Europe in The Age of Austerity

Europe in an Age of Austerity
Europe in an Age of
Austerity
Vani K. Borooah
Emeritus Professor of Applied Economics, University of Ulster, Northern Ireland
© Vani K. Borooah 2014
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For Gautam
Contents
List of Figures viii
List of Tables ix
Preface x
1 Introduction 1
2 Housing 13
3 Banking 25
4 Sovereign Debt 60
5 Reforms, Hardship, and Unrest 97
6 Conclusion 124
Notes 134
References 145
Index 155
vii
List of Figures
2.1 House prices in selected countries: 1997–2009

(2002 = 100) 14
2.2 The dynamic of a house price bubble 16
2.3 Central bank interest rates: annual data 17
2.4 Gross fixed residential capital formation as percentage of
GDP (current prices) 19
3.1 Money market equilibrium and interest rate
determination 29
4.1 General government debt as percentage of GDP 62
4.2 Deficit and debt ratios of EMU countries in 1999 70
4.3 Deficit and debt ratios of EMU countries in 2010 71
4.4 The trade-off between growth rate and the primary
surplus/deficit for fiscal sustainability 87
4.5 The trade-off between growth rates and the primary
balances to achieve desired debt-to-GDP ratio of 1.33
in Greece in 2010 89
5.1 Austerity, fiscal sustainability, and hardship 107
5.2 Growth-enhancing reforms 108
viii
List of Tables
1.1 Growth rates (%) in real GDP in selected countries,

2007–2012 3
1.2 General government balance as percentage of
GDP, 2006–2011 4
2.1 Gini coefficients for house prices, 1997–2009,
selected countries 14
3.1 A stylised bank balance sheet 27
3.2 A stylised central bank balance sheet 32
3.3 Use of non-deposit sources by banks in different countries 43
4.1 General government balance as percentage of GDP 63
4.2 Private, government, and external borrowing in
selected countries as percentage of GDP 77
5.1 EMU – 17 countries ranked by adjustment progress
and overall health indicator 101
5.2 Unemployment rates in the European Union: 2010, 2011,
and 2012 114
5.3 NEET rates for selected countries of the European Union,
age group 15–24 117
ix
Preface
While there are several good books and academic papers written about
the current recession, most of these have been written with the United
States (USA) in mind and are primarily concerned with analysing what
went, and was, wrong with the USA economy. There is, however, rela-
tively less literature on the European experience – particularly for its
“peripheral” countries that have manifested the most extreme symp-
toms of the crisis – in terms of where, and how, growth and prosperity in
Europe began to unravel and what it might do towards resuming normal
business. This book is intended to fill this gap.
This book has two themes. The first is discussion and analysis of the
broad issues that have underpinned the current European economic
crisis and, in the context of these issues, the second is about the expe-
riences of three countries – Greece, Ireland, and Portugal – that had
to be bailed out by the troika, comprising the European Commission
(EC), the European Central Bank (ECB), and the International Monetary
Fund (IMF). Towards these ends, I examine four elements of “crisis” that
have dominated the debate about recessionary Europe: (i) the housing
crisis, stemming from feverish building activity and house purchase,
and culminating in the “housing bubble” bursting; (ii) the banking crisis,
stemming from injudicious lending and culminating in banks being
forced to “deleverage” as the wholesale money market refused them
“roll overs” on their loans; (iii) the sovereign debt crisis, stemming, in the
main, from governments having to assume responsibility for private-
sector debts, and culminating in certain countries (Greece, Ireland,
Portugal, and, most recently, Cyprus) having to be “bailed out” in view
of their unsustainable levels of public debt; (iv) the austerity crisis, stem-
ming from attempts to reduce the level of government borrowing by
cutting expenditure, and resulting in economic pain and misery being
inflicted on the populations of countries that were placed under the
troika’s supervision.
This book has a central thesis. It begins by observing – in common
with other commentators – that today’s economic crisis in Europe
is mistakenly viewed as a sovereign debt crisis. In fact, the sovereign
debt crisis we see in Europe today is a derivative of private-sector over-
spending, which existed long before the present recession began in
2008. This overspending did not raise any alarm because the European
x
Preface xi
Monetary Union’s (EMU) single currency regime had no automatic

signals for warning of private-sector overspending. The EMU’s regula-
tory framework, enshrined in the Growth and Stability Pact (GSP), made
no provision for private-sector excess but severely proscribed public defi-
cits. Consequently, it was only when private overspending mutated into
public deficits and sovereign debt that warning bells began to ring.
Therein lies the major fault of the euro: it is an economic system essen-
tially run by bureaucrats, regulators, and lawyers and, thereby, lacks
many of the automatic warning systems and adjustment mechanisms
that countries with sovereign currencies take for granted. Imposing a
single currency on an economically heterogeneous group of coun-
tries was not the cleverest of ideas. The viability of the euro requires a
surrender of national sovereignty by some countries and an exercise in
pan-European generosity by others: the more that the countries of the
EMU are prepared to bow to a central European authority, the better
the chances of the euro surviving. The danger is that the have-nots will
despair about unending austerity; the haves will lose patience with the
have-nots whom they perceive as feckless and profligate; and any, or
some, of the countries – haves or have-nots – may find the progressive
ceding of national sovereignty to an “European authority” sufficiently
offensive to want to leave. The subsequent pages amplify and develop
this argument.
In writing this book I am grateful to Institut de Recherches Économiques
Fiscales (IREF) for supporting this work and to Vidya Borooah, Enrico
Colombatto, Jean-Philippe Delsol, John Fitzgerald, Anastasios Katos,
Pierre Salmon, Ashok Srinivasan, and George Tridimas for reading and
commenting on the manuscript. Thanks are due to Taiba Batool, Vidhya
Jayaprakash, and Ania Wronski for managing the production of this book
with commendable efficiency. Needless to say, I am entirely responsible
for the views expressed in this book and for all its deficiencies.
1
Introduction
On the eve of the First World War, the British Foreign Secretary, Sir
Edward Grey, offered this gloomy prognostication: “The lamps are going
out all over Europe. We shall not see them lit again in our time.” The
slaughter of the 1914–1918 War was the greatest carnage that Europe
had known in over a hundred years: on the Allied side, 5 million
soldiers, comprising of 52% of enlisted men – and, on the Central
Powers side, 8.5 million soldiers, comprising of 57% of enlisted men –
were killed.1 Since then Europe has known two economic carnages which
destroyed lives without necessarily taking them. One of them was the
Great Depression of the 1930s. The other is the Great Recession that
began in 2008 and, at in 2014, continues with no end in sight. In the
four years since it began it has blighted the prospects of a generation of
young Greeks, Irish, Spaniards, and Portuguese of obtaining a decent
job at home or of retirees securing a decent pension for their old age.
This book details the causes and consequences of the European Great
Recession by exploring four themes – constituting the book’s four core
chapters – which lie at the heart of the Europe’s economic crisis:
1. The housing bubble in Spain and Ireland which, when it inevitably

burst, wrecked their economies.
2. The banking crisis which led to a blurring of the distinction between
private and public debt and opened the door to the public financing
of private debt.
3. The sovereign debt crisis which was partly the result of governments
taking on responsibility for banking debt, but partly also the conse-
quence of national governments being able to borrow freely under
the fiction that their debt was underwritten by the collective guar-
antee of the European Monetary Union (EMU).
1
V.K. Borooah, Europe in an Age of Austerity
2 Europe in an Age of Austerity
4. The implementation of austerity and structural reform in the countries

which suffered the ignominy of being bailed out – Greece, Ireland, and
Portugal – by the troika consisting of the European Commission (EC),
the European Central Bank (ECB), and the International Monetary
Fund (IMF).
The past two decades have been for Europe both the best of times and
the worst of times: the period 1997–2007 was a period of European pros-
perity; since 2008, Europe has only known economic misery. At the
end of the last century and in the early years of the 21st Europe pros-
pered. The prosperity embraced the countries of Europe that are today
seen as its “problem” countries – Greece, Ireland, Portugal, Spain, and
Italy – and, indeed was particularly marked in several of these countries.
Ireland grew at an annual rate of 11.5% in 1997, 10.9% in 1999, and for
9 of the 11 years in the period 1997–2007 its growth rate did not fall
below 5%. Spain and Greece grew steadily at around 4% for the entire
1997–2007 period. Portugal and Italy had less successful growth expe-
riences during 1997–2007: both countries have been struggling since
2002 when their growth rates fell below 1% and neither has succeeded
in staging a convincing recovery since then.
In 2008 the economies of these five countries – and more gener-
ally, of most countries in Europe – crashed and their tale of woe has
continued into 2012. Irish real gross domestic product (GDP), which
grew at an average rate of 5.5% from 1986–1996, and by 5.6% in 2007,
contracted by 3.6% in 2008, by a further 7.6% in 2009, and has since
continued to gently decline. Greece has, since 2008, experienced six
straight years of recession. Italian real GDP contracted by 1.3% in 2008
and by 5.2% in 2009 before resuming slow growth. Portugal, which
like Italy had been struggling since 2002, slowed to zero growth in
2008 and contracted by 2.5% in terms of real GDP in 2009. Spanish
real GDP grew by less than 1% in 2008 before contracting by 3.7% in
2008 and by 0.1% in 2009.
Table 1.1 sets out the growth experiences of Europe’s “problem” coun-
tries, alongside those of some other countries, for the period 1997–2013.
The similarity between the growth experiences of the problem coun-
tries (Greece, Ireland, Portugal, Spain, and Italy) and Europe’s economic
powerhouse, Germany, is that all their economies contracted in 2009
with real GDP in Germany falling by more than it did in Greece and
Spain. The difference is that while the economies of the problem coun-
tries contracted even further (or, at best, stuttered along at low rates of
growth), Germany posted strong real GDP growth in 2010 and 2011.
Introduction 3
Table 1.1 Growth rates (%) in real GDP in selected countries, 2007–2012
2007 2008 2009 2010 2011 2012
Greece 3.5 −0.2 −3.1 −4.9 −7.1 −6.4

Ireland 5.0 −2.2 −6.4 −1.1 2.2 0.1
Portugal 2.4 0.0 −2.9 1.9 −1.3 −3.2
Spain 3.5 0.9 −3.8 −0.2 0.1 −1.6
Italy 1.5 −1.2 −5.5 1.7 0.6 −2.6
France 2.2 0.2 −3.1 1.6 2.0 0.0
Germany 3.4 0.8 −5.1 3.9 3.4 0.9
UK 3.4 −0.8 −5.2 1.7 1.1 0.1
Source: Adapted from OECD Economic Outlook, 2013.
Germany was unique in its speed of recovery: France and the UK, which
also contracted severely in 2009, failed to recover at anything resem-
bling Germany’s speed; indeed, in this respect, their recessionary experi-
ence is not dissimilar to that of the problem group.
Although the succession of economic catastrophes that have afflicted
several European countries since 2008 have several proximate causes,
the two that were common to many countries were, first, the availability
of easy credit and, second, the adoption of the single currency – the
euro – which came into circulation on 1 January 1999 with 11 member
countries who, collectively, constituted the EMU.
Easy money
Although the discussion of government deficits and debt focuses on

the countries that had to be “bailed out” – Greece (in February 2010),
Ireland (in September 2010), Portugal (in May 2011), and most recently,
in March 2013, Cyprus – it should not be forgotten that both deficits
and debt were a near-universal problems affecting several countries
outside this group of problem countries. For example, notwithstanding
today’s very public criticism of tax-avoidance behaviour in Greece and
the profligacy of its government, government revenue as a percentage of
GDP is higher in Greece than in the USA and the UK (39.1%, 30.9%, and
36.6%, respectively, in 2010) with the result that, as Table 1.2 shows, the
overall fiscal balance in 2011 was the same in Greece as in the UK and
the USA (respectively, −8.0%, −8.5 %, and −9.6%) and Greece’s primary
balance in 2010 and 2011 was healthier than that of the UK or the USA.
For these reasons Niall Ferguson writes that the ‘idiosyncrasies of the
euro area crisis should not distract us from the general nature of the
fiscal crisis that is now afflicting most Western countries’.2
Table 1.2 General government balance as percentage of GDP, 2006–2011
2006 2007 2008 2009 2010 2011
OV PM OV PM OV PM OV PM OV PM OV PM
Greece −6.1 −1.5 −6.7 −2.0 −9.8 −4.8 −15.5 −10.3 −10.4 −4.9 −8.0 −1.3
Ireland 2.9 3.9 0.1 0.8 −7.3 −6.5 −14.2 −12.4 −32.0 −28.9 −10.3 −6.8
Portugal −0.4 2.2 −3.1 −0.4 −3.5 −0.7 −10.1 −7.4 −9.1 −6.3 −5.9 −1.9
Italy −3.3 1.1 −1.5 3.3 −2.7 2.2 −5.3 −1.0 −4.5 −0.3 −4.0 0.5
Spain 2.0 3.3 1.9 3.0 −4.1 −3.1 −11.1 −9.9 −9.2 −7.8 −6.1 −4.4
UK −2.6 −1.1 −2.7 −1.1 −4.9 −3.3 −10.3 −8.5 −10.2 −7.7 −8.5 −5.6
USA −2.0 −0.1 −2.7 −0.7 −6.5 −4.5 −12.8 −10.9 −10.3 −8.4 −9.6 −8.0
Note: OV is overall balance, including all expenditure; PM is primary balance defined as overall balance less interest payments.
Source: IMF (September 2011: Statistical tables 1 and 2).
Introduction 5
The source of the West’s “indebtedness problem”, both private and

sovereign, is the trade imbalance that has existed for some time between
the world’s supplier nations – China, Germany, Middle-East oil states –
and the world’s purchaser countries – the USA and the countries of
Western Europe. At its most basic, supplier countries accumulated finan-
cial surpluses that they then ploughed back into the financial systems
of the purchaser countries. The Chinese used their growing foreign-
exchange reserves to buy US Treasury bills, and the deposits of German
savers were channelled by their banks into funds lent to banks in other
European countries and to other European governments. The upshot
was that banks in the USA and the Western Europe found themselves in
possession of vast amounts of “wholesale” money, acquired from foreign
suppliers, to lend on to their customers and which, simultaneously, freed
them from the shackles of their traditional reliance on the deposits of
their domestic savers. Not only was money plentiful, it was also cheap:
the bursting of the dot-com bubble in 2000 meant that interest rates
were kept low in a bid to revive recession-hit economies. This happy
combination of circumstances meant that banks were prepared to lend
and customers were prepared to borrow.
The question for banks, however, was one of where to direct their
loans? In his book, Boomerang, Michael Lewis3 remarked that:
The credit wasn’t just money, it was temptation. It offered entire

societies the chance to reveal aspects of their characters they could
not normally afford to indulge. Entire countries were told [by their
banks], “The lights are out, you can do whatever you want to do and
no one will ever know”.
As Lewis goes on to observe in his book, people in different countries

made different choices. The Americans, the British, and the Irish – in
whom the culture of home ownership runs deep – chose to spend on
property; Icelanders chose to buy foreign assets; the Greeks to expand
their public-sector in terms of employment, wages, and pensions. But,
whatever, their choices, they all drank deeply from the well of plenty.
The euro
The EMU, underpinned by the common currency of the euro, came into
being on 1 January 1999, as a club of 11 member countries (Belgium,
Germany, Ireland, Spain, France, Italy, Luxembourg, Netherlands,
Austria, Portugal, and Finland) and, in the subsequent 13 years, acquired
a further 6 members to comprise, in 2014, a group of 17 countries.4
The conditions for membership were set out in the Maastricht Treaty
of 1992 and the process of monitoring and enforcement of these condi-
tions, after the monetary union had been formed, was enshrined in the
Stability and Growth Pact (SGP) of 1997. Both the Treaty and the Pact
are discussed in some detail in Chapter 4. These 17 countries are a subset
of the European Union (EU) which includes a further 10 countries: these
10 countries, by virtue of retaining their national currencies, are part of
the EU but not of the EMU.5 The adoption of a single currency had two
obvious consequences.
First, instead of a plethora of different national currencies – whose
values against each other were determined by exchange rates (for
example, three Irish pounds for a German mark) – a single currency, the
euro, would prevail in every country of the EMU. Prior to joining the
EMU, countries could alter the value of their currencies vis-à-vis each
other; however, this policy instrument of currency appreciation or depre-
ciation (which is an important means of affecting competitiveness) was
no longer available after they joined the EMU. Now there was a single
exchange rate between the euro and the currency of a country outside
the EMU, determined by the foreign trade performance of the euro area
in its entirety relative to that country. Because the euro area’s foreign
trade performance was dominated by Germany’s exporting powerhouse
the euro was likely to be overvalued in respect of the smaller countries
within the EMU. This kept their exports at levels below what they might
have been with a weaker currency.
Second, prior to joining the EMU, each country could set its mone-
tary policy (by adjusting its money supply), to yield an interest rate best
suited to its needs, independently of the monetary policy set by other
countries. Post-EMU, there was to be a single interest rate across all the
EMU countries and the appropriate level of this rate, and the monetary
policy required to achieve it, would be determined by the ECB which
would take account of prevailing economic conditions over the entire
euro area (and which might not be appropriate to the specific needs of
any individual country).6 Before the current recession, some countries
like Ireland, which were booming, could have done with higher interest
rates to choke demand while other low-growth countries like Portugal
would have benefitted from low interest rates to stimulate demand.
The upshot of having a single interest and exchange rate for the
euro area was that, post-EMU, fiscal policy was the only (macroeco-
nomic) policy instrument available to national governments. Placing
the burden of adjustment on fiscal policy meant that a country could
only improve its competitive position through internal devaluation – a
Introduction 7
process of economic contraction, implemented through tax hikes and

cuts in public expenditure, to raise unemployment and lower wages and
prices. At the same time, by restricting the scale of national budgetary
deficits through the SGP, the scope for expansionary fiscal policy was
severely restricted – countries that ought to have been spending their
way out of recession were obliged, by the terms of the SGP, to restrict
their public expenditure.
Competition between currencies, as with competition in general,
makes market participants aware of the strengths and weaknesses of their
competitors and, in the process, enables them to establish an appro-
priate economic strategy. A country’s competitive position is encapsu-
lated by its unit costs of production (that is, the cost of producing one
unit of output) relative to that of its competitors, both costs expressed
in a common currency (say, dollars). Since labour costs are usually the
largest cost of production, unit costs of production are approximated by
unit labour costs (that is, the labour cost – wages plus taxes on labour – of
producing one unit of output) relative to that of its competitors.7
In order to claw back competitiveness, a country needs to exercise
real wage restraint, so that nominal wages fall relative to productivity
growth, and/or depreciate its overvalued exchange rate. Exchange rate
depreciation also reduces real wages, but indirectly, through stealth,
by raising the prices of imports and, thereby, the domestic price level.
Thus, currency depreciation softens the economic costs associated with
an adjustment of wages and prices though, of course, it cannot solve the
structural problems associated with poor competitiveness. Countries can,
therefore, choose the mix of wage restraint, productivity growth, and
exchange rate depreciation that best suits their needs. A single currency
takes away the last option and places the entire onus of adjustment on
nominal wages and efficiency.
However, a single currency is more pernicious than a fixed exchange
rate regime (for example, the gold standard), which also robs a country
of the freedom to adjust its exchange rate. Under a fixed exchange rate
regime an uncompetitive country will sell assets to finance its consump-
tion and will go bankrupt under the weight of its debt if it does not.
Long before that event, however, remedial action would have been
forced upon it through deflation: either falling real income would lead
to a sharp reduction in imports and induce a correction of its current
account problems or it would undertake, of its own volition, the reforms
it should have undertaken earlier but did not. Samuel Johnson famously
remarked that “when a man is about to be hanged, it concentrates his
mind wonderfully”.8 In this vein, the Indian government, contrary to
all previous form, undertook the historic economic reforms of 1990,

which opened up the Indian economy to competition, and thereby
transformed its prospects, only when Indian foreign-exchange reserves
had dwindled to a low of US$2.2 billion with less than 15 days’ cover
against annual imports.
The problem with a single currency is that a country is not even aware
that it is on the gallows until it feels the noose tighten around its neck
and, by then, it is too late. There is no mechanism within the single
currency framework to autonomously induce a balance of payments
correction. The economic system that buttresses the single currency is
essentially bureaucratic and legalistic, enshrined in treaties and pacts.
There is plenty of head-masterly finger-wagging enjoining good behav-
iour and threatening dire punishment for bad behaviour, but there are no
(economic) incentives to do the right thing and plenty of incentives to
do the wrong thing. Indeed, the current crisis, which appeared to come
as a surprise to policymakers, had been flagged for years by unsustain-
able levels of expenditure in several countries as manifest in their large
current account deficits. However, current account imbalance did not
feature as an issue in the SGP, which underpinned the single currency,
and so EMU countries felt that they did not need to bother about it.
Did the single currency offer incentives to overspend? The answer to
that must be yes. First, the tough anti-inflationary stance of the ECB
caused inflationary expectations to fall and this led to sharp declines in
nominal interest rates in countries like Greece, Ireland, Italy, and Spain
where, earlier, expectations of high inflation had kept interest rates high.
This, in conjunction with a ready availability of bank funds, triggered a
sharp rise in borrowing – by households and by government – in these
countries and caused severe balance of payments deficits.
Second, the system for settling inter-country transactions within the
EMU was such that national central banks did not deal with one another
but only with the ECB. This is discussed in some detail in Chapter 4.
Suffice it to say here that by the ECB taking the bilateral settlement of
accounts between national central banks out of the equation, it consti-
tuted, in effect, central bank funding of external deficits.
Third, the ECB followed rules for money creation that established a
dangerous nexus between banks and public debt. The ECB has, since
its founding, used repurchase operations as a major tool of monetary
policy. In practice, as Boone and Johnson (2011) note, this meant that
the nearly 8,000 banks in the EMU countries could buy the sovereign
debt of any euro area country and present it to their national central
banks, acting on behalf of the ECB, as collateral for new finance. Banks
Introduction 9
made a tidy profit on the difference between the interest received on

