The Flow of Capital and the Eurozone Crisis

Abstract

Historical experience shows that in the world of high capital mobility, sudden stops of capital inflows may occur, typically triggering financial crises. The latest financial crisis in the euro zone (EZ) seems to support this point of view. Euro adoption encouraged a capital flow bonanza from the countries which constitute the center of the eurozone, to the countries which make up the periphery of the eurozone, 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 (Greece, Portugal, Spain). The sudden stop which happened in 2009, made it difficult for periphery countries to roll over debt, and thus caused a crisis.

This paper analyses the role of large capital inflows in generating the EZ crisis. We argues that the impact on capital flows within the eurozone of financial deregulation and liberalization and of the adoption of the common currency was critical in exacerbating a growing competitiveness gap between core and periphery countries and explaining the evolution of the crisis.

Keywords: financial crisis, sudden stops, capital flows, EZ, recession

JEL Classification: F21, F31, F32, F37, G01