The Making of a Crisis

Author: Uri Dadush
Originally published by the Carnegie Endowment for International Peace

1. Confidence in the prospects for growth and stability of the economies of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) surged when the euro was introduced, causing their interest rates to decline to those of Europe’s more stable members.
2. Improved confidence and lower interest rates drove up domestic demand in the GIIPS and investors and consumers were emboldened to increase spending and run up debts, often owed abroad as foreign capital flowed in.
3. Growth accelerated and the prices of domestic activities (i.e., those least exposed to international competition, such as housing) rose relative to the price of exportable or importable products, attracting investment into the less productive non-tradable sectors and away from exports and industries competing with imports.
4. Meanwhile, exports rose sharply as a share of GDP in Germany, the Netherlands, and other historically stable countries in the European core. Growing demand in the GIIPS enabled these core countries to increase exports. The adoption of a common currency whose value was based on broader European competitiveness trends that made it lower than the deutschmark or guilder might have been, made their exported goods more affordable.
5. The domestic demand boom in the GIIPS induced rapid wage growth that outpaced productivity, increasing unit labor costs and eroding external competitiveness further. This trend was reinforced by especially rigid labor markets in most of the GIIPS that make wage adjustments difficult. The emergence of China, as well as currency depreciation and rapid labor productivity growth in the export sectors of the United States and Japan, added to the competitiveness problems of the GIIPS.
6. The single European monetary policy was too loose for the rapidly growing GIIPS (Spain, Greece, and Ireland) and too tight for Germany, whose domestic demand and wages grew very slowly compared to the European average. This reinforced the loss of competitiveness in the GIIPS.
7. Lower borrowing costs and the expansion of domestic demand boosted tax revenues. Instead of recognizing this as temporary revenue and saving the windfall gains for when growth slowed, GIIPS governments significantly increased spending. Blatant fiscal mismanagement added to the problems in Greece.
8. The financial crisis in 2008 brought an abrupt end to the post-euro growth model in the GIIPS. As they plunged into recession and tax revenues collapsed, government spending was revealed to be unsustainable and their loss of competitiveness dimmed hopes of turning to foreign demand for recovery. The GIIPS are left with high public and private debts and weak long-term growth prospects, unless they make difficult adjustments to cut deficits and restore competitiveness.