The eurozone predicament: three crises – many feedback loops – one figure

The evolving eurocrisis is a complex  beast. It consists of three interacting crises: a banking crisis, a sovereign debt crisis, and an economic growth crisis. To make things worse,  these crises are connected by multiple feedback loops. The figure below helps me when discussing the eurocrisis. It summarizes the three crises and their interactions.

eurocrisis - feedback loops

The banking crisis that followed after the collaps of Lehman increased sovereign debt because sovereigns were forced to bail out banks (1). Next, with some delay, the banking crisis hit growth because banks cut back on lending in an effort to deleverage (2). The drop in growth decreased tax income and increased unemployment benefits, further raising government debt (3). This triggered a loss of confidence in the ability of Greece, Portugal, Ireland to repay their debt, while raising first doubts on Italy and Spain (4 and 9).

At the same time, countries’ reduced creditworthiness hit the banking sector because the latter depended on implicit subsidies (5) and held large fractions of sovereign debt on their balance sheets (6). The deteriorating health of banks negatively impacted economic growth (2). As a consequence, loans turned bad at an increasing rate and banks were hit yet again, e.g. in Spain (7), while also hitting governments tax income (3). Because governments are expected to bear the burden of recapitalizing banks, their creditworthiness decreased further (1).

To restore market confidence, governments began to cut spending and increase taxes. This had a negative impact on economic growth (8), further deteriorating the quality of loans on banks’ balance sheets (7). At the same time the growth crisis threw doubt on the ability of sovereigns such as Italy and Spain to restore health to their economy without defaulting on their debt or implementing further austerity measures, as well as the willingness and ability of core eurozone countries to do what it takes to save the euro, further deepening the sovereign debt crisis (9).

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2 thoughts on “The eurozone predicament: three crises – many feedback loops – one figure

  1. So, mitigants. The LTRO cut arrow number 6 (the bottom part), the OMT programme cuts arrow number 9 and possibly number 4. But we still have an economic growth crisis. Is it only because of arrows 8 and 2, and should we be looking for solutions there? Or is there a deeper, underlying, cause?

    1. 9 is indeed killed by ECB but 6 is still alive and kicking. In my view banking crisis is still the number one to tackle, with growth crisis coming in a good second. With banking, however, we know in principle what to do. Growth is more difficult.

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