ASYMMetric EURope

I wanted to expand a little bit on the idea of Europe suffering from an asymmetric economic shock for those that might not be aware of what I meant. Krugman illustrated this perfectly using the two examples of Germany and Spain within the Euro currency area. Basically, Spain and Germany, or, more broadly, the core European countries and the peripheral European countries, have had very different economic experiences over the past decade, which caused problems in the periphery that require policy solutions that would be harmful to countries in the European core.

Essentially, this is a story about current account balances in the Euro area, with massive differences between the core (Germany) and the periphery (Spain, Portugal, Greece, Italy, Ireland, Cyrpus, etc).

As you can see, the growing current account surplus in Germany was mirrored by a growing current account deficit in Spain in the run-up to the crisis (current account balances refer to capital flows. A surplus is a net capital outflow; a deficit is a net capital inflow.)


So, what caused the divergence? Basically, the adoption of the common currency in 1999 caused investors in the core (primarily private banks) to load up on sovereign debt from the peripheral countries. This happened for a couple reasons: first, the common currency caused investors to misprice the risk of sovereign debt in the periphery. In spite of explicit laws preventing bailouts in the Euro area, investors assumed (correctly) that if peripheral countries got into trouble, they would be bailed out—as such, the price of debt in these peripheral countries (interest rates) dropped significantly after the adoption of the Euro.

Second, the peculiarities of domestic banking regulations exempted sovereign debt from counting against leverage ratio caps in Germany and France. As such, these banks were allowed to run-up incredible amounts of debt.

In turn, capital flowing in from the core caused higher demand in the peripheral countries, driving up wages and prices. Inflation in the periphery far outpaced inflation in the core; however, because monetary policy set by the ECB weights inflation by country GDP, low inflation in the (much larger) core countries did very little to offset inflation in countries like Spain and Portugal.


For a while, these inflationary capital inflows caused booms in the peripheral countries. However, when the US financial crisis sparked contagion in Europe, the bubbles burst, causing government deficits to rise (as unemployment skyrocketed and growth stalled). Capital inflows dried up as German and French banks pulled back their already overextended lending to the periphery, and interest rates rose as investors worried about the viability of debt obligations in Greece, Spain, Portugal, Ireland, etc.


The key point to note is that this wasn’t a problem caused by government excess—deficits in the periphery (with the exception of Greece) were lower than in many core countries—this is primarily a problem stemming from the fact that lots of money from private banks in Germany and France drove up prices in the periphery; now, wages and prices in these countries have made their economies less competitive. Monetary policy in a currency area has trouble dealing with asymmetric economic shocks as well—reflecting the distribution of power in the Euro area, monetary policy has favored the core countries (before the crisis, monetary policy was too loose for the periphery, now it is too tight).

So, that’s what is meant by asymmetric shock–basically, the last decade has seen wildly divergent capital flows, economic growth, and inflation between the core European countries and the peripheral European countries. As a result, fiscal and monetary policy-makers have struggled to adequately cope with the macroeconomic situation in Europe both leading up to the crisis and in the aftermath, contributing significantly to Europe’s economic woe over the past several years.


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