sovereign debt and the interest paid to the ECB. There was, therefore, an
appetite for sovereign debt on the part of banks and, since all countries
sheltered under the EMU’s roof carried the imprimatur of the ECB, one
country’s debt was as good as any other’s. The web of interdependency
created by the single currency meant that the failure of a EMU member
state to meet its debt obligations would pose systemic risks by creating
problems for the EMU in this entirety and, therefore, the bond markets’
assumption was that no country would be allowed to fail. Consequently,
smaller countries within the EMU enjoyed an ease of access to bond
markets they could never have imagined earlier with their national
currencies and some of them, Greece in particular, took advantage of
this by expanding debt-financed public expenditure.
Fourth, in order to meet the increased demand for expenditure by
the private sector, banks within the EMU vastly expanded their lending
by issuing short-term bonds to fund long-term loans. Investors were
prepared to buy these bonds because they assumed that the sovereign
debt that banks held as assets would, under ECB rules, give them easy
access to ECB funds in the event of mishap. Banks, too, believed they
would be bailed out by the ECB if their investments soured and this,
as detailed in the next chapter, made them careless in evaluating the
quality of their investments. The upshot of this was that the operation
of the single currency created a moral hazard regime in which banks and
government were locked in a tight embrace and which offered both
parties strong incentives to act without due care and attention.
Bail outs
A bail out is defined as an act of giving financial assistance to save a

failing business or economy from bankruptcy. The moral hazard regime,
described above, ended when investors came to realise that not all banks
and not all countries were alike: some banks were more likely to have
made a mess of their investments and some governments were more
likely than others to default on their loans. A corollary of this realisation
was that banks in trouble were being refused a “roll-over” on their short-
term loans and over-indebted governments were charged such punitive
rates of interest that, in effect, they were denied market access to funds.
Consequently, they needed to be bailed out because the alternative was
bankruptcy.
These bail outs as they affected the three countries involved – Greece,
Ireland, and Portugal – are detailed in Chapter 4 and summarised here.9
In February 2010, Greece received a bail out of €80 billion from the ECB
and the IMF. Further bail outs have meant that by 2012 a total of €110
billion has been agreed to cover Greece’s needs for the next three years:
€30 billion for 2010 followed by €40 billion for both 2011 and 2012.10
The conditions attached to the bail out are severe and include measures
to cut government expenditure and increase government revenue, the
sale of public assets, and structural economic reforms.
Greece was followed by Ireland. In September 2010 the Irish govern-
ment’s support for Ireland’s banks had raised the public deficit to 32%
of GDP and, by October, markets were sufficiently alarmed to raise the
interest rate on Irish government bonds to over 7%. By November the
game was up and the Irish government had to seek a €85 billion bail
out from the ECB and the IMF, of which €17.5 billion would come out
of its own pension funds. This bail out came with conditions attached:
there was to be a four-year austerity plan involving deep cuts in public
spending and public-sector jobs, a lower minimum wage and higher
taxes, and, most importantly, a substantial recapitalisation of its banks.
Ireland was followed by Portugal. In May 2011, Portugal’s caretaker
Prime Minister, Jose Socrates, announced that Portugal had agreed
terms for financial assistance from the EU and the IMF worth €78
billion (including €12 billion in support of its banks). Under the terms
of the agreement, Portugal would cut its deficit to 5.9% of GDP in 2011,
followed by reductions to 4.5% in 2012 and 3% in 2013. In so doing,
Portugal, like Greece and Italy, would, inter alia, cut its public-sector
wage bill by freezing wages and employment, reducing state pensions,
and increasing sales taxes. However, unlike Greece, which could not
repay debt, and Ireland, which took on the debt of its banks, Portugal’s
problems were caused by a government that could not get its austerity
measures through Parliament and, so, had to resign. It was the political
limbo of a country without a government that raised borrowing costs
for Portugal to the point where it could not cover its borrowing on the
bond market and, consequently, was forced to seek a bail out.11
The future of the euro
So where that does that leave the euro? Many of the problems associated
with the single currency that have been set out in this book (and by other
commentators elsewhere) could have been foreseen but they were not,
partly because the architects of the euro did not want to anticipate them
and so averted their eyes from the euro’s weaknesses. Their reluctance to
anticipate its problems stemmed from the fact that the single currency
Introduction 11
project, which was to fundamentally and irrevocably change the economic

landscape of Europe, was motivated more by dubious politics than by
sound economics. The founding of the European Economic Community
in 1957 was predicated on the noblest of motives – a desire to avoid
the prospects of German revanchism and Communist hegemony meant
that Europe had to provide a third way based on debate and discussion,
and underpinned by reasonableness. However, when at that time the
“European Project” had the choice between embracing a classical liberal
vision (with its emphasis on autonomy and competition at all levels) or a
socialist centralised vision (which envisaged political and economic union
culminating in a United States of Europe) it chose the latter.12
As The Economist newspaper expressed it: “The euro and its inde-
pendent central bank are elite projects par excellence. The high priests
of Europe’s political class handed down the edict that Europe needed
its own currency.”13 This vision regarded the use of a single currency as
essential for instilling a sense of unity and belonging among the people
of Europe. As importantly, it would enhance Europe’s role in world
affairs by equipping it with a currency that would rival, perhaps even
eclipse, the dollar in international trade and finance.14 And although
Germany was wedded to the Deutschmark, it was persuaded to renounce
it in favour of the euro for three reasons. First, it was promised an easy
passage towards the reunification of East and West Germany. Second, it
was assured that the new European Central Bank would be created in the
spirit of the Bundesbank – binfused with an intolerance of inflation – and
that the new currency would, therefore, possess all the anti-inflationary
robustness of the Deutschmark. Third, Germany realised that the new
currency would offer Germany a more competitive exchange rate than
the Deutschmark. The value of the euro would represent the foreign
trade performance of the euro area in its entirety while the value of
the Deutschemark represented the foreign trade performance only of
Germany. Consequently, the euro would be a weaker currency – and
hence more competitive in export markets – than the Deutschemark.
However, recent events show that the single currency has failed on
both fronts. Europe is more divided today than it was at any time since
the Second World War. The euro has pitted northern against southern
Europe, Greece against Germany, and the “periphery” against the
“core”. It has imposed a bureaucratic, centrist vision of Europe, under-
pinned by regulation and legality, on a heterogeneous group of coun-
tries that, arguably, needed instead the space and freedom to devise
national solutions for national problems. Far from learning from its
mistakes, the favourite EU solution to a fresh economic problem is yet
another treaty embodying yet more regulation and demanding yet more
conformity. There is a further tightening of fiscal discipline in the Treaty
on Stability, Coordination and Governance.. The reliance on regulation
and command is concomitant of the fact that the single currency does
not embody incentives that will lead to an autonomous correction of
imbalances.
In the international sphere the euro is so far from rivalling the dollar
that it was dismissed by an eminent economist as “the little currency
that couldn’t [hack it]”.15 Countries like the UK and Denmark – which
signed the Maastricht Treaty but opted out the single currency partly in
anticipation of its problems and partly from a reluctance to submit to
the authority of unelected “euro-bureaucrats” – congratulate themselves
on their prescience. By closing their ears to the siren call of the euro they
have escaped the clutches of an economic system run by bureaucrats,
politicians, and lawyers.
2
Housing
The housing bubble in three European countries with a strong culture

of owner-occupation – Spain, Ireland, and the United Kingdom – was a
precursor to the recession they experienced from 2008 after 2007. All
three countries have very small private-rental sectors and high home
ownership rates, defined as the proportion of the total number of resi-
dential units in the country that are owner-occupied. The home owner-
ship rate was 78% in Spain (2002), 83% in Ireland (2002), and 69% in
the UK (2002); in contrast, it was only 42% in Germany (2002), 49% in
the Netherlands (2000), and 55% in France (2000).1 According to the
European Central Bank (ECB) (2006: 65), the share of rent expenditure
in the Harmonised Index of Consumer Prices (HICP) for euro area coun-
tries was less than 3% for Ireland and Spain, compared to a euro area
average of over 6% and a high of 11% for Germany.
As Figure 2.1 shows for the period 1997–2009, house prices in Spain,
Ireland, Greece, and the UK rose sharply between 1997 and 2007 before
falling in 2008 and 2009 in all four countries. By contrast, house prices
in Germany have hardly changed since 1997 and – unlike Spain, Ireland,
and the UK – Portugal, too, has experienced low house price inflation. It
would be a mistake to think that the property bubble which existed from
1997–2007, and which burst in 2008 and 2009, was confined to a few
“problem” countries. As Figure 2.1 shows, house prices in Denmark rose
sharply between 1997 and 2007 (indeed, faster than in Ireland) and fell
precipitously in 2008 (indeed, by more than in Spain). Yet, unlike Ireland
and Spain, Denmark was unscarred by the rise and fall of its housing
market.2
A feature of the trajectory of house prices for European countries is its
volatility (or lack thereof). In some countries, house prices hover around
a central value; in others, they deviate considerably from it. In order to
13
200
180
160
140
120
100
80
60
40
20
0
97
98
99
00
01
02
03
04
05
06
07
08
09
19
19
19
20
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20
20
20
20
20
20
20
20
Ireland Germany Spain UK
Greece Portugal Denmark Italy
Figure 2.1 House prices in selected countries: 1997–2009 (2002 = 100)

Source: Adapted from the Financial Times.
Table 2.1 Gini coefficients for house prices, 1997–2009, selected countries
Germany Denmark Norway Sweden Greece Ireland Italy Portugal Spain UK
Gini 0.013 0.161 0.158 0.167 0.146 0.187 0.146 0.056 0.194 0.196
Source: Authors own calculations.
summarise house price volatility in different European countries, Gini

coefficients3 were computed for different countries using data from the
Financial Times database on European housing prices (2002 = 100 for all
countries)4 and these coefficients are displayed in Table 2.1. The greatest
house price volatility was in the UK (Gini = 0.196), Spain (0.194), and
Ireland (0.187), and the least volatility was in Germany (0.013) and
Portugal (0.056).
Volatility in house prices matters to the building industry because
houses are built on a speculative basis with builders recouping their
outlay only after the finished houses have been sold. Because there is
typically a time lag between the decision to start a house and its comple-
tion, builders have to base their decision about the number of houses to
start on circumstances they expect to prevail in the future, which will, in
The Housing Bubble 15
the main, revolve around expectations of future prices. The greater the
volatility in prices, the greater the likelihood that these expectations will
not be met with the result that builders will have built either too few or
too many houses.
Housing fundamentals: income and demography
Against this background, an important question is why house prices

rose so sharply in certain countries, in spite of the fact that they did
not experience any significant change in the “fundamental” factors
underpinning housing demand. The role of such factors in determining
house prices has been analysed by Girouard et al. (2006) and by the ECB
(2006). The factors may be separated into non-financial (house prices,
both current and expected, income growth, and demographic develop-
ments) and financial (price and availability of credit) factors.
Household income and house prices together determine “housing
affordability”. A crude measure of housing affordability is the ratio of
house prices to income: as this ratio rises, housing becomes less afforda-
ble.5 On this measure, according to ECB (2006) calculations, housing
affordability in the euro area fell continuously between 1998 and 2002.
Consequently, one can rule out rising incomes, making houses more
affordable, as a source of housing demand and, therefore, of rising
house prices. According to the Nationwide Building Society, the price-
to-income ratio of first-time buyers in the UK rose from a low of 2.1 in
1995 to 5.4 in 2007 and, for first-time buyers in London, it rose from 2.8
in 1995 to 7.2 in 2007.6
Another source of housing demand is population growth. A particular
aspect of population growth that affects housing demand is that of house-
hold formation: when a person (or persons) decides to establish a separate
household, instead of remaining as part of an existing household, they
immediately become a fresh source of housing demand. There has been a
structural shift in Europe towards smaller households as the rate of growth
of households has outstripped adult population growth (ECB, 2006: 60).
However, “headship rates” (that is, the proportion of people in an age
cohort who are heads of households) varies considerably across coun-
tries. Conefrey and Fitzgerald (2010), showed, using data from the 2006
Census for Ireland, that for every age cohort the proportion of persons
who were heads of households in Ireland was less than that in Germany
and the UK, though the difference was most marked at the younger age
cohorts.7 A similar situation prevailed in Spain: Choroszewicz and Wolff
(2010) reported that in 2008 over 50% of persons aged 18–34 in Spain
lived with their parents. This is reflected in the fact that the number of
occupied dwellings per 1,000 of the adult population in Ireland, Portugal,

and Spain was considerably lower than that in other countries, even
though the total number of dwellings did not display such differences. For
example, in 2006 Ireland had the same number of dwellings (per 1,000
adults) as the UK but 13% fewer occupied dwellings (per 1,000 adults):
478 compared to 551 occupied dwellings in the UK.8 This suggests that
there was an unmet demand for housing in Ireland: if headship rates in
Ireland had been similar to Germany or the UK it would have had many
more occupied dwellings per 1,000 adults; one of the reasons that head-
ship rates are low in Ireland (and Spain and Portugal) is that, because of
high prices, young people cannot move away from home.
However, high (and escalating) prices reduce the user cost of housing.
The user cost of housing is the cost of consuming housing services for
one period (say, a year). It comprises two terms: (i) the interest paid
(if the house was bought using borrowed funds) or foregone (if the house
was bought using equity); (ii) the capital gain from holding the asset for
a year.9 If credit is readily available, the interest rate is low and the user
cost of capital is low. If it is expected that house prices will continue to
rise, the user cost of capital is lowered even further (and could, indeed,
be negative). Under these circumstances – of low interest rates and
expectations of increasing prices – buyers will rush to buy houses even
if the house price-to-income ratio is high (that is, affordability is low).
Indeed, some of the rush to buy houses may be because affordability,
though low, is expected to deteriorate further as house prices continue
Demand for
home House prices go
Financing gets easier ownership up
increases
Anxiety to Expectations
Wholesale money get on the of further
from “saver housing increases
countries” ladder
Default rates fall:

Low interest rates mortgages are safe
Figure 2.2 The dynamic of a house price bubble

Source: Author.
to pull away from incomes. This is precisely the dynamic of a bubble as

shown in Figure 2.2: investors’ “animal spirits” make them rush to place
a foot on the housing ladder lest tomorrow house price inflation puts
the rungs out of reach.
Housing fundamentals: finance
The easy availability of finance on favourable terms makes home

purchase available to people who, in a different period, would not have
been considered for a home loan. Joining the euro on 1 January 1999
meant interest rates fell for most of the joining countries. Figure 2.3
compares interest rates in euro area countries with EU countries not
in the euro area. Interest rates in Ireland, Spain, and Portugal fell from
7.2%, 8.7%, and 8.6% respectively in 1996 to the euro area rate of 4%
in 1999. EU countries outside the euro area had interest rates consider-
ably above the euro area rate: in 2000, compared to the euro area rate
of 5.75%, central bank rates in Hungary, Lithuania, Latvia, and the UK
were, respectively, 13.75%, 7.67%, 6%, and 6%.
However, because of house price inflation, the user cost of housing fell
even faster than interest rates (ECB, 2006: 62). In addition, as ECB (2006)
shows, banks’ lending standards for house purchase were considerably
16
14
12
10
0
99
00
01
02
03
04
05
06
07
08
09
10
19
20
20
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20
20
20
20
20
20
20
20
Euro Area Latvia Hungary

Lithuania UK
Figure 2.3 Central bank interest rates: annual data

Source: Adapted from Eurostat.
relaxed after 2002. The ECB (2006) computed lending standards as the
difference between the number of respondents (to an ECB banking
survey) saying that bank lending for house purchase had “eased” and
those saying that it had “tightened”: the larger this difference, the greater
the ease of getting a mortgage. The ECB (2006) banking survey showed
the evolution of banks’ credit standards and loans for house purchase
in 2002–2005: as lending standards were relaxed, the growth in home
loans soared (ECB, 2006: 62). The final piece of evidence linking relating
financial developments to rising house prices is that the growth in mort-
gage lending and the rise in house prices were positively related between
1999 and 2004 (ECB, 2006: 63).
Bursting the housing bubble
The housing bubble, as argued above, was built on cheap and easily
available home mortgages that, combined with expectations of continu-
ally rising prices, led to a buying frenzy. People saw buying a house
(or, indeed, houses) as a good, safe investment, which, by yielding high
returns, would provide for a multitude of expenditure contingencies:
school fees, holidays, new cars, income in old age. In consequence,
several buyers overstretched themselves financially to take advantage of
the investment opportunities afforded by the housing market. In 2010,
the total value of outstanding mortgages in Ireland was €110 billion,
yielding a mortgage-liability-to-disposable-income ratio of 132%.10 Only
the UK had a comparable ratio (133%); the mortgage liability of USA
households was only 96% of disposable income and that of German
households was even lower at 67%.11 Consequently, it took only a small
rise in interest rates, from 3% in 2004 to 5% in 2007, to cause some
mortgage holders to default, to frighten off new buyers, and, in general,
to reverse the entire process by sending house prices into decline.
However, although several countries – Ireland, Spain, the UK, and
Denmark – saw their housing markets rise and fall during the period
2000–2009, it was only the Irish and, to a lesser extent, the Spanish
economies that were significantly affected by the housing boom and,
subsequent, bust. On one hand, the unemployment rate in Ireland rose
from 4.6% in 2007 to 13.7% in 2010 while in Spain it rose from 8.5%
in 2006 to 20.1% in 2010. On the other hand, unemployment rates in
the UK and Denmark – the other housing boom and bust countries –
rose between these years from, respectively, 5.4% to 7.8% and from
3.9% to 7.4%.
The reason for this asymmetric effect of the housing boom on the
economies of these countries is found in supply-side responses. In
Ireland and in Spain, builders responded to the demand for housing
by building new houses.12 Figure 2.4 shows that, in 2006, gross fixed
residential capital formation was 14% of gross domestic product (GDP)
in Ireland (up from 8% in 2000) and 9% of GDP in Spain (up from
6% in 2000). In contrast, the proportions of residential capital forma-
tion in the GDP of the UK and of Denmark were only 4% and 7%,
respectively, in 2006 (up from, respectively, 2.8% and 4.7% in 2000).
Consequently, the housing boom restructured the Irish and Spanish
economies, in a way that it did not the UK and Danish economies, by
diverting resources – skills and labour – from other sectors into construc-
tion which now, thanks to the buoyant demand for housing, offered
higher wages compared to other parts of the economy. The numbers
employed in construction in Ireland quadrupled, from 35 thousand in
2001 to 147 thousand in 2010, while in Spain employment in construc-
tion increased by 48%, from 1.95 million in 2001 to 2.89 million in
2007.13 Consequently, when boom turned slump, Ireland especially –
given its record as an exporting country – found it difficult to cope:
high wages had eroded competitiveness and the shift of workers, from
other sectors, into construction had eroded past skills.
16
14
12
10
8
6
4
2
0
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85
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20
20
20
20
Ireland Spain UK Denmark
Figure 2.4 Gross fixed residential capital formation as percentage of GDP (current
prices)
Housing downturn in Ireland: consequences
The downturn in the housing market had severe consequences for the
Irish economy. It sent the economy into a deep recession, with per capita
GDP falling by 16% from €36,900 in 2007 to €31,100 in 2010 accom-
panied by a corresponding rise in the unemployment rate from 4.6% in
2007 to 13.7% in 2010.14
The sudden and sharp rise in the unemployment rate, following the
downturn in the housing market, left many households in Ireland facing
difficulties with their mortgage. With a mortgage debt of €110 billion,15
Irish households carry a mortgage debt of €13,200 for every €10,000 of
disposable income. If one defines “mortgages in arrears” as mortgages on
which payments have not been made for 91 days, then 3.6% of residen-
tial owner-occupier mortgages (28,600 out of 792,893) were in arrears
in 2009 (though, on more stringent definitions, this figure could be as
high as 9.8%16), placing them in danger of receiving formal demands for
payment which, if not complied with, could then trigger court applica-
tions for repossession.
A fallout from mortgage default – which was but a particular instance
of bad loans made by Irish banks against property – is that mortgages
have become difficult to obtain. The number of new mortgages issued
by Irish banks fell from 203,953 in 2006 to 45,818 in 2009 and the
number of mortgages to first-time buyers in 2009 (12,684) was one-
third of the number in 2006 (37,064). Particularly badly hit were
second-time buyers (number of mortgages down from by 79% from
45,585 in 2006 to 9,395 in 2009) and buy-to-let investors (number of
mortgages down from by 78% from 26,565 in 2006 to 5,774 in 2009).17
Until mortgage lending recovers, there is little prospect of recovery in
the housing market.
However, there is new mood of caution among lenders and regu-
lators which makes it unlikely that, even after the present crisis in
bank liquidity has passed, mortgages will be issued again in the cava-
lier manner of a few years ago. The UK’s Financial Service Authority
(FSA) laid out in 2011 recommendations for lending practices, which
are likely to become the industry’s standard in the UK and elsewhere
(FSA, 2011a). In particular, self-certification of income would become
a thing of the past and lenders would be forced to verify the income of
every prospective borrower; stricter affordability tests would mean that
an assessment of whether the borrower could afford the loan would
be made on the basis of cash flow and not on the prospect of rising
house prices; borrowers would be “stress tested” to see whether they
could afford their repayments in the face of interest rate rises; and,
interest-only mortgages would be granted only under circumstances
where the buyer had a repayment arrangement in place.
A particularly worrying feature of mortgage debt is that a large amount
of it was not used to buy houses at all. In the UK, equity extraction to
fund non-housing purchases amounted to roughly half of funds raised
through mortgages in the five years since 2007. Although there is not
comparable information for Ireland, 74% of those remortgaging their
homes in Northern Ireland – representing the highest proportion in
the UK – used the opportunity to withdraw equity. Remortgagers who
extracted large amounts of equity from their homes may be in nega-
tive equity for reasons that have less to do with the fall in their house
value and more to do with extravagance in non-housing expenditure.
FSA (2011a) estimates that nearly half of remortgagers in the UK may be,
what it terms, “mortgage prisoners” – locked into their homes and unable
to move. If the UK experience is replicated in Ireland then, considering
that 15% of all new mortgages between 2005 and 2009 were remort-
gages (105,594 out of 719,434), there could be nearly 53,000 mortgage
prisoners in Ireland, in addition to the 28,600 borrowers in 2009 who
were more than three months in arrears.
A second consequence for the Irish economy is that the downturn
left builders with a large stock of unsold houses at various stages of
completion leading to, what has today become, a ubiquitous feature
of the Irish landscape: “ghost estates”, that is, housing developments
in which only a small proportion of the total number of houses on
the estate are occupied. Following the collapse of the housing market
in Ireland over the 2007–2008 period, ghost estates have become a
feature of the landscape. The term, first coined by McWilliams (2009)
is a legacy of Ireland’s housing boom that turned to bust. The collapse
of the housing market has scarred Ireland’s landscape thus providing
a constant and painful reminder of how high the Irish economy rose,
and how far it fell.
Although the topic of ghost estates features prominently in Ireland‘s
national post-mortem of “where did it all go wrong?” the phenom-
enon itself has attracted surprisingly little analytical attention. Kitchin
et al. (2010) were among the first to attempt to count ghost estates and
defined those estates as those where half or more of the properties were
either vacant or under construction. On this basis, they identified 620
ghost estates in Ireland which had been developed since 2005, with
80% of the houses on them being either vacant or under construction.
The phenomenon of ghost estates is not confined to Ireland. For over a
decade after 2000, land developers in Spain built hundreds of thousands

