The Eurozone Debt Crisis - A Simple Theory, Some Not So Pleasant Empirical Calculations and an Unconventional Proposal

Abstract

This paper explains the eurozone debt crisis as the result of self-reinforcing debt-spirals, which were caused by different inflation rates across the EMU member states. According to this view, the current crisis is not the result of a speculative attack but of a design faulty of the EMU. The data presented support this view. Time series of government budget and current account surpluses are calculated, which are compatible with constant debt-to-GDP ratios. The results show that the situation has become critical for countries like Greece, Portugal, Spain and Ireland significantly before capital markets started to demand higher interest rate spreads. The results indicate furthermore that capital markets react more sensitive towards high international net debt-to-GDP ratios than towards high government debt-to-GDP ratios. Given this empirical background, a discussion of various short-run policy options does not lead to very encouraging results. It is argued, that any future EMU needs to provide its central bank instruments to deal with country-specific business-cycle shocks.

Keywords: EMU, debt-crisis, eurozone, central bank policy, monetary unions, optimal currency areas, ECB, Greece, Ireland, Spain, Portugal

JEL Classification: E52, E58, E62