Myths and facts of the Euro crisis part 3 – capital flight and financial instability in the Eurozone – an analysis by João Madeira

My previous texts seem to suggest that the Euro is likely not the main cause for the problems several European countries currently face. If not the Euro, then what is the origin? The cause must be common not just to the periphery countries of the Euro but also to those other countries which have been significantly affected by the Great Recession. The factors that lead to the Great Recession are several and complex (I must confess I don’t really understand well a lot of what happened – if it was obvious then governments, regulators, economists or investors, among others, would have taken measures that would have prevented the recession). In my view the explanation seems to be behind the deregulation of the financial sector and the liberalisation of capital movements; the work of Reinhart and Rogoff (2008) shows empirical evidence that such factors are typically associated with financial crises.

The liberalisation of capital movements after the Maastricht treaty, which became effective in 1993, led to large capital movements from the countries which today constitute the center of the eurozone to the countries which make up the periphery of the current eurozone (and other countries, like Iceland which is also part of the European Economic Area), where it was possible to obtain better returns due to their less developed financial systems. This explains the large current account surplus in the Euro centre countries (like Germany and Netherlands) and the deficits in the Euro periphery countries and Iceland (where the deregulation of the financial sector in 2001 further worsened the situation).

Many attribute to the Euro the main role behind the periphery deficits since these countries lost competitiveness relative to Germany, lacking their own currency to correct the imbalance. This seems unlikely, as the Netherlands also lost competitiveness to Germany and had a trade surplus whilst Iceland (which did not join the Euro) was by far the country with largest current account deficit in this period (Poland also had large deficits in this period without being a member of the Euro and the same can be said of Slovakia, that only joined in 2009, or Estonia that joined only in 2011). Past research in economics has simply not found a strong and robust empirical relation between exchange rate misalignments and current account deficits (see for example Auboin and Ruta, 2012; Huchet-Bourdon and Korinek, 2011 or Chinn and Wei, 2012).

The great financial centres, like the UK but mostly the USA also experienced large current account deficits at the end of the 90s and in the early 21st century. In this case, the capital originated mostly from East Asia (particularly China) and also the Middle East (where high oil prices allowed for high savings as well). The high saving rates in these countries (the study of Wei and Zhang, 2011, suggests an imbalance in the sex ratio of young adults as one of the main factors which explains the high saving rates in China) did not encounter adequate investment opportunities in the undeveloped home financial markets and therefore flowed to countries with sophisticated financial markets like the USA (another likely contributing factor was China’s exchange rate policy of maintaining a devalued currency to favor its exports).

The study of Ito and Chinn (2007) confirms empirically this strange phenomenon – while among industrialised economies (like those in Europe) the growth of the financial sector leads to large current account deficits, the opposite happens in developing economies.

In theory, liberalisation of capital movements is something positive as it allows for a more efficient capital allocation. My speculation for the association of capital liberalisation and financial crises is as follows. Initially capital flows to those countries where it can obtain the best returns; however, when the best investment opportunities end, the flow of capital persists. The reason for this may be because the capital owners do not mind that the financial sector directs the capital to projects of dubious value because they trust the government to rescue those financial institutions from bankruptcy in case of need (that is, the financial sector benefits from an implicit government subsidy).

The bank managers have an incentive to make loans even to dubious projects since bad loans will likely only be recognised as such in the medium and long run (in the meantime managers have already received bonus from the making of such deals). The clients who receive the loans also have an incentive to go ahead with a dubious investment since if it proves disappointing they will not have to fully repay the loan. This explains why so much capital was diverted to the housing market. While supply does not keep up with demand (it takes time to build new houses and obtain the necessary permits) prices increase and the investments see a positive return. Once supply adjusts to demand housing prices fall and investors suffer losses. After this, capital flows reverse, credit tightens and a recession follows (without credit, it is hard for companies to develop new projects or expand their current business).

Public finances also suffer greatly not just because of the bail-out of the financial sector but mostly (see Reinhart and Rogoff, 2008) due to the loss of revenue (businesses in trouble do not pay much tax) and increase in social transfers (such as unemployment subsidies). Countries with a current account surplus are also affected in a negative way (but in a less extreme way) since their banks see their assets abroad lose value (French and German banks suffered large losses due to exposure to American subprime mortgages and Greek sovereign debt) and see a fall in exports.

Figure 1 below shows the growth rate of bank loans in several Euro countries. One can see that the credit crunch was particularly severe in Ireland (which explains why Ireland despite having good economic institutions has been so greatly affected by the Great Recession) and Greece.


Figure 1: Bank loans growth rate
Figure 1

It was not just the private sector that saw its credit access worsened. Initially governments were not affected but in 2010 Greece saw its interest rate rise significantly. In 2011 Portugal and Ireland also saw its interest rates increase sharply. One can see this in Figure 2 below which shows the long term interest rates for several countries. One can see that during the period of credit abundance the Euro periphery countries saw their interest rates decrease substantially (the differential that existed relative to the Euro centre countries practically disappeared). With the Great Recession and the reversion in capital movements the interest rate differential between the periphery and the centre resurged. In this aspect I’m convinced the Euro played an important role in the worsening of the crisis. The only countries which saw their interest rates rise dramatically were those of the Euro periphery (one can see for example that the UK, USA and Iceland were not affected to the same extent). De Grauwe (2011) explains that one of the reasons for this is that countries that belong to a monetary union are more vulnerable to self-fulfilling prophecies (for fearing a default on the debt, lenders demand higher interest and this leads to the fulfilling of their fears) due to having no control of the currency in which their debt is issued. De Grauwe (2012) shows evidence that a self-fulfilling prophecy explains a significant part of the rise in interest rates of the Euro periphery countries.


Figure 2: Long term interest rates
Figure 2


João Madeira

University of Exeter



Data for figure 1 can be obtained from the ECB website:

Data for figure 2 can be obtained from the OECD website:

Auboin, Marc & Ruta, Michele (2012). “The Relationship between Exchange Rates and International Trade: A Literature Review,” CESifo Working Paper Series 3868.

Chinn, Menzie & Wei, S.J. (2012). “A faith-based initiative meets the evidence: Does a more flexible exchange rate facilitate current account adjustment?” Review of Economics and Statistics.

De Grauwe, Paul (2011). “The Governance of a Fragile Eurozone.”

De Grauwe, Paul & Ji, Yuemei (2012). “Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone,” mimeo, Jan 2012

Huchet-Bourdon, Marilyne & Korinek, Jane (2011). “To What Extent Do Exchange Rates and their Volatility Affect Trade?,” OECD Trade Policy Working Papers 119.

Ito, Hiro & Chinn, Menzie (2007). “East Asia and Global Imbalances: Saving, Investment, and Financial Development,” NBER Working Papers 13364.

Reinhart, Carmen M. & Rogoff, Kenneth S. (2008). “Banking Crises: An Equal Opportunity Menace,” NBER Working Papers 14587.

Wei, Shang-Jin & Zhang, Xiaobo (2011). “The Competitive Saving Motive: Evidence from Rising Sex Ratios and Savings Rates in China,” Journal of Political Economy, vol. 119(3), pages 511 – 564.


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