of units, about 800,000 in 2007 alone. Developments sprang up on the
outskirts of cities ready to welcome many of the 4 million immigrants
who had settled in Spain, many employed in construction. Most of these
units have never been sold, and though they were finished in 2004 they
were already falling into disrepair by 2007.18
The issue of regulatory failure is often raised in the context of the
unchecked lending by Ireland’s banks to its construction industry.
Kitchin et al. (2010) raise an equally important, though relatively
neglected issue of regulatory failure: in planning policy; in the zoning
of land; and in the granting of planning permission. They argue that,
in a housing boom, land planners should act to restrain the enthusiasm
of builders and developers, which, if unfettered, could lead to grossly
excessive construction. The problem was that planners in Ireland failed
to do so; like the banking regulator, they were swept along by a tide of
pro-growth, laissez-faire rhetoric into sanctioning activities that, with
hindsight, they should not have allowed. A number of local authorities
did not “heed good planning guidelines ... conduct sensible demographic
profiling of potential demand ... or take account of the fact that much
of the land [which was] zoned lacked essential services like water and
sewerage” (p. 3). Planning failure of this nature meant that, during the
boom years, property supply in Ireland was entirely disconnected from
property demand: for example, between 2006 and 2009, 2,945 houses
were built in Leitrim County when 595 new homes would have sufficed
to accommodate its population growth.19
The third, and most serious, consequence of the crash in Ireland’s
housing market is that it reduced Ireland’s banks to near-bankruptcy
because a large number of loans, made to builders and developers
when times were good, began to sour. This, in turn, prompted the Irish
government to assume responsibility for all bank liabilities – where these
included not just its deposits from retail customers, but also its liabili-
ties to all its bond holders – thereby converting, at a stroke, Ireland’s
banking crisis into a sovereign debt crisis. These two areas – banking and
sovereign debt – are the subjects of subsequent chapters.
Appendix on mortgage securitisation
Loans to home buyers had the potential to profitably absorb a large

amount of funds, but the problem here was that creditworthy home
buyers (“prime borrowers”) – those whose stable jobs and good credit
records ensured prompt and regular repayments on their mortgages –

were in short supply. There were a large number of people who would
have liked to own their own homes but whose economic circumstances –
a loose attachment to the labour market with interrupted work histories
and/or a record of credit default – made this impossible. In the circum-
stances, lending them money entailed an unacceptable measure of
risk, though, of course, in the (purely hypothetical) absence of this risk
they would have constituted a large, profitable, and hitherto untapped
investment opportunity.
Financial innovation eliminated the risk of making home loans to
“subprime” borrowers by bundling mortgages made to customers of
different “risk types” to create mortgage-backed securities termed collat-
eralised debt obligations (CDO). Until 2004, subprime mortgages were
less than 10% of all mortgages in the USA; in 2004 they rose to nearly
20% of all mortgages and remained there through the 2005–2006 peak
of the USA housing boom.20
This bundling achieved three purposes. First, it made mortgages
marketable. Now borrower and bank were no longer tied to each other
in a marriage that only ended when the loan had been paid off. Long
before that event, the bank could sell the mortgage, which was now a
small part of a CDO, to investment banks who, in turn, could unleash
these CDOs on the bond market where they would be bought by inves-
tors such as pension funds and sovereign wealth funds. The sale of these
securities was facilitated by the AAA ratings they were awarded by the
ratings agencies. Second, it attempted to offset the risk of loans made
to subprime customers with loans made to safe customers – although
a CDO would contain some defaulters, there would be a sufficient flow
of regular payments to guarantee a steady income to such investments.
Third, it allowed the CDOs to be sliced into tranches representing
different levels of risk, with the least risky tranche, containing the safest
mortgages, paying the lowest interest rate and the most risky tranche,
with subprime mortgages, commanding the highest rates.
Financial innovation (in the form of mortgage-backed securities)
allied to marketing innovation (in the form of teaser mortgages,
interest-only mortgages, loans based on self-certified income or
“liar loans”) drove the expansion in mortgage lending in the USA.21
Elsewhere too, in countries like Ireland and Britain (where home
ownership was an important aspiration) and Spain (where owner-
ship of second homes by foreigners was the crucial factor) there was
a large expansion in home loans. Unlike in the USA, this occurred in
the context of a conventional lender-borrower relationship; however,

now, compared to past practice, Irish and British lenders, in seeking
profitable investments from their expanded supply of funds, began
applying far less stringent conditions when approving home loans:
deposits were greatly reduced if not waived; income was self-certified;
and the loan-income ratio was inflated far above previous levels.
3
Banking
In 1340, Edward III, King of England, defaulted on his debts to the two
great banking families of Florence – the Bardi and the Peruzzi – thereby
reducing these families to bankruptcy: the Peruzzi in 1343 and the Bardi
in 1346.1 As with the Bardi and the Peruzzi in Florence at the begin-
ning of the 14th century so, at the beginning of the 21st, with Lehman
Brothers in the USA, the Northern Rock in Britain, and the Anglo Irish
Bank in Ireland: defaulting borrowers caused their bankruptcy and, in
turn, their bankruptcy led their countries’ economies to tremble and
totter. The difference between the intervening centuries was that Edward
III ran up debts in pursuit of a long war with France while defaulters of
the 21st century were more into bricks and mortar.
Bookended by these two events, were numerous banking crises that
punctuated the nearly seven centuries that separated the Bardi and the
Peruzzi disaster of the 1340s and the collapse of Lehman Brothers in
September 2008. This fact offers cause for reflection. It is often tempting,
when one is in the midst of a crisis, to focus exclusively on the situation
at hand without reference to similar events that might have occurred
in the past; indeed, an unwarranted belief in the uniqueness of the
present – “this time it is different” – often acts as a barrier to learning
from the past. In their magisterial quantitative history of financial crises,
Reinhart and Rogoff (2009) examine the experiences of 66 countries,
over more than 800 years to demonstrate the endemic nature of finan-
cial crises.
In the narrower context of banking, which is the subject of this
chapter, Reinhart and Rogoff (2009) define a “banking crisis” as one of
two types of events: (i) bank runs that lead to the closure, merger, or
takeover by the government of one or more financial institutions, or
(ii) in the absence of bank runs, the closure, merger, or takeover by the
25
government of an important financial institution (due to its financial

distress) that marks a sequence of similar outcomes for other financial
institutions.
Reinhart and Rogoff (2009) show that Europe has had 112 such crises
since 1800 (of these, 26 have occurred since 1945), with France and
England having 16 crises each. In the context of sovereign default on
external debt (the subject of Chapter 4), only a handful of countries –
Australia, Canada, Denmark, New Zealand, Thailand, and the United
States – have managed to avoid sovereign default on external debt.
Banks and maturity transformation
All of this begs the question: what is a bank? Banks are, in essence, insti-
tutions that perform “banking activities”. Fundamentally, banking activ-
ities consist of financial intermediation whereby banks accept deposits
(borrow) from customers and lend to investors. In short, banks make
money by borrowing in order to lend and their profit stems from the
difference between the rates they pay their creditors and the rates they
charge their debtors. In so doing, banks engage in maturity transforma-
tion: they borrow short, but lend long. This means that their borrowing
is in the form of deposits that can be withdrawn at demand or at short
notice, or in the form of short-term loans from other financial insti-
tutions. Their lending is of longer maturity; for example, a loan to a
construction company to develop a housing estate, with the loan to be
repaid when the houses are built and sold. This exposes them to the risk
of creditor anxiety: if a bank’s customers rush to withdraw their money,
worried that they might very shortly be denied access to it, or if its credi-
tors – anxious that they may not be repaid – refuse to roll over their
loans, then a bank may have difficulty honouring its liabilities even if it
is solvent (that is, the total value of its assets exceeds that of its liabilities).
The reason is that because many of its assets will be highly illiquid they
can only be sold on highly unfavourable terms if the bank were required
to meet its liabilities in an emergency. Table 3.1 provides an example of
a bank’s balance sheet. The characteristic that is worth noting about it is
that total assets = total liabilities + capital.
The factor that eases the tension inherent in “maturity transforma-
tion”, namely, converting short-term liabilities into long-term assets is
confidence. Depositors who place their savings with banks, and finan-
cial institutions that lend to banks are not worried about their money
because they have confidence in the ability of banks to invest wisely. On
the basis of this creditor confidence, the bank is able to leverage, that is,
The Banking Collapse 27
Table 3.1 A stylised bank balance sheet
Assets Liabilities
Cash & central bank balances Loans from other banks

Customer loans (mortgages, Customer deposits (current accounts,
overdrafts, corporate loans, SME savings accounts)
loans, etc.)
Loans to other banks Debt (short-term/long-term; secured/
unsecured; senior/subordinated)
Debt and equity investments Other liabilities
Other assets Equity or capital
Source: Author.
to create an asset edifice the value of which is a multiple of the bank’s

equity base, because it is secure in the knowledge that the vast bulk of
the deposits it has accepted will remain intact on its books and that its
debt to other institutions will be routinely rolled over.
In managing their balance sheets, banks emphasise four aspects
(Mishkin, 2010):
1. Liquidity management: to ensure they have sufficient reserves to cover

deposit outflows.
2. Asset management: to find borrowers who are unlikely to default and
who are prepared to pay good rates of interest; to find securities that
are high return but low risk.
3. Liability management: to find the optimal mix of liabilities in terms of
retail deposits, bonds, and overnight loans.
4. Capital adequacy management: to ensure that it has sufficient capital
to ensure its safety in the event of an unexpected downturn in its
fortunes. If, say, through loan default, the value of its assets declines,
then unless a bank has enough capital to cover the gap between assets
and liabilities it becomes insolvent.
However, banks are more than financial intermediaries. Several financial

institutions also intermediate between people who are savers and those
who wish to borrow by accepting money from the former and on-lending
these funds to the latter: making money by “borrowing to lend” is an
activity that lies at the heart of all financial intermediation. However,
what distinguishes banks from other financial intermediaries is that they
have the capacity to create “money”. Money is anything that can be used
for settling transactions – that is, for buying or selling goods, services,
or assets – and, in the modern world, has two components: currency

(that is, notes and coins) and bank accounts with the facility to write
cheques.2 When banks lend money they usually open a bank account,
for the amount of the loan in the name of the borrower who can then
write cheques on this account and treat it as though it were money. In
consequence, banks have a special relationship with the central bank,
which, because it is charged with controlling the money supply, needs to
control and constrain the power of banks to create money.
The central bank and open market operations
Central banks are concerned with money supply because they, in

conjunction with the demand for money, determine the rate of interest
which is a very important variable in the economy: the interest rate
is a major influence on investment decisions and, through its ability
to attract or repel overseas capital flows, it is also an important deter-
minant of the exchange rate. Because the interest rate is the price of
holding money it is determined – like the price of any other freely traded
commodity – by the demand and supply of money. Central banks try to
influence the interest rate by changing the available supply of money:
a tight monetary policy involves reducing money supply to raise the
interest rate and a loose monetary policy involves increasing the money
supply to lower the interest rate
People demand money because they have a choice between holding
their financial assets as money (which does not pay interest but offers
the convenience of being able to make payments) or as interest-bearing
assets (termed “bonds” and explained below) that suffer from the incon-
venience that they cannot be used for transactions. How much of finan-
cial assets will be held as money and how much will be held as bonds
will depend upon two things: (i) the level of transactions – the greater
the level of transactions, the greater will be the demand for money, and
(ii) the rate of interest – the higher the rate of interest, the smaller will
be the demand for money. As regards the first point, we would expect
transactions to depend upon income – a person earning €10,000 a
month would require more money for transactions purposes than one
earning €5,000. The second point follows from the fact that the interest
rate is the “price” or the “opportunity cost” of holding money – every
€1 held for a year as money, rather than as a bond, represents foregone
interest income. The greater the foregone income from holding money
(that is, higher the interest rate), the more reluctant people will be to
hold money.
The role of the central bank is to manage the supply of money, and
thereby the interest rate, through the buying and selling of bonds in
the bond market – called open market operations. When the central
bank buys bonds it increases the money supply by exchanging money
for bonds and when the central bank sells bonds it reduces the money
supply by exchanging bonds for money. Buying bonds (that is, increasing
the money supply) raises the demand for bonds, which raises bond prices
and lowers the interest rate. Conversely, selling bonds (that is, reducing
the money supply) lowers the demand for bonds, which dampens bond
prices and raises the interest rate. The changes in the interest rate then
affect activity in the non-financial part of the economy by influencing
investment decisions and decisions to buy and sell non-financial assets
such as houses and cars.
Equilibrium in the money market, as shown in Figure 3.1, is deter-
mined by the equality of the demand and supply of money which, in
turn, determines the market interest rate. Buying bonds through open
market operations would increase the supply of money: bond sellers
would hold some of the money they obtained from the central bank in
currency and would deposit the remainder with their banks. In terms
of Figure 3.1, the supply of central bank money would shift to the right
and the interest rate would fall. Conversely, selling bonds through open
market operations would decrease the supply of money: bond sellers
would pay for these bonds with currency or by cheques, and as a conse-
quence, holdings of both currency and deposits with banks would fall.
Interest Rate The supply of money
The demand for money

Equilibrium
interest rate
Money
Figure 3.1 Money market equilibrium and interest rate determination

In terms of Figure 3.1, the supply of central bank money would shift to
the left and the interest rate would rise.
What are bonds?
A bond is essentially a promissory note that a borrower (which could be the

central government, or a local authority, or a corporation, or a bank), in
exchange for the loan, provides the lender, promising to pay the holder of the
bond a specified amount (face value) at a specified date (maturity date). If the
maturity period is a long one, there might be intermediate payments (called
coupon payments), say every year or every six months. The lender need not
hold the bond to maturity to collect his money. Because bonds are marketable,
he/she can sell the bond. Indeed, through repeated sales, the bond may pass
through several hands before it is cashed at maturity by whosoever happens
to be holding it at that date.
Suppose that the bond is a one-year bond which will pay, say €100 a year
from now. Suppose that the market value of the bond is €P so that anyone
100 − P
buying the bond will expect to earn an interest rate of i = . If P = €95,
P
the interest rate on the bond will be i = 0.053 (or 5.3%) and if the price fell
to say, P = €90, the interest would rise to i = 0.111 (11.1%). So, the price of a
bond (€P) and the interest rate that it pays (i) will inversely related and we can
100
make this explicit by rearranging the earlier formula as P = . This says that
1+ i
the current price of a bond is the face value divided by 1+ the interest rate: as
long as the interest rate is positive (i > 0), the market price will be less than the
face value (P < 100). Another way of looking at the relationship (and one that
is pursued in Appendix 3.1 to this chapter in the context of a more general
model) is that i is the rate interest which equates the present value (PV) of the
( )
payments from the bond this PV being, 100 with P, the current market price
1+ i
of the bond.
Consider a bond with a maturity of T years, a face value of €F, and annual
coupon payments of €C. Then the present value, €P, of the stream of payments
from the bond is:
C C C F
P= + + .... + + (2.1)
1 + i (1 + i )2 (1 + i )T (1 + i )T
The quantity i is known as the yield to maturity and is referred to as the interest
rate. It is the rate that equates the present value of the stream of payments
from holding an asset to its current price. In Equation (3.1), above, if the
market price of a 10-year bond (T = 10), with a face value of €1,000 (F =
€1,000) and 10% coupon rate (C = €100) is P = €1,100, then yield to maturity
is i = 8.48%. The table below shows the yield to maturity of a 10 year bond
with a 10% coupon rate and face value of €1,000 for different prices of that
bond. As noted earlier, price and the yield to maturity are inversely related: as
the price falls, the yield to maturity rises.
Yields to Maturity on a bond maturing in 10 years, 10% coupon rate, face
value = €1,000
Bond Price Yield to Maturity
€1,200 7.13%
€1,100 8.48%
€1,000 10.00%
€900 11.75%
€800 13.81%
Short-term and long-term interest rates
Bonds differ by maturity: a one-year bond can be redeemed in 12 months

while a 10-year bond involves a longer wait. The yield to maturity on a
10-year bond (or equivalently, the 10-year interest rate) is the constant annual
interest rate that will equate the present value of future payments on the bond
to its current price. Typically, yields on bonds of short maturity (one-year or
less) are termed short-term interest rates while long-term interest rates refer to
bonds of longer maturity: 5-year, 10-year, or longer maturities.
The relationship between short-term and long-term interest rates, at any
point in time, is referred to as the yield curve. The relationship between
yields on bonds of different maturities is defined by the principle of arbitrage.
This principle says that an investor should, in terms of what he will have
one-year from today, be indifferent as to holding a one-year bond or a two-
year bond. The yield on a two-year bond, of face value of €100 and current
price P2t, is i2t (where i2t is the two-year rate at time t) where: P2t = 100 / (1 + i2t )2 .
100
But, equivalently, P2t = where i1t is the current one-year interest
(1 + i1t )(1 + i1et + 1 )
e
rate and i 1t+1 is next year’s expected one-year interest. This implies that
(1 + i2t )2 = (1 + i1t )(1 + i1et + 1 ) and taking an approximation:
1
i2t = (i1t + i1et + 1 )
2
That is, the two-year interest rate is the average of the current and the expected
one-year interest rates. When short-term interest rates are expected to rise
(i e1t+1 > i1t), the long-term rate will be greater than the short-term rate (i2t > i1t),
which was the position on 31 May 2009.
However, when short-term interest rates are expected to fall (i e1t+1 < i1t), the
long-term rate will be less than the short-term rate (i2t < i1t), which was the
position on 30 June 2007.
The monetary base
Through their relationship with their country’s central bank, banks

also have the capacity to influence the country’s money supply and,
thereby, the rate of interest. The relationship of banks with the central
bank stems from the fact that banks hold a portion of their assets in cash
reserves. Some of these reserves are held by the bank itself, as a precau-
tionary measure against unusually large withdrawals, and the remaining
reserves are held by the central bank because banks are required to hold
a certain proportion (called the reserve ratio) of certain specified assets
with the central bank.3 As a consequence of the reserve ratio, the central
bank’s balance looks something like this:
The sum of the two items under liabilities – bank reserves held with
the central bank and currency – is termed the monetary base (and,
equivalently, central bank money or high-powered money). This is the
amount of money directly under the control of the central bank and,
as we shall see, provides the base for creating the total supply of money
(that is, currency plus all non-interest earning bank deposits).
What determines the size of the monetary base? Having decided
on how much money they need (that is, Md = currency plus all bank
deposits), people have to make a further decision about how much of
their money to hold in currency (CU) and how much to hold in deposits
(D). Suppose people decide to hold a fraction α in currency and the
remainder (1 − α) in deposits, and suppose that the central bank requires
that a proportion θ of deposits must be held as bank reserves. Then if
€1 million is demanded as money (Md = €1 million), and if 20% of this is
held in currency (α = 0.2) and 80% in bank deposits (1 − α = 0.8), and if
the reserve ratio θ = 10%, then the total demand for central bank money
(or high-powered money) is:4 €280,000 = €200,000 + €80,000.
We know that because the demand for money (Md) falls as the rate of
interest rises, the demand for central bank money, Hd, must also fall as
the rate of interest rises. The central bank, through the issue of currency
and control of the reserve ratio, controls the supply of central bank
Table 3.2 A stylised central bank balance sheet
Assets Liabilities
Bonds 1. Bank reserves held with the central bank (determined by the reserve ratio)
2. Currency = notes and coins
Source: Author.
money. Following from the above discussion, given the overall demand
for money (Md), the demand for central bank money is the demand
for currency (a fraction α of Md) and the demand by banks for bank
reserves with the central bank (a fraction θ of deposits which, in turn,
are a fraction (1 − α) of Md). Consequently, the demand for central bank
money is:
H d = [α + θ (1 − α )]M d (3.2)
Now equating the supply of money, Hs, with the demand for money, Hd,
as defined in Equation (3.1) we get:
1
HS = M d

[ α + θ (1 − α )]

Demand for Money (3.3)
Supply of money
Equation (3.3) establishes equality between the overall supply of and

demand for money. The term on the left of the equal sign in Equation
(3.3) says that the overall supply of money in the economy is a multiple
1
of its monetary base and the quantity in Equation (3.3) is
[α + θ (1 + α )]
known as the money multiplier (mm). Since [α + θ (1 − α )] < 1, the money
multiplier is greater than 1.
The size of this multiplier indicates how a given monetary base is
magnified into an overall money supply. For example, with α = 0.2 and
θ = 0.1, the value of the mm is 3.6: if the monetary base is €100 billion,
the overall supply of money will be €360 billion. The market (or equi-
librium) interest rate will be that rate that persuades people to hold that
amount of money: €360 billion.
A given change in the monetary base will bring about a larger change
in the overall money supply, and hence a bigger change in the interest
rate, when the multiplier is large rather than when it is small. Because
monetary policy will be more effective when the multiplier is large and
less effective when it is small, it is important to know the conditions
that govern the size of the multiplier.
How banks create money
In North American and Western European countries, where the banking

sector is highly developed, the demand for currency is negligible. If we
assume that α = 0 (there is no demand currency so that all transactions

are carried out via the banking system), the mm = 1/θ. If θ = 0.1, so that
banks have to keep 10% of their assets as reserves with central bank, the
mm is 10. The mm falls as the reserve requirement rises – a reserve ratio
of 50% implies that the mm is 2, and a reserve ratio of 5% implies that
the mm is 20.
Now consider the sequence of events in which the central bank buys
a bond for €100 from person A and pays her in currency.
1. Person A, who has no use for currency – remember the earlier assump-
tion that α = 0 – deposits €100 in her bank account with bank X.
2. Bank X keeps €10 of this as reserves to hold with the central bank, as
the 10% reserve ratio requires it to do, and lends the remaining €90
to person B.
3. Person B deposits this €90 in his bank, bank Y, which then keeps €9
as reserves to hold with the central bank and lends the remaining €81
euros to person C.
4. Person C deposits this €81 in his bank, bank Z, which then keeps €8.1
as reserves to hold with the central bank and lends the remaining
€72.90 euros to person D.
And so the process continues. The total increase in money supply

resulting from a €100 bond purchase by the central bank is:

