The Impact of the Economic Crisis in the Eurozone

ABSTRACT.This paper discusses the major trends in scholarship about the ongoing sovereign debt problems of the Eurozone, the inability of national governments to resolve the global economic problems, the international links among trade, capital flows, and savings, and the role played by the European financial system in fueling the credit boom in the United States. I am specifically interested in how previous research investigated the relationship among trade, the savings rate, and international capital flows, the causes of significant trade imbalances, key aspects of the European banking crisis, and the role played by global European banks in financing credit and asset price booms.JEL codes: G01,G21, E44Keywords: economic crisis, Eurozone, global finance, interbank lending1. IntroductionThe theory that I shall seek to elaborate here puts considerable emphasis on the enormity of the economic crisis in the Eurozone, the role of global finance in propagating business cycles, and Europe's huge and bloated banking system. The findings of this study have implications for the root causes of the European crisis, the functioning of the global balance of payments, the importance of bank-based intermediation in most advanced economies and emerging markets, and the sharp deterioration of interbank lending in the Eurozone.2. The Enormity of the Economic Crisis in the EurozoneNoeth and Sengupta focus on the role played by global finance in the crisis in the euro zone, pointing to deleveraging, bailout problems, and capital flight, and emphasizing the need for better regulation of global banks and financial institutions. A significant economic slowdown currently plagues the countries in Europe. The economic woes are especially severe in the Eurozone. Much of the (private and public) debt obligations of the troubled countries of the euro zone is held in euros, and were held mostly by creditors in other parts of the euro zone. Poor economic performance leads to nonperforming loans and lower tax revenues, whereas if sovereigns default on their debt, it can affect the health of financial institutions with sizable sovereign debt holdings. The growth in global capital flows among developed countries has dwarfed the current account positions, current account positions are not important drivers of cross-border capital flows among advanced countries, the bulk of gross inflows into the U.S. originated in the private sector, the most important source of capital inflow was Europe, and net capital flows do not capture the severe disruption in crossborder capital flows following the crisis.We may sum up by saying that cheap funding in U.S. money markets enabled an unprecedented expansion of the balance sheets of global European banks. Noeth and Sengupta explain that the asset side of these global European banks focused on U.S. securities. The global European banks expanded their balance sheets and significantly increased leverage. Motivations to increase leverage are may be suboptimal in the long run and had debilitating consequences for the entire financial system. The introduction of the euro and its appreciation vis-a-vis other major currencies meant a reduction in risk premia for global European banks. Most of the peripheral countries of the euro zone witnessed significant increases in capital inflows and a significant increase in asset prices. Low lending costs lead to increased risktaking in these peripheral economies. The same countries that witnessed credit booms had increasing loan defaults and sharp declines in asset prices, setting in motion a cycle of declining prices, nonperforming assets, and deleveraging by banks, deleveraging involves reducing existing debt levels through retained earnings, equity injections, or selling off assets. European corporations' reliance on bank funding is greater than that for U.S. corporations.From this, it is evident that while U.S. corporations typically have ready access to capital markets directly, European firms are more reliant on intermediated finance: the effects of deleveraging in the banking sector on the real economy are greater in Europe than the U. …