What caused the great recession in the Eurozone? What could have avoided it?

Philippe Martin, Thomas Philippon 11 November 2014



There is a wide disagreement about the nature and cause of the Eurozone crisis. Some see it as driven by fiscal indiscipline, some emphasise excessive private leverage, while others focus on external imbalances, sudden stops, or competitiveness divergence due to fixed exchange rates, as these quotes illustrate:

  • Paul de Grauwe (2012): “The situation of Spain is reminiscent of the situation of emerging economies that have to borrow in a foreign currency...they can suddenly be confronted with a ‘sudden stop’ when capital inflows suddenly stop leading to a liquidity crisis”.
  • Lorenzo Bini Smaghi (2013): “… countries which lost competitiveness prior to the crisis experienced the lowest growth after the crisis”.
  • Hans Werner Sinn (2010): “The lesson to be learned from the crisis is that a currency union needs ironclad budget discipline to avert a boom-and-bust cycle in the first place”.
  • Paul Krugman (2012): “… on the eve of the crisis (Spain) had low debt and a budget surplus. Unfortunately, it also had an enormous housing bubble, a bubble made possible in large part by huge loans from German banks to their Spanish counterparts”.

Most observers understand that all these ‘usual suspects’ have played a role and may be interrelated, 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 in the Eurozone.

Given the scale of the crisis, understanding the dynamics of the Eurozone is a major challenge for macroeconomics today. We argue that we need a quantitative framework to identify these various mechanisms, their relations and, ultimately, to run counterfactual experiments. This is what we do in a recent paper (Martin and Philippon 2014).

The US and the Eurozone experiences

We start from the observation that up to 2010, the boom and bust cycles were very similar in the US and the Eurozone. To illustrate this, take the example of Arizona and Ireland because in both cases, the increase in household debt to income ratio during the boom years was very large. Figure 1 shows the evolutions of the employment rates, normalised to zero in 2005. The employment boom and bust are almost identical up to 2010 but diverge afterwards. This suggests that the fundamental mechanisms at work in both regions were similar up to 2010 but different in later years. We argue that the key difference between Ireland and Arizona is that Arizona did not experience a sudden stop after 2010.

Figure 1. Employment rates in Ireland and Arizona.

More generally, a salient feature of the great recession in both the US and the Eurozone is that regions that experienced the largest swings in household borrowing, also experienced the largest declines in employment and output.1 Figure 2 illustrates this feature of the data by plotting the change in employment during the credit crunch (2007-2010) against the change in household debt-to-income ratios during the preceding boom (2003-2007) for the largest States and Eurozone countries.

Figure 2. First stage of the Great Recession: Household borrowing predicts employment bust in the US and the Eurozone

The American and European cross-sectional experiences look strikingly similar in this respect in the period 2007-2010. This similarity of experience in the two monetary zones suggests that the shocks they faced were similar in nature, and that the structural parameters that govern the way the economy reacts to a deleveraging shock may also be similar. The key difference between the US and the Eurozone experience is the sudden stop in capital flows and the surge in spreads, starting in 2010 and later. There was no concern about the public debt in the States, let alone on their remaining in the dollar zone. Hence, we use the US as a control group to predict private deleveraging in the period 2008-2012 in the Eurozone in the absence of the sudden stop shock. We call this the ‘structural’ private leverage shock.

New counterfactual evidence on the periphery countries

To analyse the role of household leverage, fiscal policy, interest rate spreads, and exports during the Eurozone crisis, we build a quantitative model with borrowers and lenders – as in Eggertsson and Krugman (2012) and Midrigan and Philippon (2010) – where the linkages between these usual suspects are taken into account. In particular, fiscal policy is constrained by borrowing costs, such as the surge in spreads in the periphery after 2010, and spreads themselves are affected by past private and public borrowing, as well as bank recapitalisation needs. This model is able to reproduce very well the boom and bust dynamics of Spain, Ireland, Greece, and Portugal – the four periphery countries that were hit hardest in the crisis. In order to fit the macro and public debt dynamics during the boom (2002-2008), we find that a drift in spending and in social transfers must have characterised the fiscal rule of Greece. This political economy bias in fiscal policy was also present, but to a lower extent, in Ireland and Spain. However, this was not the case in Portugal.

Our model allows us to run counterfactual experiments on the four periphery countries and answer the following four ‘what if’ questions:

  • What if they had followed more conservative fiscal policies during the boom than they actually pursued?