+ 0.9
×
+ (0.9) × 100
+ ...
2
100 100

B's deposit

A's deposit C's deposit
(3.4)
1
= ⎡⎣1 + 0.9 + (0.9)2 + (0.9)3 + .....⎤⎦ × 100 = × 100 = 1000
1 − 0.9
The increase in the money supply can be thought of as the initial deposit
with a bank (triggered by the central bank buying a bond from person
A and paying her in currency) to further rounds of deposits with banks
as borrower B deposits with bank Y, borrower C deposits with bank Z,
and so on. The final result in Equation (3.4) is obtained by summing an
infinite series and is derived in Appendix 3.2.
It is important to emphasise that the analysis does not rely on there
being several banks, but does rely on there being several customers.
There could have been a single bank, X, but with several customers: A,
B, C. Each new loan would then open a fresh deposit in the name of the
borrower and the analysis of Equation (3.4) would carry through.
Leverage
The upper left-hand corner of the bank’s balance sheet, as shown in

Table 3.1, is important because it shows bank assets as held in the form
of reserves with the central bank. These comprise an important part
of the monetary base – the more developed the banking sector, the
greater the contribution that the monetary base makes to the money.
Equally, the bottom right-hand corner of the banks’ balance sheet in
Table 3.1, showing the value of its equity or capital (equivalently, the
value of its shares), is important because the total value of its assets
divided by its equity represents its leverage. The importance of leverage
stems from the fact that banks, as companies whose shares are publicly
traded in the stock market, are concerned about their return on equity
(ROE), that is, their net profits after taxes as a proportion of their share
value. Another return is the return on assets (ROA), which is a bank’s net
profits after taxes as a proportion of their assets value. While the ROE is
a measure of the attractiveness of the bank to its shareholders, the ROA
is a measure of the efficiency with which a bank’s management utilises
its assets. Consequently:
Profits Profits Assets

ROE = = × = ROA × LVG (3.15)
Equity Assets Equity
The last term in Equation (3.5), LVG, represents leverage as a multiple

of assets over equity. The higher the leverage of banks, the higher is
their ROE (that is, the more attractive their shares appear to investors)
consistent with a given ROA. With lower leverage, banks would need
a higher ROA (that is, charge higher rates on the loans they make) in
order to maintain their ROE. More pertinently, if two banks are run
equally efficiently – that is have the same ROA – then the bank which is
more leveraged will offer a higher ROE to its shareholders than the more
lightly leveraged bank.
The equity (or capital) of a bank offers both a benefit and a cost. On
the one hand, capital offers protection against insolvency (which would
occur if the total value of a banks liabilities exceeded the total value
of its assets); thus, the larger the amount of its capital the more safe a
bank will be; on the other hand, having more capital reduces leverage
and, thereby, the ROE, thus making the bank less attractive to its share-
holders. In deciding how much capital to hold relative to its assets (that,
in deciding on their leverage) a bank has to choose the appropriate path
between safety and return.
In the context of the basic banking principle of making money by

“borrowing to lend”, raising the amount of leverage increases a bank’s
profits; equally, increasing its borrowing (that is, expanding its liability
base) also enables a bank to lend more. In addition to retail deposits (that
is, deposits by the public), banks have two further sources of borrowing.
The first is commercial paper and the second is “repurchase agreements”
(repos).
Commercial paper is an unsecured, short-term debt issued by a
company, usually to meet short-term liabilities and to finance inven-
tories. As Marco (2008) expressed it: “put simply, the commercial paper
market works like a credit card for big companies. Some days they have
money, and some days they do not. So if they need money Tuesday, but
will have money Friday, they’ll go to the commercial paper market and
borrow some money. Then on Friday they will pay back the money, plus
interest.”
Repos operate as deposits. Bank A agrees to lend €100 million to bank
B “overnight” (or, equivalently, deposits €100 million with bank B over-
night). Next morning, Bank A is to receive its €100 million from bank
B plus interest. The transaction is formalised by bank B issuing a bond
to bank A, for say €101 million, as collateral; the next morning, bank B
agrees to buy back from bank A the bond it has issued for €101 million,
thus, in effect, returning to bank A its €100 million plus interest. (The
fact that the loan is backed by a marketable security means that in the
event of default by bank B, the security can be sold by bank A without
the need for bankruptcy proceedings.) However, in practice, bank A
would not liquidate its loan to bank B but, instead, keep rolling it over
for further periods as long as it was reasonably confident that bank B
could repay the loan. It would liquidate the loan – in effect, withdraw
its deposit when, for whatever reason, it refused to roll over the repo.
The interest rate on repos determines the maximum leverage (profits)
that a bank can achieve. The implicit maximum is provided by borrowing
conditions governing repos under which the borrowing bank sells a secu-
rity (its bond) to a lender at a price below the market price on the under-
standing that the borrower will buy back the security from the lender
at a specified date and price. The amount by which the purchase price
is below the market price determines the “haircut”: it is the percentage
amount that is subtracted from the market price of the asset being used
as collateral.5 For example, if a bond the market value of which is €100
is accepted as collateral for a loan of €96 then the haircut is 4%. The
haircut then determines the maximum leverage possible. For example,
the maximum leverage associated with a haircut of 4% is 25, so that, at
a maximum, total assets can be 25 times equity: a haircut of 4% means

a €100 security will fetch €96; the €96 will fetch €(96 × 0.96) which, in
turn, will fetch €(96 × (0.96))2, yielding, in total, an amount €96/0.04
for a leverage of 25.6,7
The haircut represents the share of the price of a firm’s market-traded
asset which cannot be funded in the repos market but which must be
funded from the firm’s own funds or from unsecured borrowing, for
example, through the sale of commercial paper. Haircuts are a hedge
against the risk on collateral. They represent an adjustment to the market
value of the collateral security to take account of the loss the lender may
incur due to the difficulty of selling the security if the borrower defaults.
Consequently, inter alia, the haircut will depend on market conditions;
benign conditions will be associated with small haircuts while more
turbulent times may see the haircut increase, for example, the haircut
on corporate bonds at the height of the financial crisis in March 2008
was 10% whereas the typical pre-crisis haircut on such securities was 5%
(Shin, 2009).
Irrational exuberance
A situation such as that described above is sustainable into the future

but for the fact that a prolonged period of economic upturn engenders
“irrational exuberance” – a heighted state of speculative fervour – in
market participants.8 This leads all economic agents (lenders, private
borrowers, governments) to overextend themselves by taking on exces-
sive debt, conscious only of the profits to be made from increased
lending and borrowing – and, for governments, of the electoral bene-
fits of additional spending and reduced taxation; all are heedless of
the dangers of carrying excessive debt in the downturn that inevitably
follows.
Shiller (2005) observes that “the boom years of the 1990s created a
business atmosphere akin to a gold rush and led many people to distort
their business decisions”. During this period, people invested in assets –
shares, property – as though it was inevitable that the prices of those
assets would rise inexorably. Most investors viewed the stock market
(and, up to, 2007 the property market) as a force of nature without
considering that the “price level is driven by a self-fulfilling prophecy
based on similar hunches held by other investors and reinforced by
the news media” (Shiller, 2005). Irrational exuberance was the psycho-
logical basis for a speculative bubble: “a situation in which news of price
increases spurs investor enthusiasm which spreads by psychological
contagion from person to person” drawing in an increasing number

of investors motivated “partly by envy of others’ successes and partly
by a gambler’s excitement” and sustained by the warmth of the herd
and the comfort of being part of “received wisdom”. A consequence
of this is that, as Reinhart and Rogoff (2009: xxxiii) observe, “many
players in the global financial system dig a debt hole far larger than
they can reasonably expect to escape from”. Generalising from such
views, Akerlof and Shiller (2009) argue that many economic actions,
both in financial and non-financial spheres, are motivated by psycho-
logical considerations.
The foundations of the crisis
Irrational exuberance lays the foundations of a banking crisis. When

the speculative bubble bursts, asset prices crash and people default on
their bank loans. As the proportion of bad loans on the bank’s balance
sheet rises, the value of its assets falls. Depositors grow anxious about
the safety of their deposits and the bank’s creditors are reluctant to roll
over their loans. In consequence, the bank may have to sell assets to
meet its liabilities and if these, mostly illiquid assets, are sold at “fire-
sale prices” its problems will be compounded. As it deleverages, by
reducing the value of its assets, it may face either a liquidity problem or
an insolvency problem. With a liquidity problem, the value of its assets
is more than sufficient to meet its liabilities (it has positive equity)
but it does not have the necessary “cash in hand” to do so. In such a
situation, the central bank, acting as the lender of last resort, can bail
it out by providing the necessary cash support until the bank is back
on its feet.
If, however, the bank’s assets are insufficient to meet its liabilities then
it faces an insolvency problem and to solve this requires more than a
temporary cash injection. The possibilities are that the bank is declared
insolvent (Lehman Brothers), seeks an injection of equity to stay afloat
(Barclays from Abu Dhabi), or is taken over by the government (Northern
Rock in Britain and Anglo Irish in Ireland). The problem with allowing
a bank to become insolvent is one of systemic risk. In most sectors of
the economy the failure of one firm does not jeopardise other firms
in the sector; however, there is a very real danger that the failure of a
major financial institution can adversely affect the rest of the economy.
This capacity of the failure of a single institution to have adverse conse-
quences for the rest of the economy is termed systemic risk and it is for
this reason that governments go to inordinate lengths – far in excess

of what they might do for a non-financial company in similar circum-
stances – to prevent financial insolvency.
The channels through which systemic risk operates have been set
out by the UK’s Independent Commission for Banking (UKICB, 2010).
First, if a bank has liquidity problems and sells assets (say, houses) in a
“fire sale” this could depress asset (house) prices and adversely affect
the balance sheets of other banks that also have these assets on their
books.
Second, a lack of depositor confidence in a particular bank may spread
to other banks and affect the entire banking system. Consequently,
banks may be vulnerable to the contagion effects of a bank run even if
they, themselves, are solvent.
Last, in times of crisis, inter-bank linkages can cause shocks to ripple
through the system. Inter-bank lending – whereby banks lend each other
large sums of money short-term – is an efficient way of economising on
liquidity because banks not making immediate use of their money can
earn income from it by lending “at call” or “overnight” to other banks
in need of liquidity; inter-bank lending thus has the effect of increasing
the pool of liquidity available to the banking system. However, these
linkages, which oil the banking system in times of normalcy, could
cause the entire system to freeze in times of crisis: if a substantial propor-
tion of loans made by bank A default, then this might raise fears about
its capacity to repay loans it has taken from bank B, C, and/or D and
threaten to bring them down. In response, banks scale back their inter-
bank lending thereby reducing the availability of inter-bank funds and
prompting all banks to reduce their lending activities. Because a great
deal of economic activity is carried out with bank funding – particularly
with respect to small and medium enterprises (SMEs) – reduced lending
sends recessionary ripples throughout the economy. It is for these reasons
that important financial institutions are seen as “too big to fail” and are
referred to as systemically important financial institutions (SIFIs).
Moral hazard
Being a SIFI – and, more relevantly, knowing that one is a SIFI – raises
moral hazard problems with respect to the financial sector. Institutions
that are “too big to fail” would be inclined to excessive risk-taking
because they know that, in the event of an adverse outcome, they would
be bailed out by a government concerned about the systemic effects of
their failure. Mervyn King, the Governor of the Bank of England, said in
a speech in Edinburgh on 20 October 2009, that “it is hard to see how
the existence of institutions that are ‘too important to fail’ is consistent
with their being in the private sector” and concluded that the support
handed out by the government had “created possibly the biggest moral
hazard in history”.9
Another possible source of moral hazard is deposit guarantee. Demirgüç-
Kunt and Detragiache (1998, 2005) argue that the presence of an explicit
deposit guarantee scheme tends to increase the likelihood of systemic
banking problems. Such schemes may reduce the likelihood of bank
runs by reassuring depositors that their money is safe but, in freeing
banks from the fear of banking panics, it creates a moral hazard problem
by effectively removing a major constraint on excessive risk-taking on
the part of banks.10
In general, moral hazard is a greater problem in liberalised financial
systems, which offer greater opportunities for risk-taking, and in coun-
tries with weaker regulatory controls. One of the reasons that there were
no banking crises during the turbulent period of the 1970s was because
the banks were tightly regulated. Thus the issue of bank regulation and
supervision is of prima facie importance in explaining the propensity
to banking crises. After analysing measures of supervision and regula-
tion, Barth et al. (2004) concluded that the regulatory and supervisory
practices that forced the accurate disclosure of information empowered
private-sector monitoring of banks. It did so by providing institutions
with incentives to exercise corporate control and, thereby, fostered
better bank performance and stability.
The systemic importance of banks leads to the central paradox of
financial crises, succinctly expressed by the US Treasury Secretary,
Timothy Geithner: “what feels just and fair is the opposite of what’s
required for a just and fair outcome.”11 It feels just and fair that banks
should not be bailed out: first, because one of the central tenets of
capitalism is that while businessmen should benefit from their good
judgement, they should also be penalised for their mistakes; and
second, because, given the wealth of bankers, they are the least obvious
candidates for bailing out. However, given the fact that the financial
system is the engine room of the modern economy supplying power
to its non-financial part, the banking system must be saved in order
to save the economy; and, saving the banking system means saving
bankers. Another paradox follows from the distaste associated with
saving bankers (and their bonuses): although government intervention
is needed to address a financial crisis, the political opprobrium that

such intervention inevitably attracts means that it is usually too little
and too late.
Macroeconomic events and banking crises
In addition to institutional factors, macroeconomic turbulence, particu-

larly as it relates to exchange rate movements, also plays an important
role in causing banking crises. Indeed, the causes of many of the banking
crises that occurred in the past three decades can be traced to the greater
volatility of the global economy since the 1980s. For example, in the
Nordic banking crisis in the early 1990s, deregulation expanded both
the opportunities and capabilities of lenders and borrowers to take risks.
However, as Drees and Pazarbasioglu (1998) argue, it was the expan-
sionary macroeconomic environment that provided the incentive to
take risks: the removal of direct controls on-lending and restrictions
on foreign exchange led to an eagerness to lend by banks who then
had access to new funding sources; this eagerness was matched by
borrowers’ – whose access to credit had hitherto been rationed – appetite
for credit. The result was a credit boom, rapidly escalating asset prices,
and an increasingly overheated economy. The banking crisis arose when
a collapse of asset prices and the onset of a severe recession caused bank
balance sheets to deteriorate sharply: in Norway, banks’ losses on loans
rose from 0.7% of total loans in 1987 to 6% in 1991, while in Finland the
rise was from 0.5% in 1989 to 4.7% in 1991 (Drees and Pazarbasioglu,
1998). In Mexico, the devaluation of the peso in December 1994, in the
context of dollar-denominated debt, caused a financial crisis (Edwards
and Veigh, 1997); in Thailand, an investment boom in property funded
by dollar-denominated debt preceded falling asset prices and the devalu-
ation of the baht on 30 June 1997 (Kaufman et al., 1999).
The connection between macroeconomic events – particularly
currency crises – and banking crises led Kaminsky and Reinhart (1999)
to examine a number of currency and banking crises (currency, 76, and
banking, 26) in 20 industrial and emerging countries between 1970 and
1995. Their study focused on the phenomenon of the “twin crises”,
namely the simultaneous occurrence of currency and banking crises.
From this they concluded that periods of high international capital
mobility have repeatedly produced international banking crises.12 In 18
of the 26 banking crises they studied, the financial sector had been liber-
alised in the five years (or less) preceding the banking crisis.13
Global liquidity
A related, but more focused, issue is that of surges in external capital

inflows into a country and the role that such “capital flow bonanzas”
play in banking crises. Interlinked markets offer several advantages, not
least being that transactions in a country no longer depend upon local
funds but can, instead, draw upon global capital. As Rajan (2005) points
out, a world rate of interest is close to reality with capital flowing to
where returns are most attractive. As a consequence of international
capital mobility the correlation between saving and investment rates
within regions has fallen from 0.6 in the period 1970–1996 to 0.4 in the
period 1997– 2004.14 Reinhart and Reinhart (2008) describe the process
as one that begins with a country catching the attention of international
investors with the consequence that capital flows into the country and
its asset prices rise.
However, international liquidity has its downside. The rise in asset
prices, engendered by capital inflows, triggers a credit expansion and the
equity base of bank assets becomes progressively flimsier. Unfortunately,
capital inflow episodes often end abruptly as other countries appear on
investors’ radar and the current favourite is discarded.15 Asset prices
fall, borrowers default on their bank loans, and a banking crisis results.
In this context, Reinhart and Reinhart (2008) show that, compared to
the unconditional probability of a banking crisis, the probability of a
banking crisis, given a capital flow bonanza, is considerably higher.16
Notwithstanding the risk that banks’ greater reliance on market
liquidity makes their balance sheets more vulnerable,17 in the first
decade of this century here has been an increasing tendency on the part
of banks to fund their investment activities through borrowing from the
wholesale money market as opposed to compared to funding from retail
deposits. Table 3.3 shows that in 2007, in several countries in Europe,
retail deposits comprised less than half of total liabilities. Using the
Lehman Brothers bankruptcy on 15 September 2008 as a control event,
Raddatz (2010) shows that banks that, before the Lehman bankruptcy,
had a high level of dependence on wholesale funding experienced a
larger decline in returns compared to banks with a low level of depend-
ence. This result was valid even after controlling for country character-
istics such as coverage of deposit insurance, amount of international
reserves, and the quality of financial regulation.
The growing dependence of banks on wholesale funds raises the ques-
tion of why banks accept wholesale funds and finance long-term illiquid
projects with such volatile funds. There are two reasons why they do
Table 3.3 Use of non-deposit sources by banks in different countries*
Mean ratio of retail deposits to

Country Number of banks liabilities
Austria 7 0.51
Belgium 2 0.36
Denmark 35 0.64
France 33 0.23
Germany 31 0.35
Ireland 4 0.40
Italy 29 0.39
Portugal 5 0.57
Spain 10 0.58
UK 21 0.32
Note: *As at 30 June 2007.

Source: Adapted from Raddatz (2010).
so. First, the availability of these funds allows new banks to enter the
market easily without having to compete for deposits with more estab-
lished institutions. For example, the Northern Rock bank in Britain,
which was formed in 1997 from the Northern Rock Building Society,
relied on wholesale money to compete in the mortgage market: more
than 75% of its funding came from wholesale markets and, in the first
six months of 2007, approximately one in every five new mortgages in
the UK was issued by Northern Rock.18
The second reason why banks have become so reliant on whole-
sale funds is not dissimilar to the one that George Mallory offered
for attempting Everest: “because it’s there!” The foundation for the
cross-country movement in wholesale funds is the “carry trade” – the
practice of borrowing cheaply in one currency to invest in another.
The carry trade is one of the principal ways that debtor countries like
the USA have been able to recycle their deficits: “surplus countries
have historically offered their citizens lower short-term interest rates
than deficit countries and this has encouraged these citizens to seek
higher returns – and, therefore, investment risk elsewhere” (Tett and
Garnham 2010). Today it is estimated that the carry trade is worth
$1,000 billion.19
The fact that banks drink deeply from the pool of global liquidity also
has the tacit approval of their countries’ governments who often view
capital inflows, and the economic expansion that results, as a sign of
international approval of the government’s policies and regard it as a
permanent, rather than a transitory, phenomenon.20 At the same time,
those who express doubt about the wisdom of such expansion are exco-
riated for “talking down the country”.21 Consequently, as Rajan (2005:)
observes, “governments mistake a cyclical phenomenon for a secular
trend and initiate a plethora of long-term projects on that basis, only to
be forced to liquidate them when the cycle turns”. The political approval
of the economic expansion engendered by capital inflows is likely to be
particularly warm, and the pressure on regulators to adopt a light-touch
approach will be particularly great, when money flows into electorally
rewarding areas like housing.
There are few slogans more popular with politicians than those that
relate to housing. Phrases like “affordable housing for all”, “every
household a home owner”, and “get our country building” roll off the
tongues of politicians with easy mellifluence. Political folklore would
have it that promises based on clichés such as these appeal to the
multitude who would like to buy their first house, to the many who
want to move to a better house or to renovate their present home, and,
indeed, to the thousands, perhaps millions, of voters who desire to be
part of their country’s “ownership society”. Even though the bursting
of a housing bubble caused the biggest recession of modern times, the
British prime minister, David Cameron, promised on 21 November 211
that “we will restart the housing market and get Britain building again”
through ministers intervening to kick-start some of the 130,000 building
projects estimated to have been approved but delayed by funding prob-
lems.22 Rajan (2010) argues that “Politicians love to have banks expand
housing credit, for credit achieves many goals at the same time. It
pushes up housing prices, makes households feel wealthier, and allows
them to finance more consumption. It creates more profits and jobs
in the financial sector as well as in real estate brokerage and housing
construction.” Viewed in these terms, credit, and particularly housing
loans, is the opium of the electorate, the palliative that enables govern-
ments to win re-election without having to do anything substantive
for voters.
The seeds of the current financial crisis were, therefore, sown in the
early years of the new millennium when growth in global liquidity,
and a consequent expansion in banks’ balance sheets, abetted by loose
monetary policy and light-touch regulation which encouraged – or, at
least, did not discourage – risk-taking, financial innovation in the form
of the securitisation of assets which expanded trading opportunities, and
last, the poor judgement of rating agencies in pronouncing mispriced
assets and high-risk securities to be safe investments. From the summer
of 2007 onwards, losses on securities backed by subprime mortgages in
the USA shook the financial system: inter-bank lending declined in the
face of uncertainty about the worth of collateral in a forced sale, banks
deleveraged, lending declined, and the USA and Europe experienced the
most severe recession since the Great Depression. The next part of this
chapter examines how these events unfolded in a selection of European
countries.
Between October 2008 and October 2011, the European Commission
approved €4.5 trillion (equivalent to 37% of EU gross domestic product
(GDP)) of state aid measures for financial institutions. This averted
massive banking failure and economic disruption, but has burdened
taxpayers with deteriorating public finances and failed to settle the ques-
tion of how to deal with large cross-border banks in trouble. In response
to the hitherto loose and unstructured supervision of banks in the euro
area, a ‘banking union’, comprising the euro area’s banks, was estab-
lished by the European Commission in September 2012. The first plank
of this union was the Single Supervisory Mechanism (SSM) under which
the European Central Bank (ECB) had the legal capacity to supervise all
the banks in the euro area (and any banks outside the area that decided
to join this union). In order to facilitate this, the governance structure
of the ECB now consists of a separate supervisory board and there would
be a clear demarcation within the ECB between its supervisory and
monetary policy functions.23 In addition to the SSM, the Bank Recovery
and Resolution Directive (BRRD) would, when adopted, determine the
rules for how EU banks in difficulties are restructured, how vital func-
tions for the real economy are maintained, and how losses and costs
are allocated to the banks’ shareholders and creditors. Lastly, in July
2013 the Commission proposed a Single Resolution Mechanism (SRM)
for the banking union which was formally adopted in March 2014 by
the European Parliament. This was intended to complement the SSM by
centralising key competencies and resources for managing the failure of
banks in the euro area and in any other Member States participating in
the banking union
Swedish banks and the Baltic states
The three Baltic states of Estonia, Latvia, and Lithuania – which, after
gaining their independence from Soviet hegemony in 1991, joined the
EU in 2004 – embarked on a series of structural reforms in 2000 aimed
at liberalising their economies. The European Bank of Reconstruction
and Development (EBRD) structural index reform lists nine areas of
reform: large-scale privatisation, small-scale privatisation, enterprise
restructuring, price liberalisation, trade and foreign exchange, competi-

