Whitaker Ideas Forum: Anastasios Matopoulos, The European Financial Crisis: How Bad Banks & Bad Governments Interact

The financial crisis that plagued the European economy during 2008-2013 was one of the most severe on record among advanced economies. The crisis followed a decade of reasonable growth and financial stability since the creation of the Euro in 1999, during which time some smaller peripheral Euro-area Member States experienced very rapid growth and convergence of living standards to European averages. But this strong economic performance during the 2000s concealed rising financial imbalances and increasing vulnerabilities.  We show that large amounts of financial capital flowed from core European economies (such as Germany and the Netherlands) to peripheral economies (such as Ireland, Spain and Portugal) during the 2000s. These flows were intermediated through domestic banking systems, thereby generating increased risks for banking sector stability. We argue that these flows did not make their way into the more productive traded-goods and traded-services sectors of these peripheral economies, but rather were invested in non-traded sectors, especially into real estate assets, or were used to finance unsustainable consumption. When these flows came to a sudden stop, borrowing costs on money markets for some governments rose to unsustainable levels, banking systems became stressed, and economies fell into deep recession.

We examine factors that have been identified in the literature as sources of stress in markets for government debt. We also explore factors that can, in principle, give rise to stress on banking systems. We identify that some of these factors were at work in the European crisis. We argue that a key feature of the European financial crisis, which is important in explaining the severity of the crisis, was the interaction between the problems in markets for government debt and problems in the banking sector. We highlight how these interactions operated to produce an exceptionally severe crisis. We conclude that it is not possible to fully identify growing vulnerabilities in the government debt market unless attention is paid to developments in banking systems, and vice-versa.