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The Euro Crisis in the Mirror of the EMS: How Tying Odysseus to the Mast Avoided the Sirens but Led Him to Charybdis

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Abstract

Why was recovery from the euro area crisis delayed for a decade? The explanation lies in the absence of credible and timely policies to backstop financial intermediaries and sovereign debt markets. In this paper we add light and color to this analysis, contrasting recent experience with the 1992–3 crisis in the European Monetary System, when national central banks and treasuries more successfully provided this backstop. In the more recent episode, the incomplete development of the euro area constrained the ability of the ECB and other European institutions to do likewise.

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Notes

  1. As indicated by the fact that the U.S. approached full employment already in 2017.

  2. Standard chronologies of banking and financial crises have omitted those years altogether, an exception being recent work at the ECB (ECB 2017).

  3. The first step toward banking union came with the commencement of operations by the Single Supervisory Mechanism in 2014, while the European Stability Mechanism opened for business in 2012.

  4. This allows us to include the UK, which was at the center of events in 1992–3. See the Appendix for details on data sources.

  5. The rise in non-EU trade in Greece and the Netherlands was largely driven by import growth from China, with a subsidiary role for the post-Soviet countries. The Netherlands also saw significant growth in imports from emerging Asian countries. In Ireland’s case, the growth of trade with China was supplemented by growing trade with the Middle East.

  6. Only France and Italy increased their within-EU FDI by more than FDI to and from non-EU countries.

  7. Periphery euro area countries are the so-called GIIPS (Greece, Italy, Ireland, Portugal, and Spain), while core euro area countries are the rest of the original euro area members.

  8. This development is not unique to Europe, as demonstrated in Hahm et al. (2013).

  9. At the same time they were smaller, reflecting the six-fold increase in the size of the European banking system between the two periods.

  10. In the more recent period, moreover, such assets had to be marked to market, heightening the fragility of balance sheets in the event of shocks.

  11. This mechanism is shown to break down during financial crises, with bank linkages creating co-movement during crises (Kalemli-Ozcan et al. 2012)

  12. The chart also shows the dispersion of unemployment across US states, for comparison.

  13. Explanations for this divergence are beyond the scope of the present paper. For a start on an analysis see Eichengreen (2019).

  14. In the most extreme case, the ratio of equity to total assets was under 2% for Deutsche Bank prior to 2008.

  15. The currency swap arranged between the Federal Reserve and the ECB was intended to alleviate this problem to some extent by providing ample dollar liquidity to European banks, but did not help with balance sheet effects of dollar appreciation.

  16. Because banks in the periphery were substantially financed by banks in the core, these problems also affected the condition of core banks.

  17. Even if the assets are not marked to market on the balance sheet, a decline in their value leads to reduction of the banks’ franchise value and results in increased cost of raising external equity and debt.

  18. Denmark constituted a third category, as a country that chose to remain out of the single currency but which adopted an exchange rate target (against the deutschmark and then the euro) rather than an inflation target.

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Acknowledgements

This project is funded in part by the Keynes Fund at Cambridge University, with the title The Making of the Euro-Area Crisis: Lessons from Theory and History (JHLP). We also thank the Clausen Center at UC Berkeley for its financial support.

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Authors and Affiliations

  1. Cambridge University, Cambridge, UK

    Giancarlo Corsetti

  2. University of California, Berkeley, Berkeley, CA, USA

    Barry Eichengreen

  3. Federal Reserve Bank of San Francisco, San Francisco, CA, USA

    Galina Hale & Eric Tallman

  4. University of California, Santa Cruz, Santa Cruz, CA, USA

    Galina Hale

Authors
  1. Giancarlo Corsetti
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  2. Barry Eichengreen
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  3. Galina Hale
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  4. Eric Tallman
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Correspondence to Barry Eichengreen.

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Appendix: Data Sources and Definitions

Appendix: Data Sources and Definitions

Table 1. Integration of EU-15 with the EU and the World:

  • Trade vs. world: IMF’s Direction of Trade Statistics

  • Trade vs EU: IMF’s Direction of Trade Statistics

  • Gross FDI vs. world (flow): World Bank/IMF’s Balance of Payment statistics and UNCTAD

  • FDI vs. EU (flow): OECD

  • Capital flows vs. world: Lane and Milesi-Ferretti (2007)

Figure 1 a. Trade Flows: IMF’s Direction of Trade Statistics

Figure 1 b. FDI Flows: OECD/World Bank

Table 2. Size and State of the Banking Systems: World Bank Global Financial Development database

Table 3. Currency composition of EU banking system assets and liabilities: Bank of International Settlements

Figure 2. Global GDP Growth: IMF’s International Finance Statistics

Figure 3. Unemployment Rate Divergence: EU data from IMF’s International Financial Statistics and FRED; U.S. data from Haver Analytics/Bureau of Labor Statistics

Figure 4. Current Account Balances: Jorda et al. (2016), CEIC, and Eurostat

Table 4. Macroeconomic conditions in EU-15 prior to ERM and euro crises:

  • Real GDP growth rate: IMF’s World Economic Outlook database

  • Unemployment rate: IMF’s International Financial Statistics and FRED

  • Inflation rate (CPI): IMF’s International Financial Statistics, Haver Analytics/OECD, and FRED

  • Policy Rate: Eurostat, IMF’s International Financial Statistics, Haver Analytics/OECD, and CEIC

  • Government debt/GDP: Jorda et al. (2016), IMF’s World Economic Outlook database, FRED, and CEIC

  • Government deficit/GDP: Eurostat and CEIC

  • Current account: Jorda et al. (2016), CEIC, and Eurostat

Figure 5. a. Government Debt: Jorda et al. (2016), IMF’s World Economic Outlook database, FRED, Statistics Austria, and CEIC

Figure 5 b. Government Deficit: Eurostat

Table 5. Monetary and Fiscal Policy and Current Account Indicators:

  • Policy Rate: Eurostat, IMF’s International Financial Statistics, CEIC, and Haver Analytics/OECD

  • Current account: Jorda et al. (2016), CEIC, and Eurostat

  • Government debt/GDP: Jorda et al. (2016), IMF’s World Economic Outlook database, FRED, and CEIC

  • Government deficit/GDP: Eurostat and CEIC

  • 5-yr Government Bond Yield: Global Financial Data (French data supplemented from Bloomberg)

Figure 6. Nominal Exchange Rates against the Dollar: IMF’s International Financial Statistics

Figure 7. Composition of net foreign liabilities of GIIPS: Hale (2013) and original data from International Monetary Fund, national central banks, European Financial Stability Facility, Eurostat

Figure 8. Share of Domestic Debt in Domestic Banks: EBA 2011 Stress test

Figure 9. Fiscal Consolidation as % of GDP: Pescatori et al. (2011)

Figure 10. 5-yr Government Bond Yield: GFD (French data supplemented from Bloomberg)

Table 6. Fiscal costs of banking system support and extent of systemic banking crises: Laeven and Valencia (2018)

Figure 11. Real Exchange Rates against the Dollar: Nominal exchange rate data from the IMF’s International Financial Statistics; CPI data from the IMF’s International Financial Statistics, Haver Analytics/OECD, and Haver Analytics/BLS

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Corsetti, G., Eichengreen, B., Hale, G. et al. The Euro Crisis in the Mirror of the EMS: How Tying Odysseus to the Mast Avoided the Sirens but Led Him to Charybdis. Open Econ Rev 31, 219–236 (2020). https://doi.org/10.1007/s11079-019-09555-5

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