tion policy, banking reform, non-bank financial institutions, and insti-
tutional reform (EBRD 2009:). A country’s performance, with respect to
each area, is scored from 1 (lowest) to 4+ (highest); the EBRB, in its
annual Transition Report, charts the progress of the Central and Eastern
European (CEE) countries – which include the Baltic countries – with
respect to structural reform (and, of course, several other economic
indicators).
Taking the three countries, Estonia, Latvia, and Lithuania, in their
entirety, the main focus of reform has been in the areas of price and trade
liberalisation. According to EBRD (2009), all three countries achieve
the maximum CEE score for both areas. In terms of reform, however,
Estonia has gone further than either Latvia or Lithuania: it achieves
the maximum CEE country score for all nine areas, while Latvia and
Lithuania have underperformed, with respect to the CEE maximum, in
terms of enterprise restructuring and competition policy. By improving
their competitiveness through these reforms the three countries enjoyed
the highest rates of economic growth in the EU between 2000 and 2007
with, compared to an EU (27) average GDP growth rate of 3.3% in 2006,
annual GDP growth rates in 2006 of 10.1% in Estonia, 11.2% in Latvia,
and 7.6% in Lithuania.24
A large proportion of the credit sustaining the boom was provided
by subsidiaries of Swedish banks operating in the Baltic States. From
the late 1990s, the two Swedish banks, SEB and Swedbank, were buying
stakes in local banks and, by 2005, they were majority shareholders. The
local banks in the Baltic states thus became fully incorporated subsidi-
aries of the relevant parent bank and the funding of these subsidiaries
became heavily reliant on loans from the parent bank. As a conse-
quence, the loans-to-deposit ratios of banks in the Baltic states were
very high compared to ratios in other countries (Bank for International
Settlements, 2010).
A common feature of reform in all three countries was that they pegged
their respective currencies – kroon (Estonia), lats (Latvia), and litas
(Lithuania) – to the euro.25 One of the reasons for this was that all three
countries were scarred by their inflationary experience in the early 1990s
when high rates of inflation in Russia spread to the Baltic states. In this
context, pegged exchange rates were seen as imposing a cost discipline
on the domestic economy: loss of competitiveness at home could not
be “adjusted for” by external devaluation. However, low interest rates in
the euro area, combined with a ready supply of credit from banks which
had access to funds from their parent bank and were not constrained by
domestic deposits, triggered a credit boom in which citizens of the three
countries borrowed in euros to fund asset purchases.
When the global financial crisis caused the credit bubble in the Baltic
states to burst, the fall in income was of epic proportions: in 2009,
real GDP fell by 14% in Estonia, 18% in Latvia, and 15% in Lithuania
(Eurostat). Erixon (2010:) suggests that this spectacular crash was not
due to some fundamental flaw with the “Baltic model” of develop-
ment but rather because “too many political leaders in the Baltic region
became complacent. With real growth figures in the 8–10% region, it
became easy to neglect the maintenance of sound economic policy and
the need to gear up competitiveness.” Inflation rates went up sharply in
all three countries in the two years prior to the crisis and, in 2007, the
current account deficit, as a percentage of GDP, was over 15% in Estonia,
over 20% in Latvia, and over 14% in Lithuania (EBRD, 2009:).
This left the three countries with two policy options to improve
competitiveness: they could opt to devalue their currencies (external
devaluation) or to undertake a massive deflation by reducing wages
(internal devaluation). The first option was ruled out because it would
have called into question the credibility of their aspiration of wanting
to join the European Monetary Union and also resurrected memories
of past hyperinflation. As a consequence, the Baltic countries have
embarked on a process of severe deflation. Between 2007 and 2010, the
unemployment rate rose: from 5% to 14% in Estonia; from 6% to 19%
in Latvia; and from 4% to 18% in Lithuania. In Latvia and Lithuania
the government deficit which in 2007 was less than 1% of GDP rose to
nearly 10% of GDP in 2009 and, in Estonia, a surplus of 2.5% of GDP
was converted into a 2% deficit by 2009 (Eurostat).
The scale of economic misery in the three Baltic states has impacted
on Swedish banks, which suffered big losses after expanding aggres-
sively across the Baltic region. Swedbank’s (its exposure to the Baltic
states accounted for 6% of its loan book) share price fell by 18% and
SEB (with a Baltic exposure of 12%) shares fell by 12% in June 2009.26
As a consequence, mirroring the actions of banks everywhere in a reces-
sion, Swedish banks have reined in credit prompting the Latvian prime
minister to warn: “The abrupt stopping of credit is a very problematic
issue ... of course you can say that Latvians were borrowing irresponsibly
but to borrow irresponsibly you need someone to lend irresponsibly ... we
had very easy credit in a very overheated economy, now we have almost
no credit in a very deep recession.”27
British bank failures
The first intimations of a crisis in British banking were provided in

the early months of 2007 when liquidity in the market for short-term
asset-backed commercial paper began to dry up in the wake of the US
subprime crisis which was characterised by mortgage defaults, reduc-
tions in the prices of mortgage-backed securities, and increases in the
cost of insuring of these securities against default (OECD, 2008). On
9 August 2007, the London Inter-Bank Offered Rate (LIBOR) increased
significantly. The LIBOR is a daily reference rate for inter-bank borrowing
of unsecured funds in the London wholesale market and its rise effec-
tively froze the market for inter-bank lending.28
The first casualty of this freeze was the Northern Rock bank. This
bank, which had been formed in June 1998 through the merger of two
building societies,29 was unusual among British banks in its heavy reli-
ance on non-retail funding with retail deposits constituting only 23%
of its liabilities in June 2007. This reliance was largely explained by
its ambitious expansion from its inception to its moment of crisis in
June 2007: over this decade, Northern Rock’s assets grew at an annual-
ised rate of 23.2% (from £17.4 billion in June 1998 to £113.5 billion in
June 2007) and, by June 2007, it was the fifth largest bank in the UK,
calculated by mortgage assets. This rapid rate of expansion meant that
its retail deposits were no longer an adequate source of funding and it
had to look elsewhere for other sources to fund its expansionary ambi-
tions. This was funded by securitised notes and other forms of non-retail
funding: as a consequence, the proportion of its liabilities emanating
from retail deposits fell from 60% in June 1998, to 23% in June 2007.
Although this reliance on non-retail funding by Northern Rock
reflected the general trend in British banking (up from 27.8% of total
liabilities in December 2000 to 47.8% in December 2007), what set
Northern Rock apart from other British banks was the scale of its reli-
ance (Shin, 2009). This meant that although Northern Rock dealt only
with prime borrowers and had a solid asset book without any subprime
mortgages, it was particularly hard hit by a general scaling back of
inter-bank lending following the US subprime crisis. It was, therefore,
creditor retrenchment rather than – as is more usual with bank crises –
imprudent lending that forced Northern Rock on 13 September 2007 to
seek Bank of England emergency support, which culminated in it being
nationalised on 21 February 2008.
The next casualty of Britain’s banking crisis was the Royal Bank of
Scotland (RBS) though here, unlike Northern Rock, its collapse was due
to imprudent risk-taking rather than to excessive reliance on non-retail

funding. Under Basel III, the largest systemically important banks (of
which RBS was one) were required to hold 9.5% common equity tier 1
capital in normal times in order to operate without any restrictions on
dividends and other distributions. In addition, Basel III increased risk
weights for some assets and changed the definition of core capital to
ensure that it included only capital resources available to absorb losses
on a going concern basis. In its entirety, Basel III imposed considerably
more capital stringency on banks compared to Basel II. Calculations by
the UK Financial Services Authority (FSA) showed that the RBS’s common
equity tier 1 ratio under Basel III would have been only 1.97%, far short
of the required 9.5% (FSA, 2011b). Even under the less demanding
requirements of Basel II, the RBS with a published tier 1 ratio of 7.3% (in
excess of the 4% required by Basel II), was, up to December 2007, one
of the most lightly capitalised of UK banks. This reflected a deliberate
policy of, in the RBS CEO’s words, “capital efficiency” (FSA, 2011b).
The problem arose when RBS (as part of a consortium with Santander
and Fortis) beat Barclays Bank to acquire the Dutch bank ABN Amro for
£49 billion.30 This deal, finalised in October 2007 and funded through
debt rather than equity, pushed RBS’s tier 1 capital ratio below its own
internal requirement of 5.25%. The acquisition, in the words of the FSA
(2011b), “significantly increased RBS’s exposure to risky asset catego-
ries, reduced an already relatively low capital ratio, increased potential
liquidity strains and, because of RBS’s role as the consortium leader and
consolidator, created additional potential and perceived risks. RBS’s
decision to proceed with this acquisition was made on the basis of due
diligence which was inadequate in scope and depth given the nature
and scale of the acquisition and the major risks involved.” It added
that “the FSA’s overall supervisor response to the acquisition was also
inadequate”.
In October 2008, RBS failed. In order to address its capital inadequacy,
on 13 October 2008 RBS attempted to raise £20 billion through equity
sales: £15 billion of ordinary shares and £5 billion of preference shares.
However, only 0.24% of the rights issue of £15 billion was subscribed.
In the wake of this spectacular failure to raise capital, which would have
pushed it into insolvency, the RBS received an injection of £20 billion
from the UK government’s £50 billion Bank Recapitalisation Fund,
announced on 8 October 2008, with the purpose of this Fund being
to allow the UK government to underwrite ordinary shares and to buy
preference shares in distressed banks.31 At the same time, after another
ill-starred banking merger – that between HBOS and Lloyd’s TSB – the
merged entity was required to raise £17 billion from the Fund, half in
preference shares and half in ordinary shares.32
Irish bank failures
Anglo Irish Bank is the bank that most symbolises the rise and fall of the
Irish banking system. In that sense, Anglo Irish is the Irish counterpart
of the UK’s RBS and RBS’s ex-CEO Fred Goodwin is the counterpart of
Sean Fitzpatrick the ex-CEO of Anglo Irish. Formed in 1963, Anglo Irish
emerged by the mid-1990s, under the stewardship of Sean Fitzpatrick
who was appointed CEO in 1987, as a bank that specialised in loans to
property developers not only in Ireland but also in the USA. By 2004,
Anglo Irish had become the 10th fastest growing bank in Europe and
in 2007 it recorded an annual profit of €1 billion. These spectacular
achievements, engendering the growing market share of Anglo Irish,
were not lost on its major competitors and other Irish banks plunged
into the inviting waters of property loans.33 The concentration of loans
in property can be seen, in retrospect, as one of the vulnerabilities of the
Irish banking system because it left it cruelly exposed following the burst
of the property bubble. Although Anglo Irish and the Irish Nationwide
Building Society were the most culpable in this respect (in 2006, nearly
80% of Anglo Irish loans were against commercial property) such loans
became an ingrained feature of the banking system.
As Honohan (2009) points out, a very simple test of whether a bank
is exposed to excessive risk is provided by the growth rate of its assets,
with a rate of 20% providing a trigger for regulatory correction. Yet,
Anglo Irish crossed this threshold in eight of the nine years of the
period 1999–2008 with an average growth rate of 36%. This excessive
growth was dangerous, not just for Anglo Irish, but also for the banking
sector in its entirety as its competitors invested their resources and ener-
gies in catching up. The growth in the market share of Anglo Irish in
total Irish banking assets (comprising: Anglo Irish, Bank of Ireland,
Allied Irish, Educational Building Society, Irish Life and Permanent, and
Irish Nationwide Building Society), from 3% in 1999 to 18% in 2008
was, according to Honohan (2009), “certainly an important influence
inducing other banks to relax lending terms to avoid losing even more
market share”. As a consequence, credit to the private sector by the Irish
banking sector grew by nearly 30% per year in 2004, 2005, and 2006
(Regling and Watson, 2010).
As with Northern Rock in Britain, and with the subsidiaries of Swedish
banks in the Baltic countries, the scaling up of bank lending in Ireland
was only made possible through foreign borrowing by Irish banks: if

lending by Irish banks had been constrained by their retail deposits,
such an increase would not have been feasible. Foreign funding was
the consequence of two factors: first, following Ireland’s entry into the
European Monetary Union (EMU), there was an increase in the avail-
ability of cross-border bank funding without foreign exchange risks;
second, there was the growing presence of foreign (especially UK-based)
banks in Ireland attempting to take advantage of Ireland’s property
boom. The stock of net foreign borrowing of Irish banks rose from 10%
of GDP in 1999 to over 60% of GDP by 2008 (Honohan, 2009). As a
consequence of these factors, as Regling and Watson (2010) point out,
the loan-to-deposit ratio of Irish banks was considerably higher than
that of comparable euro area economies. The increased supply of funds
to Irish banks was accompanied by a loosening of conditions under
which they made loans against property; for example, there was sharp
rise in loan-to-value (LTV) ratios with two-thirds of loans made in 2006
to first-time buyers having a LTV in excess of 90%.
Even in the halcyon days of the property boom in Ireland, Kelly (2007)
warned about the Irish banking system’s fragility but his cautionary
words were almost routinely dismissed as “talking down the country”.
He pointed out that while lending to construction and development
comprised only 8% of Irish bank lending in 2000, by 2007 it had risen
to 28%; by September 2007, lending to builders and developers stood at
€100 billion (roughly the value of public deposits with retail banks) and,
in the 12 months between September 2006 and 2007 had increased by
€20 billion (twice the market value of Bank of Ireland shares) – “effec-
tively, the Irish banking system has taken all its shareholders’ equity,
with a substantial chunk of its depositors’ cash on top, and handed it to
over to builders and property speculators”. He went on to draw atten-
tion to the mutually profitable relationship between banks and builders:
banks provided builders with lines of credit at above wholesale rates and
builders repaid the loans after they sold their properties which, given
the housing frenzy in Ireland at the time, they were able to do before they
had even been built.
This cosy state of affairs came to an end with the bursting of the
housing bubble. People stopped buying new houses in the apprehension
that builders would further reduce prices leaving those who were foolish
enough to buy in negative equity. The knock on effect of a sharp decline
in new housing sales – Kelly (2007) reported a Dublin estate agent as
having sold only 100 units in 2007 compared to more than 3,000 in
2006 – meant that builders were unable to service their debt and this, in
turn, led to large bank losses. Honohan (2009: ) put it succinctly when
he wrote that “although international pressures contributed to the
timing, intensity, and the depth of the Irish banking crisis, the under-
lying cause of the problem was domestic and classic: too much mort-
gage lending (financed by heavy foreign borrowing by banks) into an
unsustainable housing price and construction boom.” In contrast to the
USA, where the mortgage-driven banking crisis was related to the new
financial technology of collateralised debt obligations and credit default
swaps, the property-driven Irish banking crisis was based on traditional
lending methods, just scaled up several times over past lending levels,
the scaling up being made possible by the ready availability of foreign
funding.
The crisis bubbled to the surface when, in the final week of September
2008, one of the banks (reputedly Anglo Irish) failed to turn over its
foreign borrowing. Although other banks had not experienced similar
difficulties it was judged that it would only be a matter of time before they
did. To restore confidence in Ireland’s banking system, on 30 September
the government announced a guarantee on the liabilities – deposits plus
sums owing to senior bondholders – of the six Irish banks.34 The total
cost of this guarantee, made under the Eligible Liabilities Guarantee
(ELG) Scheme, is estimated by Fitzgerald and Kearney (2011) at £113
billion.35
The second prong in the government’s strategy was to set up, in
April 2009, a National Assets Management Agency (NAMA) that would
take property development loans off the balance sheets of banks and,
after applying a suitable haircut, replace these with low risk, market-
able government bonds. The original book value of these loans was €77
billion but their market value was only €47 billion; in addition, many
of these loans were non-performing because the debtors were unable to
service them.36 By replacing these loans with government bonds, banks
could ease their liquidity problems by now having suitable collateral
for ECB repos loans. The replacement would occur at the “long-term
economic value of these assets” (estimated at €54 billion) rather than
their market value (€47 billion). Fitzgerald and Kearney (2011) estimate
the value of these bonds, up to 2011, at €29 billion. However, because
they are housed in a special purpose vehicle, they do not appear on the
government’s accounts.
It was recognised, nonetheless, that while easing banks’ liquidity
problems, the NAMA might create solvency problems for them because,
by taking significant losses on their loans, their balance sheets would
be adversely affected. In these circumstances the government would be
prepared to inject capital into banks, but only by taking an equity stake.
The third prong of the Irish government’s strategy towards repairing its
banking structure was, therefore, to recapitalise six banks – Anglo Irish,
Bank of Ireland, Allied Irish, Educational Building Society, Irish Life and
Permanent, and the Irish Nationwide Building Society. After five rounds
of recapitalisation, the total cost of bailing out the Irish banking system
stood at £63 billion, the latest tranche of £17 billion being provided
by the state in July 2011 in response to results from the Central Bank
of Ireland’s stress tests on Irish banks. This €63 billion – which is £28
billion over the provision that the EU-International Monetary Fund
(IMF) bailout of November 2010 made for banks – represents the addi-
tion to Irish public debt that was the result of bailing out its banking
sector.37
Conclusion
The banking crisis that engulfed the USA and Western Europe raises the
important question of whether one should view the crisis as an episode
with specific causes or whether one should view banking crises as funda-
mental to the structure of modern capitalist economies and the occur-
rence of which is inevitable. The corollary to the “episodic” view is that
if the causes from which the present crisis sprang had been circumvented
it could have been avoided. Furthermore, the history of past crises was
an unreliable guide to the present crisis because the “world was different
then” and, anyway, “this time it is different”.
Those who take the episodic view point to the fact that the “Great
Moderation” in the economies of the industrialised world, which began
in the 1980s and continued till 2008, saw the volatility of economic
activity decline and banking and financial crises to disappear.38 This
happy state of affairs could have continued into the future but for the
“mistakes” of 2008, which engendered a financial crisis that derailed the
world economy. However, notwithstanding the gravity of the current
situation there are still grounds for optimism about the future: if the
appropriate lessons are learned, and these mistakes not repeated, then
there is no reason why industrialised economies could not resume the
journey mapped by the Great Moderation.
The gloomier conclusion, stemming from the “structuralist” view, is
that notwithstanding their resolve to address the proximate causes of the
current situation, capitalist economies are doomed to experience such
crises in the future. Those who take this view – most recently expressed
by Gorton (2012) – argue that “market economies have an inherent
feature that can lead to financial crises if not checked” (Gorton, 2012).
Although each particular crisis has a specific context, the overarching
feature of financial crises is the vulnerability of short-term liabilities
of financial intermediaries – deposits, commercial paper, repurchase
agreements – to the vagaries of public anxiety morphing into panic. As
Gorton (2012) expresses it:
A financial crisis in its purest form is an exit from bank debt. Such
an exit can cause a massive deleveraging of the financial system.
[However] it is not the asset side of banks that is the problem but the
liabilities side. Financial intermediaries cannot possibly honour these
short-term debt obligations if they are withdrawn or not renewed.
And when the whole banking system cannot honour its obligations,
it is a systemic problem.
However, the line of causation is not that exit from debt causes prob-
lems for banks, but rather that problems with banks generate exit from
debt. The reason that problems (or the perception of problems) emerge
with banks is that bank debt is backed by collateral in the form of bank
assets, some of which is in bonds but a greater proportion of which is
in loans made by banks. Although, by construction, this collateral is
not riskless, there is a tolerance among banks’ creditors for a certain
acceptable amount of “bad collateral”; it is only when these limits are
breached that eyebrows are raised and the murmuring begins. Even then,
anxiety does not necessarily metamorphose into exit because govern-
ments intervene – or are expected to intervene – to address the problem.
So, the absence of financial crises during the Great Moderation should
not be interpreted as evidence of an absence of banking problems; there
were banking problems but they were dealt with. However, the point
remains: the riskiness of privately created money leads to an inherent
mistrust of such money so that, when it is perceived as becoming “too
risky”, there is a marked reluctance to use it.
The difference between the banking crises of 2008 and earlier crises –
and which perhaps gives it a sense of uniqueness – was that the earlier
crises were associated with panic among the banks’ retail customers,
evidenced by snaking queues, outside banks, of people anxious to with-
draw their money; the crisis of 2008 did not have such visible signs
of public panic – save for queues outside Northern Rock branches in
England –largely because it was caused by a loss of confidence by institu-
tions depositing with banks in the form of repos or purchases of commer-
cial paper. This resulted in repo lenders shortening the duration of their
loans, asking borrowers to post higher-quality collateral, and in many

cases refusing to roll over repos. For example, during the week of 10
March 2008, prime brokerage clients of Bear Stearns withdrew their cash
and repo lenders declined to roll over repo loans even against secured
high-quality collateral.39 A similar situation developed at Lehman
Brothers: counterparties to repo transactions began to withdraw busi-
ness and hedge fund customers moved their money into other forms of
investment.40 As the Federal Reserve saw it in October 2008:
The commercial paper market has been under considerable strain

in recent weeks as money market mutual funds and other investors,
themselves often facing liquidity pressures, have become increasingly
reluctant to purchase commercial paper ... a large share of outstanding
commercial paper is issued or sponsored by financial intermediaries,
and their difficulties placing commercial paper have made it more
difficult for those intermediaries to play their vital role in meeting
the credit needs of businesses and households.41
The question is whether there are structural features of the financial

