Martin Wolf has already, after only a few chapters, given his opinion of our research question – “No”. Many people, including myself, think that the Euro crisis was offset by the US financial crisis, but that does not seem to be the case. Europe was obviously affected by it since the global financial system is all interconnected but it was not the cause of the crisis. What caused the Euro crisis, according to Wolf, was the current account imbalances that were caused by “stupid” lending and borrowing.
Prior to the crisis, investors viewed all Eurozone government bonds as equally risky. Countries with excess saving and no credit demand then felt safe to invest in and lend billions of dollars to Ireland and southern Europe where there were higher credit demands and higher rate of returns. This caused huge current account imbalances where countries like Greece (-$44.7bn) and Spain (-$144.3bn) had big deficits while Germany ($248bn) and the Netherlands ($52.7bn) had major CA surpluses. Countries with current account deficits have excess spending over income and they were unfortunately not able to use all the credit properly. In the beginning of 2009, spreads started to emerge between troubled countries´government bonds and Germany´s bonds. At this point, investors understood that their investments in Ireland and southern Europe were not as safe as they thought. They started pulling their money out of these countries and there was a sudden stop in funding. The spending of the CA deficit countries collapsed.
The CA deficit countries were suddenly running larger fiscal deficits. They were forced to cut spending and raise taxes without external credit, which dug the deficits deeper. If Spain, for example, had its own currency, previous investors would try to sell that currency and that money would probably be re-invested in Spanish assets and the Spanish government would be ensured that the liquidity is around to fund the debt. Deficit countries cannot get the unlimited support they would have with their own currencies. Hence, Eurozone countries with fiscal debts depend on external credit to fund that debt. The European Central Bank can provide limited funding and then it is up to the other individual member countries to decide if they want to lend money to deficit countries. Many countries think the risk is too high to lend deficit countries the money they need. Wolf argues that the major problem is that the Eurozone is a currency union, not a banking union. It does not have the central authority that could fund all these public debts.
Martin Wolf concludes this chapter by saying that the Euro crisis was not initially a fiscal deficit problem, but the “stupid” lending and borrowing made fiscal deficits a major post-crisis problem.