This entails eliminating the political economy drifts in public spending and transfers that characterised their fiscal rules in the boom. For Greece and Ireland, such policies would have stabilised or reduced public debt in the boom as shown by the difference between the observed data (in blue) and the counterfactual (in dashed green) in the top panel of Figure 3. In turn, it would have reduced spreads and fiscal austerity during the bust, helping in terms of employment, especially in Greece (see bottom panel of Figure 3). Ireland would not have avoided most of the employment slump from private deleveraging in 2008 but would have experienced an earlier exit. However, the conservative fiscal policy necessary to achieve this looks implausible in Ireland – it would have entailed entering the bust with no public debt. This suggests that fiscal policy alone cannot act as a stabilisation tool in presence of a massive private credit boom.

Figure 3. Public debt and employment in data and fiscal counterfactual: Greece and Ireland

Public debt


Note: Public in % of GDP and employment normalised to one in 2002.

  • What if the periphery countries had successfully conducted macroprudential policies to limit private leverage during the boom?

This would have reduced the boom-bust cycle of employment in Ireland (see bottom right panel in Figure 4 below). It would have entailed lower bank recapitalisation and lower spreads during the bust, and would have allowed for a more countercyclical fiscal policy during the bust. In Spain (Figure 4, bottom left panel), such macroprudential policy would not have been very successful in stabilising the employment. Given the existing spending bias in the fiscal rule, public debt would have been substituted to private debt (see top panel of Figure 4), and employment would still have experienced a boom-bust cycle, although less pronounced than in the data. This suggests that in presence of a spending bias in the fiscal rule, macroprudential policy alone would not have successfully stabilised the employment.

Figure 4. Public debt and employment in data and macroprudential counterfactual: Spain and Ireland

Public debt


Note: Public in % of GDP, and employment normalised to one in 2002.

  • What if Mario Draghi’s declaration of ‘whatever it takes’ and the OMT programme had come in 2008 rather than 2012, and had been successful in reducing the spreads?

The four countries would then have been able to avoid the latest part of the slump because lower borrowing costs would have helped to limit fiscal austerity. With an earlier response of the ECB to the sudden stop, Irish employment, in particular, would have looked very much like Arizona’s one in Figure 1, with a rebound in 2011-2012. Spanish employment would have stopped deteriorating in 2010. In this counterfactual, the Eurozone and the US are both monetary unions where central banks are successful in eliminating the risk of exit. This policy would not have avoided the large build-up of public debt but would not have exacerbated it either.

  • What if these countries had been able to regain in the bust the competitiveness they had lost in the boom?

One can think of this counterfactual as close to a situation of flexible exchange rates where the exchange rate can depreciate quickly during a recession. In this counterfactual, we assume that export prices fall in the bust years (2008 to 2012) by the amount that prices increased relative to the Eurozone in the boom years (2002 to 2007). We find that because of the increase in exports after 2008, the periphery countries – especially those more open, such as Ireland – would have experienced a shorter and milder bust and a much smaller build-up in public debt.

Concluding remarks

One lesson we take from our exercise is that fiscal and macroprudential policies are complements not substitutes in stabilising the Eurozone economy. A prudent fiscal policy, although helpful, cannot by itself undo the consequences of a private leverage boom, and the reverse is also true. Both prudent fiscal policies and macroprudential policies are required to stabilise the economy and to make the Eurozone a viable monetary union.


Bini Smaghi, L (2013), “Austerity and stupidity”, VoxEU.org, 6 November.

Eggertsson, G and P Krugman (2012), “Debt, deleveraging, and the liquidity trap: a Fisher-Minsky-Koo Approach”, Quarterly Journal of Economics, 127(3), 1469–1513.

Krugman, P (2012), “Europe's Economic Suicide”, The New York Times, April  

De Grauwe P (2012), “The Governance of a Fragile Eurozone”, Australian Economic Review, vol. 45, issue 3, pages 255-268

Martin, P and T Philippon (2014), “Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone”, CEPR DP 10189 and NBER WP 20572.

Mian A and S Amir (forthcoming), “What Explains the 2007-2009 Drop in Employment?” Econometrica.

Midrigan, V and T Philippon (2010), “Household leverage and the recession”, NYU Working Paper

Sinn, H W (2010), “Reining in Europe’s Debtor Nations”, Project Syndicate, April


1 Consistent with this observation, Mian and Sufi (2012) show that differences in the debt overhang of households across US counties partly explain why unemployment is higher in some regions than others.



Topics:  Global crisis Macroeconomic policy

Tags:  EZ crisis, Macroprudential policy, peripheral countries

Professor of Economics at Sciences Po (Paris) and CEPR Research Fellow

Professor of Finance, Stern School of Business, NYU and CEPR Research Affiliate

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