Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone

63 Pages Posted: 14 Oct 2014

See all articles by Philippe Martin

Philippe Martin

Sciences Po

Thomas Philippon

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2014

Abstract

We provide a first comprehensive account of the dynamics of Eurozone countries from the creation of the Euro to the Great recession. We model each country as an open economy within a monetary union and analyze the dynamics of private leverage, fiscal policy and spreads. Our parsimonious model can replicate the time-series for nominal GDP, employment, and net exports of Eurozone countries between 2000 and 2012. We then ask how periphery countries would have fared with: (i) more conservative fiscal policies; (ii) macro-prudential tools to control private leverage; (iii) a central bank acting earlier to limit sovereign spreads; and (iv) the possibility to recoup the competitiveness they lost in the boom. To perform these counterfactual experiments, we use U.S. states as a control group that did not suffer from a sudden stop. We find that periphery countries could have stabilized their employment if they had followed more conservative fiscal policies during the boom. This is especially true in Greece. For Ireland, however, given the size of the private leverage boom, such a policy would have required buying back almost all of the public debt. Macro-prudential policy would have been helpful, especially in Ireland and Spain. However, in presence of a spending bias in fiscal rules, macro-prudential policies would have led to less prudent fiscal policies in the boom. Central bank actions would have stabilized employment during the bust but not public debt. Finally, if these countries had been able to regain in the bust the competitiveness they lost in the boom, they would have experienced a shorter and milder recession.

Keywords: Eurozone crisis, Fiscal policy, Macroprudential policy, private leverage, sudden stop

JEL Classification: E44, E62, F32, F41, G01

Suggested Citation

Martin, Philippe and Philippon, Thomas, Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone (October 2014). Available at SSRN: https://ssrn.com/abstract=2510006

Philippe Martin (Contact Author)

Sciences Po ( email )

27 rue Saint-Guillaume
Paris Cedex 07, 75337
France

Thomas Philippon

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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