system that periodically lead to crises of confidence – either on the part
of the public or, as in the most recent crisis, institutions – in the cred-
itworthiness of banks. There are several reasons for thinking that there
might be such features. First, the period leading up to the crisis is usually
a period of heightened economic activity, fuelled by easy bank lending,
and in such a period of prosperity the electoral standing of governments
is high. Commentators, within and outside government, who might
urge caution can be, and are, brushed aside by bullish politicians who
are either persuaded that the good times will last forever or that, if the
day of reckoning arrives, it will come packaged as a “soft landing”.
Explanations for why politicians behave in this manner – overesti-
mating benefits, underestimating costs – may be found in cognitive
psychology. Kahneman (2011) refers to anchoring effects that occur when
people have a particular value of an unknown quantity in mind before
estimating that quantity: the estimate is then anchored on that prior
belief. Subsequent events may move us away from this anchor but the
adjustment may be insufficient because we are wedded to the anchor.42
A statistical analogy is that in Bayesian statistics evidence updates our
prior belief in an event but the extent of our updating is anchored in
the strength (or weakness) of our prior belief. In this context, politi-
cians adjust insufficiently when they think that the economy may be
overheating because they are anchored to the high level of support they
currently enjoy and are loath to move too far away from it. Anchors also
explain the “too little, too late” feature of unpopular policy changes –
bailing out banks (necessary), as noted earlier, implies bailing out
bankers and, by extension, protecting their high salaries and bonuses
(unpopular).
Nor are banks free of cognitive habits that nudge the sector towards
crisis. A feature of the banking crises in the Baltic countries, Britain,
and Ireland was the comfortable cartel-like banking sector, following
orthodox banking methods, being discomfited by the entry of outsiders
employing unconventional and unorthodox tactics. Banks in the Baltic
countries were destabilised by the entry of two Swedish banks that, after
buying up local banks, liberalised credit, using funds from the parent
banks. Banking in Britain was destabilised by the Northern Bank, which,
by drawing on wholesale funding, departed from the usual banking
model of reliance on retail deposits, and by the Royal Bank of Scotland’s
unorthodox policy of high leverage by economising on its capital. In
Ireland, it was the parvenu Anglo Irish Bank that unsettled its banking
sector by lending aggressively to the construction industry and to prop-
erty buyers.
The reason that these outsiders were able to enter the banking sector
in their countries is that financial liberalisation had lowered barriers to
entry. The reason they were willing to enter the industry is that there
were rich pickings to be had by departing from banking orthodoxy.
The interesting feature of these entries was the reaction of existing
banks to these banking parvenus. In the 1970s, IBM’s slogan “nobody
ever got fired for buying IBM equipment” became a metaphor for
caution in business operations. The appropriate slogan for the 2008
crisis – “no one kept his job by leaving money on the table” – became
a metaphor for following the leader, heedless of consequences. As the
newcomer banks saw their profits increase and their share prices soar,
pressure from their shareholders forced existing banks to shed their
old ways and follow suit. Unorthodoxy became the new orthodoxy
as all banks sought to leverage, to make more use of the wholesale
money market, to relax lending requirements, and to lend to the
booming housing sector.
Shiller (2005) describes the “herd mentality” associated with human
behaviour: people are prepared to accept the judgement of a group,
even when this contradicts their own individual assessment of a situa-
tion, partly because the collective judgement of a group is often proved
right43 and partly because it is more comforting to err in company than
to err in isolation. However, in describing the banking crisis of 2008 it is

more useful to use the metaphor of panic among the herd. For example,
among wildebeest, the exceptional animal, by breaking away from a
herd and galloping off, injects panic among the others who then run
after the leader. After running for several hours the herd suddenly comes
to a stop and resumes grazing. As with the wildebeest on the Serengeti,
so with bankers on Wall Street.
If the financial system has an inbuilt tendency towards instability then
what explains the episodic approach of looking for causes specific to a
particular crisis and, in effect, ignoring lessons from economic history?
Kahneman (2011) speaks of an outcome bias whereby:
When outcomes are bad, clients blame their agents for not seeing the
handwriting on the wall – forgetting that it was written in invisible
ink that became legible only afterwards. Actions that seemed prudent
in foresight can look irresponsibly negligent in hindsight.
He goes on to argue that the worse the outcome, the greater the bias. For
momentous catastrophes, like the financial crisis of 2008, the search for
scapegoats is particularly intense: financial wizards who believed they
could conjure up riskless securities; regulators and rating agencies who
were asleep at their job and, indeed, might have been sedated by the
very persons they were paid to oversee; the Chinese who, after accumu-
lating vast foreign reserves by buying from us only a fraction of what
we buy from them, happily supplied banks in Western countries with
money to lend to their customers; bankers who, overcome by greed,
readily accepted these funds; homebuyers who recklessly borrowed far
in excess of what they could reasonably repay; governments that turned
a blind eye as the economy overheated and, as in the case of Greece,
fanned the flames by borrowing heavily in order to distribute largesse
to their electorates.
George Santyana famously remarked that “those who cannot
remember the past are condemned to repeat it”. In 2013, the British
government threatened to reprise the housing bubble of 2006 through
its “help-to-buy” scheme under which people who can afford mort-
gage repayments, but cannot raise the deposit, are helped to get on the
housing ladder. Under the first phase of this scheme, the government
offers a 20% equity loan to buyers of newly built properties who must
provide a 5% deposit. Under the second phase, borrowers across the UK
can put down a deposit of as little as 5% of the property price with the
lender offering a mortgage for the remaining 95%. As a consequence,

the annual rate of price inflation increased to 5.8% in October 2013, its
highest level in over three years, bringing the average cost of a UK home
to £173,678.44 This is almost £10,000 more than at the end of 2012 and
represents a 2.5% increase over the past three months. Plus ça change,
plus c’est la même chose.
Appendix 3.1: The algebra of bonds
Consider a bond with a maturity of T years, a face value of €F, and annual
coupon payments of €C. Then the present value, €P, of the stream of
payments from the bond is:
C C C F
P= + + .... + + (3.6)
1 + i (1 + i )2
(1 + i )T
(1 + i )T
The quantity i is known as the yield to maturity and it is referred to as the

interest rate. It is the rate that equates the present value of the stream of
payments from holding an asset to its current price. In Equation (3.1),
above, if the market price of a 10-year bond (T = 10), with a face value of
€1,000 (F = €1,000) and 10% coupon rate (C = €100) is P = €1,100, then
yield to maturity is i = 8.48%.
If the bond is a perpetual bond with no maturity date (known as
a consol) and, therefore no face value, which makes payments of €C
forever, then Equation (3.5) becomes:
C C C
P= + + + .... ⇒
1 + i (1 + i ) (1 + i )3
2
(3.7)
1
P = C( x + x2 + x3 + ...) for x =
1+ i
1
Since the infinite series (1 + x2 + x3 + ...) = Equation (3.6) becomes:
1− x
⎡ 1 ⎤ ⎡ x ⎤ C 1
P = C⎢ − 1⎥ = C ⎢ = , since x = (3.8)
⎣ 1 − x ⎦ ⎣ 1 − x ⎥⎦ i 1+
C
And the yield to maturity of a consol is i = .
P
The yield to maturity of a one-year bond (such as a Treasury bill)

which pays €F in a years’ time is obtained from Equation (3.5) by setting
T = 1 and C = 0:
F F−P
P= ⇒i= (3.9)
(1 + i ) P
Another important distinction is between the interest rate on a bond (the

yield to maturity) and the rate of return on a bond. The rate of return
refers to the payments to the owner plus all capital gains or losses stem-
ming from changes in the price of the bond. So, the return on a bond,
with an annual coupon of €, bought at price Pt in year t and held a year
till year t+1:
C + ( Pt +1 − Pt ) C Pt +1 − Pt
R= = + = ic + g (3.10)
Pt Pt Pt
where ic is the current yield on the bond (that is, coupon payment over
price), as distinct from the yield to maturity, and g is the capital gain
(if g > 0) or loss (if g < 0) on the bond. Suppose that the current yield ic is
a good indicator of i, its yield to maturity. Then, as Equation (3.9) shows,
the current yield on a bond and the one-year return on a bond can vary
considerably especially if fluctuations in bond prices lead to substantial
capital gains or losses.
Appendix 3.2: Summing an infinite series
Consider the series:
S = 1 + x2 + x2 + .... + x N (3.11)
Multiply S by x to obtain:
xS = x + x2 + x3 + .... + x N +1 (3.12)
Subtract xS from S to obtain:
1 − x N +1
S − xS = S(1 − x) = 1 − x N +1 ⇒ S = (3.13)
1− x
1
As N→∞, S =
1− x
4
Sovereign Debt
The economist Paul Krugman claimed, in the New York Times, that
“when people [in Washington, DC] talk about deficits and debt, by and
large they have no idea what they’re talking about – and people who talk
the most understand the least”.1 Krugman’s ire was directed particularly
against those who regarded the debt of sovereign governments (here-
after, sovereign debt or, equivalently, public debt, or government debt) as no
different from the debt owed by households. As with households who
have difficulty repaying a loan that is too large relative to their income,
so with governments – “deficit worriers portray a future in which we are
impoverished by the need to pay back money we’ve been borrowing”.
Krugman’s optimism about public debt was based upon the post-war
experience of the United States (USA). At the end of World War II, and
in consequence of it, the USA had a debt that was over 100% of its gross
domestic product (GDP). However, by 1960 the USA debt-to-GDP ratio
had fallen to 55%. Not only did the ratio fall, the fall was relatively
painless. First, economic growth averaging 4% per year over the period
generated large tax revenues. Second, low interest rates meant that the
cost of servicing debt was relatively small. Third, most of the debt of
the USA government was owed to its citizens and taxpayers (domestic
debt) who, simultaneously, also owned the debt through their holdings
of government bonds and securities: thus, the post-war debt of the USA
represented money that it largely owed itself. The debt didn’t make
the United States poorer and, in particular, it did not prevent it from
enjoying a large and sustained economic boom.
It is precisely because these conditions do not apply to Europe today
that “deficit worriers” hold sway and policy prescriptions for heavily
indebted European countries place a heavy emphasis on “austerity”, “fiscal
discipline” and – through devising and implementing “money-saving
60
The Sovereign Debt Crisis 61
reforms” – the general overhaul of state finances. We set out below the
scale of Europe’s debt problem before detailing the ways in which the
context of European sovereign debt differs from that of the USA in
the golden years of post-World War II prosperity. A corollary of these
differences is that one cannot be as dismissive of European deficit worriers
as Krugman is about their USA counterparts. But are European policy-
makers, through their anxiety that countries should shed debt obesity
with the greatest possible haste, in danger of starving their patients to
death? Or, at least, so weakening them that their leaner bodies never
recover the vigour and energy they once enjoyed? This chapter attempts
to answer these, and related, questions.
Europe’s sovereign debt: the scale of the problem
Against an average-debt-to-GDP ratio for the euro area of 91% in 2012,

the five most indebted countries in the area in were: Greece (debt-to-GDP
ratio of 157%); Italy (127%); Ireland (117%); Portugal (124%); and Belgium
(100%).2 Figure 4.1, shows the trajectory over 1999–2012 of govern-
ment debt-to-GDP ratios for the five countries which had the highest
debt-to-GDP ratios in 2012 – Greece, Italy, Belgium, Portugal, and
Ireland – and compares these ratios with the corresponding ratios for the
17 euro area countries (EU17) and for all the 27 EU countries (EU27).
Although all the five above-mentioned countries had debt-to-GDP
ratios at or above 100% in 2012, the trajectories of their ratios were very
different. Greece always had a high debt-to-GDP ratio: this hovered
around 100% till 2007 but the recession that followed pushed it up to
nearly 170% by 2011 before falling to 157% in 2012, Indeed, of all the
five countries depicted in Figure 4.1, Greece is the only country to register
a fall in its debt-to-GDP ratio between 2011 and 2012. Italy’s debt-to-GDP
ratio has also been just above 100% but the present recession pushed this
to nearly 127% in 2012. In a similar vein, Belgium also has had debt-
to-GDP ratios around 100%; although, Belgium’s ratio declined over the
period 1999–2007, achieving a low of 84% in 2007, the present recession
raised it to 100% in 2012. By contrast, Ireland’s debt-to-GDP ratio fell
from 81% in 1999 to 25% in 2007, when it had the lowest debt-to-GDP
ratio of the euro area countries, before rising in recessionary conditions to
reach 117% in 2012. Similarly, Portugal‘s debt-to-GDP ratio was around
50% till 2004, but a combination of sluggish growth since 2004 and the
post-2007 recession raised it to 124% by 2012.
So, although these five countries appeared to be highly indebted in
terms of 2012’s snapshot of debt-to-GDP ratios, moving pictures of these
180
160
140
120
100
80
60
40
20
0
99
00
01
02
03
04
05
06
07
08
09
10
11
12
20
19
20
20
20
20
20
20
20
20
20
20
20
20
Greece Italy Belgium Portugal
Ireland EU17 EU27
Figure 4.1 General government debt as percentage of GDP

Source: Author’s elaboration based on data from Eurostat.
ratios tell very different stories of how they arrived at their 2012 posi-
tion. For Greece, the story was one of profligacy. It was a heavily indebted
country even over the period 1997–2004 when its economy grew rapidly
and, indeed, faster than the EU average, but it spurned the opportu-
nity that these high growth rates offered for reducing its debt burden.
Belgium, too, like Greece, has an unhealthy record of public-sector prof-
ligacy to blame for its high indebtedness. In Portugal, the story was one
of sluggish growth rates brought about by loss of competitiveness, while
in Ireland it was one of government assuming, perhaps misguidedly,
responsibility for its banks’ liabilities and altering the nature of its tax
base to raise more revenue from property based taxes.
Although the discussion of government deficits and debt in Europe
focuses on the more indebted countries – principally the “peripheral”
countries of the euro area that have been bailed out, Greece, Ireland,
Portugal – it should not be forgotten that government indebtedness
is a near-universal problem affecting several countries outside the
much-maligned periphery. For example, notwithstanding today’s very
public criticism of tax-avoidance behaviour in Greece and the profligacy
of its government, government revenue as a percentage of GDP in 2012
Table 4.1 General government balance as percentage of GDP
2006 2007 2008 2009 2010 2011 2012
OV PM OV PM OV PM OV PM OV PM OV PM OV PM
Greece −6.0 −1.3 −6.8 −2.0 −9.9 −4.8 −15.6 −10.4 −10.7 −4.8 −9.4 −2.3 −6.4 −1.2
Ireland 2.9 3.7 0.1 0.7 −7.4 −6.6 −13.9 −12.5 −30.9 −28.2 −13.4 −10.6 −7.7 −4.6
Portugal −3.8 1.3 −3.2 −0.6 −3.7 −1.0 −10.2 −7.5 −9.8 −7.1 −4.4 −0.6 −4.9 −0.8
Italy −3.4 1.0 −1.6 3.1 −2.7 2.2 −5.4 −1.0 −4.3 −0.0 −3.7 1.0 −3.0 2.3
Spain 2.4 3.7 1.9 3.0 −4.5 −3.4 −11.2 −9.9 −9.7 −8.3 −9.4 −7.5 −10.3 −7.9
UK −2.7 −1.2 −2.9 −1.3 −5.1 −3.5 −11.4 −9.9 −10.1 −7.6 −7.9 −5.1 −8.3 −6.1
USA −2.0 −0.2 −2.7 −0.8 −6.7 −4.8 −13.3 −11.6 −11.1 −9.3 −10.0 −7.9 −8.5 −6.4
Note: OV is overall balance, including all expenditure; PM is primary balance defined as overall balance less interest payments.
Source: IMF (2013: Statistical tables 1 and 2).
was higher in Greece than the UK and the USA (43.9%, 35.2%, and
31.8%, respectively, in 2012).3 The Greeks resist paying taxes, using tax
evasion, but Americans exhibit the same resistance through party poli-
tics and the ballot box. In consequence, as Table 4.1 shows, the overall
fiscal balance in 2012 was better in Greece compared to the UK and the
USA (respectively, −6.4%, −8.3%, and −8.5%). For these reasons, Niall
Ferguson writes that the “idiosyncrasies of the Eurozone crisis should
not distract us from the general nature of the fiscal crisis that is now
afflicting most western countries”.4
Europe’s sovereign debt: poor growth prospects,

external ownership
Sovereign debt in Europe differs in several essential respects from the

debt of the USA after World War II and these factors combine to provide
several European economies with a less optimistic future than that of
the post-war USA.
First, given the present recession, and given the presence of economic
powerhouses like India and China, circumstances for rapid, renewed
growth in Europe are considerably less favourable than they were for
the USA which, in the years after World War II, ruled supreme as an
economic behemoth. The average annual growth rate of the euro area
countries was 1.5% between 1992 and 1996, 2.8% between 1997 and
2001, and 1.7% between 2002 and 2006; in 2010, it was only 1.8%.5
Second, much of the sovereign debt of European countries is external
debt held by lenders in other countries. The European Banking Authority
(EBA, 2011) calculated the exposure of EU banks and domestic banks
to public debt in the three peripheral countries, Greece, Ireland, and
Portugal: of the Greek government debt of €328.6 billion in 2010, €98.2
billion (or 30%) was the exposure of EU banks and €65.79 billion
(20%) was the exposure of Greek banks; of the Irish government debt of
€148.1 billion in 2010, €52.7 billion (or 36%) was the exposure of EU
banks and €32.2 billion (22%) was the exposure of Irish banks; of the
Portuguese public debt of €160.5 billion in 2010, €43.2% billion (or 27%)
was the exposure of EU banks and €27.2 billion (17%) was the expo-
sure of Portuguese banks.6 Outside the periphery of Greece, Ireland, and
Portugal, about 69% of the Belgian government debt of €326 billion in
2010 was held by foreign investors7 with Belgium owing €25 billion to
the French bank BNP Paribas and €9 billion to the Dutch bank ING.8 A
little more than half of Italian public debt (€1,843 billion in 2010) was
held by non-residents.9
The large exposure of the debt of heavily indebted European coun-

tries to foreign investors had the major consequence of opening up
these countries to the scrutiny of markets and their alter ego, the rating
agencies. The rating assigned to countries by these agencies (Moody’s,
Standard and Poor, and Fitch) influences the rates of interest the bond
market demands for holding their debt. Indeed, as Macdonald (2006:
472) observes, “the bond market is now feted as a supranational, almost
godlike force that passes daily judgment on the behaviour of govern-
ment – stampeding like a ‘galloping herd’ at the merest whiff of reck-
less policy”. There is a considerable gap between the rates offered by
the bond market to different countries depending upon its assessment
of their economic viability. From 1998 until 2014, yields on 10-year
Greece government bonds averaged 7.8%, reaching an all-time high
of 48.6% in March 2012. By contrast, from 1980 until 2014, 10-year
German government bonds averaged 5.6%, reaching an all-time high
of 10.8% in September 1981 and a record low of 1.2% in May 2012.10
The rise in the yields of bonds (in effect, the interest received by bond-
holders) issued by highly indebted governments is reflected in a rise in
the prices of credit default swaps offering protection against sovereign
default by euro area countries. In July 2011 (under the assumption of
a 40% recovery rate) these prices implied that the “market” thought
that there was a 88% chance that Greece would default and a 25%
chance that Italy would default within the next five years (Boone and
Johnson, 2011).11
Europe’s sovereign debt: the dollar as the currency of

global banking
Another important difference between the public debt of the USA and
that of European countries is the fact that the dollar is not only the
world’s most important reserve currency and the invoicing currency
for foreign trade, but it is the currency that underpins global banking. As
Shin (2011) points out, the United States hosts branches of around
160 foreign banks whose main function is to collect wholesale dollar
funding in capital markets and ship it to head office for disbursement
to borrowers in their own countries. In 2010, foreign banks collectively
raised $1 trillion in dollar wholesale funding of which $600 million
was channelled to their headquarters. The USA, therefore, presents a
paradox: it is the largest net debtor in the world, but it is, simultane-
ously, a substantial net creditor to the global banking system. In effect, as
Shin (2011) points out, the United States borrows long (through Treasury
bills) and then recycles the dollars by lending short through the banking
sector. There is, therefore, a global demand for dollars that sustains large
USA current account deficits. This is in marked contrast to countries
like Ireland that funded current account deficits through an inflow of
wholesale money into its banking sector and then suffered a banking
collapse when wholesale lenders withdrew credit from Irish banks.
Europe’s sovereign debt: culture wars between north

and south Europe
In his magisterial book on the evolution of public debt through history,

Macdonald (2006) develops the concept of the “citizen-creditor” – the
person who willingly lends money to their government. The concept of
the citizen-creditor who democratically gives their approval for a level
of public debt and, thereby, assumes ownership of it, constitutes the
fiscal foundation of democracy and provides part of the glue that binds
a country’s citizens through a sense of national solidarity and unity
of purpose.12 However, according to Macdonald (2006), this sense of
solidarity and purpose disappears when debt is held by foreigners or
by institutions – he contrasts the post-World War II situation in the
USA, when almost all its debt was held by its citizens, with the fact
that, today, the proportion of USA’s debt held by its citizens is less
than 10%, with financial intermediaries holding about 37%, and other
countries (principally China and Japan) holding about 30%, of USA’s
debt.
Although a significant proportion of the debt of the highly indebted
European countries is external debt, non-European exposure to this debt is
very small with most of the external debt holders being other European
banks and, ipso facto, citizens of countries within the EU and, in most
cases, within the euro area. The fact that much of the sovereign debt
problem in Europe is an intra-Europe issue should create a sense of fiscal
solidarity à la Macdonald’s citizen-creditor. Instead, the current crisis
has led to greater inter-country hostility within Europe than, arguably,
any time since World War II. It verges today on a “cultural war” between
northern and southern Europe with Germans, for example, caricaturing
Greeks as tax-evading, work-shy spendthrifts addicted to the largesse of
the public purse and Greeks resurrecting memories of the German occu-
pation of Greece by portraying the German-led austerity imposed on
Greece as the 21st-century version of the Wehrmacht (yet again) riding
roughshod over Greek sovereignty.
The evidence is that the EU – and, in particular, the euro – is an

elitist project for which support from the political and social elites in
its Member States coexists with scepticism among their wider popula-
tions (Risse, 2006). A major reason for the surfacing of national stere-
otypes is that, underlying the veneer of European unity, there is a robust
feeling of inter-European differences based upon national identity and
rooted in past internecine conflict. In moments of crisis, this atavistic
antagonism pits nation against nation. For example, in July 2007 the
German Presidency of the EU wanted to introduce the principle of the
“double majority”. For a resolution to pass in the Council of Ministers,
at least 55% of the states with 65% of the EU population have to agree.
Poland, on the other hand, demanded that the weight of the vote be
computed according to the square root of the total population thereby
reducing the influence of the largest states and increasing that of the
smaller states. However, this demand by Poland, and its rejection by
Germany, was phrased in the most inflammatory terms. To the Germans,
the Poles were “unloved and annoying neighbours”; to the Poles, the
Germans had Great Power ambitions and sought influence in Europe at
any price.13 As Janusz Reiter, Poland’s former Ambassador to Germany,
bitterly observed in an interview with Der Spigel:
Besides, there was also an old tradition of condescension towards the

