New paper on the mechanisms behind the eurozone crisis

Philippe Martin and Thomas Philippon have written a new paper about the mechanisms of private leverage and fiscal policy within the eurozone, from its creation through the Great Recession. (NBER link, ungated version).

From the introduction (emphasis mine):

There is wide disagreement about the nature of the eurozone crisis. Some see the crisis as driven by fiscal indiscipline and some by fiscal austerity, some emphasize excessive private leverage, while others focus on external imbalances, sudden stops or competitiveness divergence due to fixed exchange rates. Most observers understand that all these “usual suspects” have played a role, but do not offer a way to quantify their respective importance. In this context it is difficult to frame policy prescriptions on macroeconomic policies and on reforms of the eurozone.

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...we propose a simple model that focuses on three types of shocks: household leverage, fiscal policy, interest rate spreads and exports. A key challenge is then to empirically identify private leverage shocks that are orthogonal to shocks on fiscal policy and shocks on spreads. To help us identify the eurozone shocks, we use the US as a control.

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The key difference between the US and the eurozone experience is the sudden stop in capital flows starting in 2010 in the later.

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Contrary to the eurozone, the US states did not experience any shock on spreads in borrowing costs and no fear an a potential exit of the dollar zone. This allows us, for the eurozone, to identify the part of the private deleverage dynamics that is not due to the spreads shocks by the private deleveraging predicted in the US on the period 2008-2012. We call this the “structural” private leverage shock.

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Starting in the Spring of 2010, sovereign spreads widen and several European countries find it difficult to borrow on financial markets. The US and EZ experiences then start to diverge. While US states grow (slowly) together, eurozone countries experience drastically different growth rates and employment. A state variable that correlates well with labor markets performance in 2010-2011 in the Eurozone is the change in social transfers during the boom. Eurozone countries where spending on transfers (and also government expenditures) increased the most from 2003 to 2008 are those that are now experiencing severe recessions in the later stage. This suggests that in the second stage past fiscal policy, because of its effect on accumulated debt, had an impact on the economy through spreads and the constraint on fiscal policy it generated after 2010.

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In this paper, we analyze a model where borrowing limits on “impatient” agents drive consumption, income, the saving decisions of “patient” agents and employment in small open economies belonging to a monetary union. We introduce nominal wage rigidities which translate the change of nominal expenditures into employment. We first consider the predictions of the model taking as given the observed series for private debt, fiscal policy and interest rate spreads between 2000 and 2012.

Maybe I don't understand the paper, but it seems to me that using U.S. states to identify the causal mechanisms is crucial. It also seems (and I might be wrong) that the identifying vehicle are the spread shocks. Now, there exist important differences between U.S. states and eurozone countries: fiscal, political, labor markets, cultural, etc. Insofar as those differences are not reflected in spreads or spread shocks, but played a role in determining the path of unemployment, deficits, etc., the identification strategy is flawed. Comments?

Putting those doubts aside, I love this paper.

Summary of main findings, from the conclusion:

1. The private leverage boom (in 2000-2008) was the key igniting element of the crisis, especially in Spain and Ireland.

2. Pro cyclical fiscal policy during the boom worsened the situation, especially in Greece.

3. In Ireland and Spain, a more conservative fiscal policy during the boom would have helped, but would have entailed an implausibly large fall of public debt.

4. A macro-prudential fiscal policy to limit private leverage during the boom would have stabilized employment in all countries. However, in the absence of more prudent fiscal policy, this would have induced a larger buildup in public debt.

5. Fiscal and macro-prudential policies are thus complements, not substitutes, in order to stabilize the economy.

6. The sudden stop in the eurozone worsened the crisis by further constraining fiscal policy. If the ECB's "whatever it takes" line had come earlier (and had been successful at that earlier time), Ireland, Spain, Greece and Portugal would have been able to avoid the latest part of the slump.