireland
goods increased. This crowded out production of traded what looked like a healthy budget while house prices were
goods, lowering net exports. Another way to see how an rising and residential construction was booming, turned
increase in domestic absorption ended up worsening the almost overnight into a large fiscal imbalance when
real exchange rate is through its effect on wages. Higher residential investment and house prices collapsed. Credit
demand for non-traded goods put pressure on domestic growth, its composition and its source should become
wages. Higher wages translated to the exportables sector crucial elements in the policy assessment: currently the ECB
worsening competitiveness. Of course none of this would does not even publish the data we used to construct Table
have happened if higher nominal wages had been 3. Current account balances should become relevant as an
accompanied by higher productivity. Though it is difficult to indicator of potential imbalances. More important, at least
isolate the effects of relative excess inflation and of relative in my view, is the establishment of a “Sovereign Bankruptcy
productivity trends, the end result was a sharp real Code” and of rules for orderly sovereign default. By
appreciation (Table 5 and Figure 1). addressing the issue of how to deal with sovereign defaults,
such rules would implicitly convey the message that such
defaults are possible. This would avoid the under-estimation
of credit risk, which was an important factor in the buildup
of the imbalances.

Table 5 - Convergence
MANUFACTURING ALL INDUSTRIES MANUFACTURING ALL INDUSTRIES
value added value added
value added per value added TFP TFP
per hour per hour
worker per worker
worked worked
2007/1999 2007/1999 2007/1999 2007/1999 2007/1999 2007/1999

Germany 1,34 1,3 1,15 1,1 1,15 1,07

Greece 1,19 1,24 1,21 1,27 na na
Ireland 1,7 1,64 1,26 1,21 0,97 0,99
Portugal * 1,19 1,18 1,07 1,07 na na
Spain 1,13 1,05 1,07 1 0,98 0,95
Italy 1,06 1,03 1,04 1 0,99 0,99
* Portugal: 2006/1999