Poles. To this day, the average German knows nothing or very little
about the fact that the Nazis didn’t just commit crimes against the
Jews, but also conducted an ethnic war against the Slavs. Its purpose
was to destroy the national elites. In Poland, that was the key expe-
rience of the 20th century. What is still absent in the German-Polish
relationship, most of all, is respect, which hasn’t always been the Germans’
strong suit. (emphasis added)14
Indeed, as Boros and Vasali (2013) argue, negative attitudes towards

the European Union have been on the rise in the majority of European
societies. Eurobarometer data for 2012 show that, for example, 49% of
respondents in Greece, 40% in Portugal, 35% in both Spain and in
Czech Republic had a negative image of the EU; it was only in Bulgaria
that a majority of respondents (56%) had a positive view of the EU.15
It was not always so. In 2003, only 4% of respondents in Spain and 8%
of respondents in Greece had a negative image of the EU. Furthermore,
in 2012 only 22% of all respondents thought the EU was headed in the
right direction and 52% thought it was making the wrong decisions.16
Europe’s sovereign debt: sharing the blame?
The truth about Europe’s sovereign debt problem is that neither the
creditor nor the debtor nations are free of blame. Everyone has contrib-
uted to the mess and, rightly, everyone should contribute to clearing
it. Creditors and debtors are but two sides of the same coin because
one country’s surplus is another country’s deficit. The plain fact of the
matter is that everyone cannot be in surplus. Surplus countries (credi-
tors) produce goods and services in greater quantities than their own
citizens are prepared to buy; deficit countries are unable to produce
goods and services in the quantities (and of the quality and variety) that
their residents wish to buy. The result is a flow of capital from creditor
nations to debtor nations as the former accumulate claims on the latter’s
assets. It was the savings of German citizens – finding their way via
German banks into the Irish and Greek banking systems – that were, in
substantial part, funding the borrowing spree of Irish property devel-
opers and the deficits of Greek governments.
As Mervyn King, former Governor of the Bank of England, put it:
Persistent trade surpluses in some countries and deficits in others did

not reflect a flow of capital to countries with profitable investment
opportunities, but to countries that borrowed to finance consump-
tion or had lost competitiveness. The result was unsustainably high
levels of consumption (whether public or private) in the US, UK and
a range of other advanced economies and unsustainably low levels
of consumption in China and other economies in Asia, and some
advanced economies with persistent trade surpluses, such as Germany
and Japan.17
However, it is the creditors who set the rules. Debtors have to beg while
creditors insist that their view of the causes of a crisis is the right one.
Germany affirms that the crisis is the result of the Greek government’s
profligacy (and not the consequence of excessive German thrift); the
Greeks have no option but to accept this diagnosis and to tighten their
belts accordingly.18
Europe’s sovereign debt: the Maastricht Treaty and

the Stability and Growth Pact
On 9 February 1992, members of the European Community signed

a treaty in the Dutch town of Maastricht. This Treaty (hereafter, the
Maastricht Treaty but, more formally, the Treaty on European Union)

detailed the parameters of the European Monetary Union (EMU), which
was to come into force on 1 January 1999 under the aegis of a single
currency, the euro. Countries could be part of the EMU only if they satis-
fied five conditions:
1. Inflation. To be eligible for EMU membership, a country’s inflation

rate should not exceed, by more than 1.5 percentage points, the
average of the three lowest inflation rates of the EU Member States.
2. Long-term interest rates. Long-term interest rates should not exceed, by
more than two percentage points, the average long-term interest rate
of the three countries with the lowest inflation rates.
3. ERM membership. Every country in the EMU should have partici-
pated in the Exchange Rate Mechanism (ERM) for the past two years
without devaluing its currency.
4. Budget Deficit. A country’s budget deficit should not exceed 3% of its
GDP.
5. Public Debt. The debt of a country’s government should not exceed
60% of its GDP.
Taken collectively, the conditions implied conservatism in monetary

and fiscal policy. The first condition reflected the German abhorrence of
inflation and required that the joining countries should have a credible
record of low inflation. In order to ensure that low inflation rates were
not the result of some temporary artefact, conjured up just before the
joining date – through, for example, freezing administered prices – the
second condition placed emphasis on the long-term nominal interest
rate. Because the nominal rate of interest equals the real rate plus the
expected rate of inflation, and because real rates are fairly constant, low
nominal rates of interest would be associated with low expected rates of
inflation. The third condition served to undercut the practice of compen-
sating, through exchange rate devaluation, for the loss of competitive-
ness engendered by domestic inflation: countries joining the EMU had
to demonstrate a record of eschewing this practice. The fourth and fifth
conditions emphasised fiscal restraint – there was a ceiling to the current
deficit (3% of GDP) and also to the cumulated deficit in terms of the stock
of debt (60% of GDP).
In 1999, after the start of EMU on 1 January 1999, the average budget
deficit for the 17 countries currently (except for Latvia which joined on 1
January 2014) in EMU19 was 1.5% of GDP with an average public debt of
71.6% of GDP.20 Of the ten countries in EMU at its inception, none of the
countries violated the “3% deficit-GDP rule” but Belgium and Italy, with
debt levels of 113.6% and 113% of GDP, respectively, flagrantly violated
the “60% debt-to-GDP rule” (Figure 4.2). However, because Belgium and
Italy were also founding members of the Common Market in 1957, they
were accommodated with respect to their public debts by recasting the
condition to allow for a GDP ratio less than 60% or “moving in that
direction” (Baldwin and Wyplosz, 2009). By 2010, when there were 17
Member States in EMU, 12 countries violated the 60% debt rule and 14
countries violated the 3% deficit rule (Figure 4.3).
The Maastricht Treaty of 1992, while setting out the criteria for
membership of EMU, enjoined member states to “avoid excessive defi-
cits” and went on to say that, “[t]he Commission shall monitor the
development of the budgetary situation and of the stock of govern-
ment debt in the Member States with a view to identifying gross errors”
(Article 104c). The Stability and Growth Pact (SGP), adopted in 1997,
set out the practical details of: (1) what constitutes “excessive deficits”;
(2) avoidance measures for excessive deficits; (3) corrective measures for
excessive deficits; (4) penalties for excessive deficits.
1. In terms of what constituted excessive deficits, the watchword was

flexibility: “exceptional circumstances” or “other relevant factors”
could permit the 3% rule to be breached.21 Member States sought
to define “other factors” in their own interests by excluding from
Y-axis: 1999 Debt/GDP

X-axis: 1999 Deficit (–) or Surplus (+)/GDP
120
AUS is Australia
IT BL BL is Belgium
100 DE is Germany
ESP is Spain
80 FIN is Finland
AUS FR is France
ESP NL
60 IRL is Ireland
POR FR DE IRL IT is Italy
FIN
LX is Luxembourg
40 NL is Netherlands
POR is Portugal
20
LX
0
–4 –3 –2 –1 0 1 2 3 4
Figure 4.2 Deficit and debt ratios of EMU countries in 1999

Source: Based on Eurostat databank.
Y–axis: 1999 Debt/GDP

X–axis: 1999 Deficit (–) or Surplus (+)/GDP
AUS is Australia
160 BL is Belgium
GR CYP is Cyprus
DE is Germany
140 ESP is Spain
Debt to GDP
EST is Estonia
IT
120 FIN is Finland
FR is France
IRL POR BL 100 GR is Greece
FR IRL is Ireland
DE IT is Italy
AUS 80 LX is Luxembourg
ESP NL MLT
MLT is Malta
60 NL is Netherlands
CYP
POR is Portugal
FIN 40 SVK is Slovakia
SVK SVN SVN is Slovenia
20
LX EST
0
–35 –30 –25 –20 –15 –10 –5 0 5
Deficit to GDP
Figure 4.3 Deficit and debt ratios of EMU countries in 2010

Source: Based on Eurostat databank.
the deficit calculation what they regarded as “good expenditures”:

France wanted a reference to research and, after unification, Germany
wanted a reference to the “unification of Europe”.
2. The measures to avoid excessive deficits required each country to
submit an annual Stability Programme that would present its budget
forecast for the current year and the subsequent three years. In
the event that the expected deficit exceeded 3%, the document
was required to explain the corrective measures that were being
adopted to reduce it. The European Commission (EC) would then,
on the basis of the Stability Programme document, forward indi-
vidual country assessments to ECOFIN (the Economic and Financial
Affairs Council of the EU comprising the finance ministers of the
Member States) which would deliver an opinion adopted by a quali-
fied majority.22
3. The corrective measures were based on the Excessive Deficit Procedure
(EDP). If, following an ECOFIN report, the Council decided that an
excessive deficit existed, it would simultaneously issue recommen-
dations to the Member State concerned. The Council established a
deadline of no more than six months for effective action to be taken

with the correction of the excessive deficit being completed, unless
there were special circumstances, in the year following its identifica-
tion. In its recommendations the Council requests the Member State
to achieve a minimum annual improvement of at least 0.5% of GDP
as a benchmark.
4. The penalties for excessive deficits follow when no effective action
has been taken within six months of the identification of an excessive
deficit. After a country had been “named and shamed” by the Council
making its recommendations public, and after a warning notice to
the Member State, the Council could impose a financial penalty. In
principle, the interval between the reporting of the figures indicating
that an excessive deficit existed and the decision to impose a penalty
should not exceed 16 months. The penalty would start at 0.2% of
GDP for a 3% deficit, rising to 0.5% of GDP if the deficit was 6% or
more of GDP. Initially it would take the form of a non-remunerated
deposit with the Council but if the excess was not corrected within
two years, the deposit would convert to a fine.
Perhaps the most infamous event in the history of the SGP was
Germany’s flouting its strictures in 2005. In 2003, both France and
Germany (countries which are today two of the most vocal proponents
of fiscal discipline) had budget deficits of, respectively, 4.2% and 4.1%,
well in excess of the SGP limit of 3%. Moreover, their projected deficits
for 2004 and 2005 were also above the 3% limit.23 This led the EC (the
President was then Romano Prodi) to issue mandatory recommenda-
tions, the last step before sanctions. However, ECOFIN – comprising the
15 finance ministers of the EU’s Member States – decided, after intense
lobbying by France and Germany, to “hold the excessive deficit proce-
dure for France and Germany in abeyance for the time being”. After
the ECOFIN decision, Sir John Grant, then Britain’s Ambassador to the
EU, remarked that the “credibility of the Commission and the readi-
ness of the Member States to accept the authority of the Commission
as the independent enforcer of the Maastricht criteria were gravely
undermined”.24 Such behaviour on the part of France and Germany,
by signalling to the smaller countries that they too might thumb their
noses at Maastricht and the SGP with impunity, arguably sowed the
seeds for the crisis that followed. As Peter Doukas, then Deputy Finance
Minister for Greece, observed: “if the big boys won’t impose discipline
on themselves they are going to be more relaxed in enforcing the treaty
[on us].”25
Most recently, on 2 March 2012, 25 European leaders signed the

Treaty on Stability, Coordination and Governance, which aimed to
further strengthen fiscal discipline within the euro area by introducing
the “balanced budget rule”. This requires the national budget to be in
balance or in surplus, a condition that would be satisfied if the annual
structural deficit – the deficit that would exist even after the economy
recovers its “normal” level of output – did not exceed 0.5% of GDP at
market prices. Putting aside the question of how to measure this elusive
concept,26 the emphasis on structural deficit meant that the focus of
policy was to eliminate cyclical deficits rather than to control annual
deficits. Moreover, this balanced budget rule needed to be incorporated
into the legal systems of the Member States and, preferably, enshrined
in their constitutions. Under the terms of the treaty, the EU Court of
Justice would offer a binding decision as to whether a national govern-
ment had adhered to this rule, with breaches penalised by a fine of up
to 0.1% of GDP.
In November 2013, the EC presented a major package of budgetary
surveillance announcements, covering 13 euro area Member States not
under an economic adjustment programme (that is, all except Cyprus,
Greece, Ireland, and Portugal) and three non-euro Member States. The
EC issued, for the first time, opinions on euro area Member States’ Draft
Budgetary Plans in order to provide an early signal on whether the
underlying national budgets were in line with the relevant country’s
obligations under the SGP. The Commission also assessed the actions
taken by seven Member States in response to the new Council recom-
mendations adopted in June 2013 setting new deadlines for the correc-
tion of excessive deficits. The countries concerned were Belgium, Spain,
France, Malta, the Netherlands, Poland, and Slovenia.27
Government versus private borrowing
The Maastricht Treaty and the SGP emphasised the importance of public
deficits and public debt but ignored issues relating to a country’s overall
indebtedness as revealed in its current account deficits/surpluses. So,
from the start of EMU, deficits due to private-sector overspending were
considered very different (and, indeed, much less serious) than defi-
cits that resulted from government overspending (Fitzgerald, 2012; Soros,
2012). Indeed, as Soros (2012) expressed it: “They [the fathers of the
euro] believed, in particular, that only the public sector is capable of
producing unacceptable economic imbalances.” The fact that policy-
makers could ignore imbalances produced by the market stemmed from
the “Lawson doctrine” – named after Nigel Lawson, British Chancellor

of the Exchequer from 1983–1989 – which stated that, provided there
are no distortions and expectations are rational, current account defi-
cits as reflected in private saving and investment decisions represent
optimal economic outcomes and do not require government interven-
tion (Blanchard, 2007).
The gap between a country’s investment expenditure (I) and its
saving (S) is identically reflected in the difference between the value
of its exports (X) and its imports (M). The latter gap is its current count
balance, X − M (in surplus, if X > M, in deficit, if X < M). Consequently:
S − I
= − M
X
(4.1)
saving − investment gap current account balance
When countries run a deficit on their current balance (X − M < 0), their
investment expenditure exceeds what can be financed through domestic
saving (S − I < 0). This excess expenditure is financed through the sale of
assets: in effect, borrowing from abroad and offering domestic assets as
collateral. This borrowing could be by a country’s government or by its
private sector. To distinguish between the government and the private-
sector, one can disaggregate saving S as the sum of private saving (Sp)
and government saving (Sg). The government runs a budget deficit if
Sg < 0 and it runs a budget surplus if Sg > 0. After this disaggregation of
aggregate saving into its private and government components, E(4.1)
can be rewritten as:
S − I = [ S p + Sg ] − I = S −I + Sg = X − M

p
N external borrowing (4.2)
private borrowing government borrowing
A situation in which the government budget is balanced (Sg = 0) and

domestic private saving is exactly enough to fund domestic investment
(Sp = I) will result in the current account being in balance (X − M = 0)
so that foreign lending/borrowing will be zero. From this position,
the current account will go into deficit, with a concomitant inflow of
borrowing from abroad, if either or both of two things occur:
1. Government behaviour changes so that it spends more, or taxes less,

with the consequence that its original budget balance now becomes
a budget deficit (Sg = 0 becomes Sg < 0).
2. Private-sector behaviour changes so that the private-sector spends
more, either as higher consumption (so that, Sp falls) or as higher
investment (I increases).
Whatever the source of the higher spending, it can only be financed

through foreign borrowing. The division of foreign borrowing between
private and government borrowing will depend upon the amounts of
private and government spending (points 1 and 2, above) but this split
will not affect the overall indebtedness of the country as reflected in its current
account deficit. For a country with its own currency, its current account
deficit serves as a warning: unless corrective action is taken there will
come a time when overseas lenders refuse to lend any further because
they have lost confidence in its ability to repay. Bankruptcy will then
result as overseas borrowers refuse to extend their credit and/or gold and
foreign exchange reserves are depleted. The country will have no further
assets to sell.28
Such corrective action would involve measures to reduce the deficit
by increasing exports and reducing imports. Increasing exports
requires improving competitiveness. One way of improving competi-
tiveness is through currency depreciation. This reduces the price of a
country’s exports in terms of foreign currency and increases the price
of a country’s imports in terms of its own currency: exports rise and
imports fall. Another way a country can improve competitiveness is
by deflating its economy: reducing wages and incomes so that the cost
of exports falls and the demand for imports is reduced. Deflation is
achieved by taking demand out of the economy through the appro-
priate exercise of monetary and fiscal policies: a tight monetary
policy raises interest rates by reducing the money supply and a tight
fiscal policy reduces budgetary deficits by spending less and taxing
more. Taking demand out of the economy creates unemployment,
which has the effect of moderating wage growth. When the growth
rate in wages falls below the growth rate of productivity, real incomes
fall: people have a lower standard of living in terms of what their
money income can buy in terms of goods and services. Consequently,
exports rise because their unit cost (and, therefore, their price) falls
and imports fall because the lower real income dampens demand.
Measures to improve competitiveness are analysed in greater detail in
Appendix 4.1 to this chapter.
For countries in the EMU, neither exchange rate depreciation nor the
independent exercise of monetary policy is an option. The first is impos-
sible by virtue of a single currency; the second option is ruled out because
the interest rate across the euro area is set by the European Central Bank
(ECB) which in doing so takes into account prevailing economic condi-
tions over the entire eurozone without regard to the specific needs of any
individual country. Because fiscal policy is the only (macroeconomic)
policy instrument available to national governments its proper exercise

