Although EU governments do bear responsibility for their current debt problems, this is only half the story as the financial crisis was triggered by unsustainable increases in private debt, writes Paul de Grauwe, professor of economics at the Katholieke Universiteit Leuven in Belgium.
This commentary was first published on Eurointelligence.
''After much political posturing, the European Council agreed to tighten the Stability and Growth Pact, promising stiffer sanctions to countries that fail to abide by the rules. In addition, the Council followed the advice of the Task Force to set up a system aimed at reducing macro-economic imbalances produced by a lack of convergence of economic policies within the euro zone.
These decisions and recommendations were inspired by the view that the source of the debt crisis in the euro zone is the misbehaviour of national governments. These have allowed their budget deficits and debt levels to balloon, and have done too little to prevent divergent movements in their economies. Thus governments are to blame for the crisis in which the euro zone finds itself today.
Although governments certainly bear responsibility for the crisis, this is only part of the story. It fails to take into account the fact that the financial crisis erupted because of unsustainable increases in private debt (of households and financial institutions), forcing many governments to pick up the pieces. In addition, blaming national governments for the macro-economic divergences within the euro zone fails to take into account that the origin of these divergences has little to do with what governments did or did not do.
Market systems are regularly gripped by moves of optimism and pessimism ('animal spirits'). These have largely a national component in the euro zone. Thus, while in the early 2000s, a wave of optimism (helped by a strong decline in real interest rates) gripped countries like Spain, Greece and Ireland, pessimism prevailed in Germany and other Northern countries. These animal spirits have a self-fulfilling property and lead to bubbles and booms in the countries gripped by optimism, and the reverse in the others.
The severity of these booms and bubbles ultimately depends on how they are financed. In particular, these bubbles and booms become intense when they are made possible by bank credit. In fact the causality between bubbles and booms on the one hand and bank credit on the other hand runs in both directions.
When a bubble and boom starts, bank credit tends to increase automatically, mainly because the boom-and-bubble increases the value of assets, in particular of real estate, thereby increasing the value of collateral presented to banks in order to obtain a loan. Conversely the increase in bank credit intensifies the boom and the bubble. It is the combination of bubbles (mainly in the housing markets) and bank credit that makes these bubbles so lethal.
This phenomenon has been very pronounced in Ireland and Spain. Ultimately, only the monetary authorities can control bank credit. Governments can do relatively little about this. Thus, the responsibility of the European monetary authorities in the development of unsustainable private debt levels is stronger than that of the national governments.
Defenders of the European monetary authorities will argue that the ECB [European Central Bank] is helpless in controlling national aggregates, in particular national bank credit. It can only affect eurozone-wide variables, in this case bank credit in the euro zone as a whole. Even on that count, however, there is a large responsibility for the ECB. During the period 2004-2007 the growth rates of total bank credit in the euro zone exceeded 10% per year. Surely the ECB could have affected the growth rates of bank credit. In fact it is probably the only one in town who could have done so.
I am not arguing [that] the ECB should have followed a different interest rate policy than the one it did. But it could have used other instruments at its disposal, e.g. minimum reserve requirements, to control the growth rate of bank credit. This would have reduced the intensity of the expansion of bank credit in these countries experiencing bubbles in their real estate markets.
In addition, the Eurosystem could have used different minimum reserve requirements in different national banking markets, applying higher minimum reserve requirements in countries experiencing much faster growth rates of bank credit (Ireland and Spain). The retail component of the banking sectors in the euro zone is still very segmented along national lines, making the application of such differential minimum reserve requirements possible.
Thus, the Eurosystem bears a large part of responsibilities in allowing bubbles in national housing markets and the associated increases in private debt to develop. These unsustainable developments ultimately forced governments to step in. In doing so they saved the financial system and prevented the economy [from being] pulled down in a deflationary dynamic.
Reforms of governance in the euro zone should therefore not only focus on the responsibilities of national governments (and these are serious) but also on those of the European monetary authorities, and in particular those of the ECB. Some more hard thinking about how this can be done will be necessary.''