is of great importance to the country’s well-being.
The countries of the EMU, individually and collectively, do not fully
appreciate what the appropriate role of fiscal policy ought to be in the
context of a common currency. This role should be broader, and more
proactive than the current requirement of individual governments exer-
cising fiscal discipline by keeping their deficits and debt levels below
prescribed levels (3% of GDP for deficits and 60% of GDP for debt).
Instead, fiscal policy ought to act as a countervailing force to private-
sector excesses by dampening “irrational exuberance” or boosting
“irrational pessimism”. This requires each government to monitor the
foreign indebtedness of their country by keeping a watchful eye on the
balance of payments current account and taking offsetting action when-
ever there is danger of overspending. This is something that the EMU
countries, with their preoccupation with Maastricht limits, conspicu-
ously failed to do during the heady years prior to the 2008 recession.
Indeed, it could be argued that their governments’ preoccupation with
the mechanistic strictures of the Maastricht Treaty engendered a feeling
that that was all they needed to do in terms of fiscal policy, thus blinding
them to the dangers of private-sector overspending.
Table 4.2 highlights the role that private-sector debt played in the
crisis within the EMU. The numbers in Table 4.2 represent the empirical
counterpart of Equation 4.2: they show, for a selection of countries, the
balance on current account (OV: X − M), private borrowing from abroad
(PV: Sp − I), and the government deficit (GV: Sg), all as a percentage of
GDP, with the numbers under the OV column equal to the sum of the
numbers under the PV and GV columns.
The most striking feature of these numbers is that, up to 2007, in
several countries that had large current account deficits it was private,
as opposed to government, spending that was responsible for the defi-
cits. In 2007, Spain had a current account deficit of 10% (of GDP) but
a government surplus of 1.9%; Estonia had a current account deficit of
17.2% but a government surplus of 2.5%;29 Ireland had a current account
deficit of 5.5% but a government surplus of 0.1%; Portugal had a current
account deficit of 10.2% but a government deficit of 3.1%. Even Greece,
where governments are excoriated for spending excesses, had a current
account deficit of 15.6% and a government deficit of 6.4%, with private-
sector overseas borrowing reaching 9.2% of GDP in 2007. The interesting
question is why, in the face of these large deficits, were governments
disinclined to intervene? There are several answers to this question.
Table 4.2 Private, government, and external borrowing in selected countries as percentage of GDP
2002–2005 2006 2007 2008 2009 2010
OV PV GV OV PV GV OV PV GV OV PV GV OV PV GV OV PV GV
Belgium 4.5 5.1 −0.6 3.4 3.3 0.1 3.9 4.2 −0.3 1.1 2.4 −1.3 2.0 7.9 −5.9 2.4 6.5 −4.1
Germany 4.2 7.5 −3.3 6.6 8.2 −1.6 7.6 7.3 0.3 6.7 6.6 0.1 5.0 8.0 −3.0 5.1 8.4 −3.3
Estonia −11.8 −13.3 1.5 −15.7 −18.1 2.4 −17.2 −19.7 2.5 −8.8 −6.0 −2.8 4.5 6.2 −1.7 2.8 2.7 0.1
Ireland −1.3 −2.5 1.2 −3.7 −6.6 2.9 −5.5 −5.6 0.1 −5.6 1.7 −7.3 −3.1 11.2 −14.3 −0.7 31.7 −32.4
Greece −11.8 −6.0 −5.8 −12.7 −7.0 −5.7 −15.6 −9.2 −6.4 −16.3 −6.5 −9.8 −14.0 1.4 −15.4 −11.8 −1.3 −10.5
Spain −6.0 −6.4 0.4 −9.0 −11.0 2.0 −10.0 −11.9 1.9 −9.6 −5.4 −4.2 −5.5 5.6 −11.1 −4.5 4.7 −9.2
France −0.6 2.6 −3.2 −1.8 0.5 −2.3 −2.2 0.5 −2.7 −2.7 2.6 −3.3 −2.9 4.6 −7.5 −3.5 3.5 −7.0
Italy −1.0 2.5 −3.5 −2.0 1.4 −3.4 −1.8 −0.3 −1.5 −3.2 −0.5 −2.7 −3.0 2.4 −5.4 −4.2 0.4 −4.6
Luxembourg 10.5 9.9 0.6 10.4 9.0 1.4 10.1 6.4 3.7 5.3 2.3 3.0 6.9 7.8 −0.9 7.8 9.5 −1.7
Netherlands 7.5 8.8 −1.3 9.0 8.5 0.5 8.4 8.2 0.2 4.8 4.2 0.6 3.4 8.9 −5.5 6.7 12.1 −5.4
Austria 2.4 4.4 −2.0 3.3 4.9 −1.6 4.0 4.9 −0.9 3.7 4.6 −0.9 2.6 6.7 −4.1 2.6 8.2 −4.6
Portugal −8.9 −5.0 −3.9 −10.8 −6.7 −4.1 −10.2 −7.1 −3.1 −12.6 9.1 −3.5 −10.7 −0.6 −10.1 −9.8 −0.7 −9.1
Finland 5.6 2.5 3.1 4.6 0.6 4.0 4.2 −1.0 5.2 2.9 −1.3 4.2 2.2 4.8 −2.6 3.0 8.5 −2.5
Euro Area 0.5 3.0 −2.5 0.3 1.7 −1.4 0.2 0.9 −0.7 −0.8 1.2 −2.0 −0.6 5.7 −6.3 −0.4 5.6 −6.0
Denmark 3.3 0.7 2.6 3.0 −2.2 5.2 1.4 −3.4 4.8 2.7 −0.5 3.2 3.6 6.3 −2.7 5.3 8.0 −2.7
Latvia −12.5 −11.3 −1.2 −22.5 −22.0 −0.5 −22.3 −22.0 −0.3 −13.1 −8.9 −4.2 8.6 18.3 −9.7 3.6 11.3 −7.7
Lithuania −7.4 −6.3 −1.1 −10.4 −10.0 −0.4 −15.1 −14.1 −1.0 −13.1 −9.8 −3.3 2.6 12.1 −9.5 1.8 8.9 −7.1
Sweden 6.7 6.1 0.6 7.9 5.6 2.3 8.6 5.0 3.6 8.9 6.7 2.2 6.8 7.5 −0.7 6.2 6.2 0.0
UK −2.3 0.7 −3.0 −3.4 −0.7 −2.7 −2.6 0.1 −2.7 −1.6 3.4 −5.0 −1.7 9.7 −11.4 −2.5 7.9 −10.4
United States −5.2 −1.5 −3.7 −6.0 −4.0 −2.0 −5.1 −2.3 −2.8 −4.7 1.5 −6.2 −2.7 8.5 −11.2 −3.3 7.9 −11.2
Note: OV is current account balance as a percentage of GDP – it represents a country’s overseas borrowing (−)/lending (+).
PV is private borrowing (−)/lending (+) – it is the difference between private saving and investment computed as OV−GV.
GV is the general government deficit (−)/surplus (+) as a percentage of GDP.
Source: European Commission (2011a: 221 (GV) and 227 (OV)).
First, a concomitant of the large current balance deficits was that the
years from 2002 to 2007 were also periods of rapid growth: real GDP
in Ireland grew at over 5% annually; in Greece by over 4%; in Spain
by nearly 4%. When the economy is growing rapidly, governments are
not inclined to slow it down by taking a deflationary stance. Instead,
they are more inclined to encourage growth and to take credit for it.
That high growth conveys electoral benefits is fairly well established.
In the United States (USA), for example, an additional percentage point
of real income growth in the second quarter of a presidential election
year increases the incumbent party’s expected popular vote margin by
more than 5 percentage points.30 Needless to say, when voters’ moods
are strongly influenced by current economic conditions, policymakers
become myopic and place great emphasis on “what is” and little on
“what might be”.
Second, the Maastricht Treaty and the SGP limited government respon-
sibility to keeping within prescribed budgetary and debt limits and, as
long as they did so, the governments did not feel they were required
to do more. This suggests that governments of the EMU countries are
quasi sovereign rather than fully sovereign: as part of EMU, governments
operate under the direction of the EC and its scrutiny and are subject to
its proscriptions and its penalties. In accepting this, governments lose
part of their sovereignty. In this state of quasi-sovereignty, governments
of Member States (particularly those of smaller countries) instead of
leading their countries are content to follow the directives and instruc-
tions from a higher authority – the EC – and wait on its approval for
having done so.
Third, because of the nature of the financing system within the
European System of Central Banks, it has not been necessary for govern-
ments to intervene.31 In order to appreciate this point, it is useful to
begin with the observation that the EMU operates an “updated version of
the classical gold standard”.32 Under the gold standard, current account
imbalances between countries result in an inflow of private finance into
the deficit countries and, after this dries up, an outflow of gold from the
deficit to the surplus countries. Equilibrium would be restored by wages
and prices falling in the deficit countries, because of reduced economic
activity, and rising in the surplus countries, because of increased
economic activity. Under EMU, the current account deficits of countries
has largely been financed through their banks borrowing from banks
in EMU countries that are in current account surplus. Consequently,
the overseas liabilities of domestic banks increase and this increase is
approximately the size of the current account deficit.
So, for example, if an Irish buyer (Sean), who banks with Allied Irish
in Dublin, wants to spend €50,000 on a car being sold by a German
(Helga), who banks with Deutsche Bank in Hamburg, he arranges for the
amount to be transferred from his account to Helga’s account. However,
the transaction follows a slightly circuitous route: Allied Irish debits
Sean’s account by €50,000 and transfers the sum to the Central Bank of
Ireland which then transfers it to the Bundesbank which then transfers
it to Deutsche Bank which then credits Helga’s account with €50,000.
The difference between this transaction and one conducted under the
erstwhile ERM, which was the precursor to EMU, is that under ERM
there would have been a flow of foreign currency between the Central
Bank of Ireland and the German Bundesbank: Sean would have paid
for his car in Irish pounds and Helga would have received her money in
German marks. Now, under EMU, the transaction is conducted entirely
in euros.
Now suppose that Sean asks Allied Irish for a loan to buy the car but
Allied Irish does not have the resources, in terms of domestic deposits,
to make this loan, largely because importers are drawing down their
deposits (with Allied Irish) to make overseas payments faster than
exporters are adding to their deposits (with Allied Irish) from overseas
payments received. Allied Irish then borrows €50,000 from Deutsche
Bank and lends it to Sean (making money on the difference between the
interest rate paid to Deutsche Bank and that charged to Sean) who pays
Helga for the car. The flow of €50,000 from the Central Bank of Ireland
to the Bundesbank for the car is exactly offset by a flow of €50,000 from
the Bundesbank to the Central Bank of Ireland for the loan.
Inter-country payments under the ECB’s TARGET system
The preceding paragraphs described the nature of the usual bilateral

flows that take place between national central banks in response to
movements between their respective countries in goods, services, and
assets. However, a slightly different system of inter-country payments
exists for countries within EMU: payments do not take place bilater-
ally (say, between the Central Bank of Ireland and the Bundesbank)
but through the ECB. Thus, in the above example, the Central Bank of
Ireland transfers €50,000 to the ECB which then transfers the amount to
the Bundesbank. In the process, ECB claims against the Central Bank of
Ireland and Bundesbank claims against the ECB increase simultaneously
by €50,000 without any direct involvement between the two national
central banks: the Central Bank of Ireland owes €50,000 to the ECB and
not to the Bundesbank; the Bundesbank is owed €50,000 by the ECB and
not by the Central Bank of Ireland.33 Under this system (Trans-European
Automated Real-Time Gross Settlement Express Transfer (TARGET)), national
balances with the ECB continually increase or decrease according to
their countries’ net borrowing and lending.
While, on the face of it, TARGET is nothing more than a payments
system, its power as a means of supporting EMU – and, indeed, ensuring
its existence – was revealed when the economic situation in Europe
began to unravel in 2008. The moment of crisis occurred when, as in
Ireland in 2008, overseas banks were unwilling to rollover their credit
and began to demand payment on outstanding amounts. At this stage,
banks in the deficit countries, in possession of illiquid assets, the prices
of which were falling, faced collapse and this, in turn, triggered a with-
drawal of deposits that pushed the national banking system towards
bankruptcy.34 Now, instead of the outflow resulting from the current
account deficit being matched by an inflow of short-term capital
(€50,000 outflow from Ireland, through Sean’s purchase of a car from
Helga, being offset by an inflow of €50,000 into Ireland from Deutsche
Bank’s loan to Allied Irish), there was an outflow of funds under three
headings:
1. The deficit on the current account of the balance of payments: €1.4

billion for Ireland and €32.1 billion for Greece in 2010.35
2. The withdrawal of deposits from the banking system: €110 billion in
Ireland36 and €16.1 billion in Greece in 2010.37
3. Foreign banks withdrawing their lending from peripheral countries
and bringing the money home: €7.2 billion for Ireland between 2007
and 2010.38
The imbalances caused by these large outflows persisted because the only
consequence for the deficit countries was that their debit balances with
the ECB increased and this was matched by a corresponding increase in
the credit balances of the surplus countries with the ECB. Such imbal-
ances could not persist for countries with their own currencies whose
central banks engaged in a bilateral settlement of accounts through the
appropriate transfer of gold and foreign exchange reserves because the
depletion of reserves would quickly lead to bank failure and government
default. However, these imbalances could persist under the TARGET
system because it is more than just a payment system. In effect the
ECB funds external deficits because the bilateral settlement of accounts
between national central banks is replaced by a system by which each
country’s central bank transacts with the ECB and not with other central
banks. Indeed, as Sinn and Wollmerahäuser (2011: 2) observe, the
TARGET system is comparable to “a special form of jointly and propor-
tionately guaranteed Eurobonds to finance credit to the peripheral
countries that are sold by a central European institution to the German
state for whose acquisition the German state borrows from the capital
market”.
The bail outs
Up to 2007 there was little indication of a sovereign debt crisis in Europe

or even that it was a problem specific to Greece, Ireland, Spain, and
Portugal (Figure 4.1). Apart from Greece, with a 2007 deficit that was 6.4%
of its GDP, the countries running deficits satisfied the Maastricht and
SGP upper limit of 3% and, indeed, several countries (including today’s
“problem” countries, Ireland and Spain) had budgetary surpluses.39 In
terms of the debt-to-GDP ratio, it was Greece, with a government debt
that was 105% of GDP in 2007, that was again the outlier. In the other
“peripheral” countries, debt as a percentage of GDP in 2007 was 25%
in Ireland, 36% in Spain, and 68% in Portugal in comparison to the
percentages (in today’s fiscal hawk countries) of 65% in Germany, 64%
in France, 45% in Netherlands, and 35% in Finland. By 2009, however,
the situation regarding public finances in the peripheral countries had
changed dramatically with Greece running a deficit of 15% of GDP,
Ireland a deficit of 14% of GDP, Spain a deficit of 11% of GDP, and
Portugal a deficit of 10% of GDP. In consequence, by 2009, Greece’s
debt-to-GDP ratio rose to 127%, Portugal’s to 83%, Ireland’s to 66%, and
Spain’s to 53%.40
So, what happened in the period between 2007 and 2009 that so
altered the picture regarding sovereign debt? First, there was the global
recession. The Irish economy, which grew by 5.6% in 2007, shrank by
7.6% in 2009; growth in Greece, Spain, and Portugal plunged from,
respectively, 4.3%, 3.6%, and 2.4% in 2007 to −2%, −3.7%, and −2.5%
in 2009. Nor were other countries immune from the recession: Germany
contracted by 3.9%, France by 2.6%, the Netherlands by 3.9%. This
meant that in virtually every country in Europe tax revenues fell and,
as the numbers of unemployed rose, government expenditure increased
concomitantly. In 2009, the German deficit was 3% of GDP (up from a
0.3% surplus in 2007), the French deficit was 7.5% of GDP (up from a
2.7% deficit in 2007), and the Dutch deficit was 5.5% (up from a 0.2%
surplus in 2007).
However, for a mix of reasons – one general, the other specific to the
countries concerned – the recession hit government finances in Greece,
Portugal, Ireland, and Spain particularly badly and required the first three
of them to be bailed out by the troika of the European Commission, the
ECB, and the International Monetary Fund (IMF).41 The general reason
is one that was discussed earlier: prior to the recession all these coun-
tries were running large deficits on their balance of payments current
account which were largely being financed through domestic banks
borrowing from their counterparts in other euro area countries. In all
four countries, culpability for running such deficits could be appor-
tioned between their private and government sectors. In Ireland and
Spain, the deficits were entirely the handiwork of the private sector
with the Irish and Spanish governments running budget surpluses but
with the balance of payments current account being in deficit in both
countries for the five-year period leading up to, and including, 2007. In
Greece and Portugal, the government was also culpable: the Greek and
Portuguese budget deficits averaged 5.8% and 3.9% of GDP over the
2002–2006 period compared to a current account deficit of, respectively,
11.8% and 8.9% of GDP. When the recession hit, overseas lenders were
no longer prepared to rollover their loans in the face of falling asset
prices and, in conjunction with the existing current account deficit, this
meant there was a large outflow of funds from these countries. The fact
that nervous depositors were also withdrawing their money from banks
only compounded the problem and threatened the very existence of the
banking sector in the peripheral countries.
The recession simply exacerbated the government deficits in Greece
and Portugal. In Ireland, the debt crisis had its origins in the collapse of
construction activity causing Irish GDP to decline by 3.5% in 2008 and
by 7.6% in 2009. The problem was, as Whelan (2011) points out, that
the Irish government had no room for creating a fiscal stimulus to ease
the recession. In order to take advantage of its construction boom, the
Irish government had altered its tax base to collect increasing amounts
of revenue from property-related taxes – stamp duty, capital gains
tax, and capital acquisition tax – and decreasing amounts from taxes
on income. When the housing bubble burst and construction activity
collapsed, triggering the Irish recession, a substantial source of govern-
ment revenue also disappeared (Whelan, 2011).
Consequently, notwithstanding the recession, the Irish government
has been contracting its budget since November 2008 resulting in a
cumulative reduction in the deficit of €20.8 billion, equivalent to a
reduction of €4,600 per person. The large exposure of Irish banks to the
property market meant that, in the wake of the construction collapse,

international investors were no longer prepared to rollover their loans
and Irish banks turned to their government for help. The government
responded by assuming responsibility for all the liabilities of Irish banks
for a period of two years from 30 September 2008. In September 2010,
it was estimated (the “final” estimate) that this guarantee would cost
the government €30 billion (or €700 per person in Ireland) resulting
in a government deficit that was nearly one-third of Irish GDP in 2010
and a government debt that was 96% of GDP (up from 25% of GDP in
by 2007).
The problems with the Greek economy were much more fundamental
and long-standing. Its private-sector was highly uncompetitive, char-
acterised by anti-competitive regulation and barriers to entry.42 At the
same time, successive governments, in order to increase their popularity
with the electorate, had spent large amounts of money on expanding
public-sector employment and raising wages and pensions. Overlaying
these problems was widespread tax evasion by Greeks, with the EU esti-
mating that uncollected tax revenue in Greece in 2006 amounted to
3.4% of its GDP (Featherstone, 2011).43
Portugal’s problem was one of economic stagnation. Although the
country had grown rapidly in the 1990s (its average annual growth rate
over the 1997–2001 period was 3.9% compared to the euro area average
of 2.8%), growth had stalled after 2002, averaging only 0.7% per year
between 2002 and 2006 compared to the euro area annual average of
1.7% over that period. Moreover, the economic growth and prosperity
of the 1990s gave rise to economic imbalances and excessive spending
which were difficult to sustain in years of stagnation. Portugal’s loss of
competitiveness, brought about by rapid wage increases, dulled its appeal
as a low-cost producer and competition from emerging East European
countries further eroded its ability to compete in international markets.
Unlike Greece, however, the Portuguese government was assiduous in
implementing austerity measures: the governing Socialists moved to
cut the deficit while the new government, which came to power in the
summer of 2011, has reduced the government’s budget deficit by more
than one-third. However, because of the recession, GDP fell faster than
the rate at which the government’s deficit was being reduced so that
Portugal’s government debt climbed inexorably from 93% of GDP in
2010 to 107% in 2012.
The event that crystallised Greece’s precarious finances in the minds of
bond dealers and credit rating agencies, and precipitated its subsequent
bail out by the troika of the EC, the ECB, and the IMF, was the admission
on 20 October 2009 by the newly appointed Greek Finance Minister –

following his party’s (PASOK) victory in the recently concluded general
election – that the outgoing government’s44 claim that the government
deficit was 3.6% of GDP was incorrect: it was, in fact, 12.8% of GDP
(Featherstone, 2011).45 This “duplicity”, in conjunction with Greece’s
mounting debt, led rating agencies to downgrade Greek debt, begin-
ning with Fitch downgrading Greece from A− to BB+ and culminating
in Standard & Poor’s judging, on 27 April 2010, that Greek government
bonds had no more than “junk status” (bond ratings below Baa are collo-
quially termed “junk bonds”). In March 2009, Ireland’s credit rating was
downgraded from AAA to AA+ by Standard & Poor, then to AA− in August
2010, and to A in November 2010. In April 2010, Portugal’s credit rating
was downgraded from A+ to A− by Standard & Poor.46
Following on the heels of the credit downgrades was a sharp rise in the
yield on government bonds of the affected countries. Long-term interest
rates in February 2012 were nearly 30% in Greece and close to 15% in
Portugal; the Irish rate peaked at 12% in the previous year but, in spite
of falling subsequently, it remained around 7%. The rise in bond yields
made it impossible for governments in Greece, Portugal, and Ireland
to meet their funding needs through the market. On 6 May 2010, the
Greek Finance Minister announced to his Parliament:
In less than two weeks, a €9 billion bond becomes due and the state
coffers don’t have this money ... as we speak the country can’t borrow
it from foreign markets and the only way to avoid bankruptcy is to
get this money from our European partners and the IMF.47
Thus began the bail outs of three euro area countries – first Greece, then
Ireland, and then Portugal. At first the governments of the euro area
countries were slow to recognise the gravity of the events unfolding in
Greece in the last quarter of 2009, beginning with the hole in govern-
ment finances (revealed on 18 November 2009), proceeding to the debt
downgrade on 8 December 2009, and culminating in the rise in Greek
government bond yields shortly thereafter.
After a 15 February 2010 meeting of the finance ministers of the 16
countries in the euro area (Economic and Financial Affairs Council
(ECOFIN)), the view was that Greece should address its problems by
reducing its deficit. The ministers made it very clear that they were
ignoring Greece’s appeal for a rescue plan that would calm market fears
of a Greek default in lieu of a plan that further emphasised new austerity
measures.48 However, on 26 March 2010, following debt downgrades of
Portugal and Ireland, Germany agreed to a rescue package for Greece; on

23 April 2010, the Greek government requested that this package be acti-
vated with a loan of €45 billion to cover its financial needs till the end
of 2010. On 1 May 2010, the Greek parliament passed a raft of austerity
measures49 and, in response, the very next day the euro area countries
and the IMF agreed to the first bail out: a three-year €110 billion loan at
5.5% interest. On the day following this agreement, the ECB announced
that Greek bonds, notwithstanding their junk status, would continue to
be accepted by it as collateral.50
After the austerity measures of May 2010, Greece embarked on further
austerity measures in June 2011, the most newsworthy of which was
a tax on immovable property (expected to raise €4 billion in revenue)
tied to electricity bills of property owners. This was followed by another
austerity package in February 2012 which imposed a 22% cut in the
minimum wage, planned to eliminate 150,000 public-sector jobs by
2015, and decreed that formerly closed professions should be opened up
to competition. Coming on the heels of the February austerity package
was a second bail out programme worth €130 billion, but with stricter
conditions. The main condition, which has now been implemented,
was a debt swap agreement under which holders of Greek government
bonds issued under Greek law – which comprise 92% of outstanding Greek
bonds – would voluntarily swap their existing bonds for bonds of longer
maturity and, thereby, erase nearly €107 billion from the Greek debt.51
These conditions, in conjunction with the earlier austerity measures,
were expected to bring the Greek government’s debt down to 120% of
GDP by 2020.
Ireland’s problems came to a head in 2010. After the government’s
underwriting of banking liabilities, Irish banks were able to raise money
through government-backed bonds. But, as the date for the expiry of
this guarantee approached, banks, faced with the prospect that govern-
ment cover might not be extended, found it difficult to raise funds on
money markets and, increasingly, began borrowing from the ECB (€36
billion in April 2010, €50 billion in August, €74 billion in September).
However, here they faced the problem of not having sufficient eligible
collateral to offer the ECB. In order to maintain the liquidity of Irish
banks, the ECB allowed the Central Bank of Ireland to make “Emergency
Liquidity Assistance” (ELA). The ELA allowed the Central Bank of Ireland
to continue giving banks money, even if Irish banks had run out of
ECB-eligible collateral; ELA carried a higher interest rate, reflecting the
lower quality of collateral being advanced, and was “explicitly” guaran-
teed by the state. This guarantee was provided by the state issuing bonds
and selling them to its banks that then used these bonds as collateral
to borrow money from the ECB.52 The fact that the Irish government,
through ELA guarantees, was propping up a banking system that was
increasingly looking insolvent rather than simply illiquid raised fears
about sovereign default which, in turn, raised bond yields on Irish
government debt quite substantially (See Figure 4.4) effectively shutting
the government out of the bond market.53
On 29 November 2010, the Irish government reached a bail out agree-
ment with the EU, the IMF, and three countries (the UK, Denmark, and
Sweden) under which it would receive a loan of €67.5 billion which,
together with €17.5 billion from the government’s pension reserve fund,
would amount to a bail out fund of €85 billion. This loan was provided
subject to a number of conditions, the most important of which was
that the Irish government would address the problems of the banking
sector. These problems had already toppled a government – Taoiseach
Brian Cowan’s Fianna Fáil – and had threatened to engulf the state. It
would do this by providing funds to recapitalise its banks (except Anglo-
Irish and Irish Nationwide Building Society, which were to be wound
down) to the full extent required by the results of a round of bank “stress
tests” conducted in March 2011. This amount turned out to be nearly
€70 billion in total.
On 7 April 2011, Portugal put in a formal request for troika aid after
the yield on the country’s 10-year bonds rose to 8.6% and the Portuguese
banking sector let it be known that it was not prepared to continue
purchasing the country’s sovereign debt; on 5 May 2011, Portugal
received a bailout of €78 billion of which €12 billion was offered to its
banks to enable them to raise their Tier 1 capital ratios to 9% in 2011
and to 10% by the end of 2012. In exchange, Portugal – which had
not had a balanced budget in more than 30 years – was to reduce its
persistent deficit through spending cuts, higher taxes, and privatisation
which was to include its national airline TAP and its power companies
Energias de Portugal SA and Redes Energeticas Nacionais SGPS.54
Fiscal sustainability
A critical concept in debt reduction is that of fiscal sustainability, which

means that a country’s debt-to-GDP ratio remains unchanged over time.
The important question is what determines fiscal sustainability? In turns
out (see Appendix 4.1 to this chapter for details) that fiscal sustainability
depends upon two things: (i) the economy’s growth rate and (ii) the
government’s ‘primary surplus’, where a primary surplus is government
revenue less government expenditure, when expenditure excludes interest

payment on debt.55 Given a primary surplus, a higher growth rate, by
generating tax revenue and reducing government expenditure on social
payments, reduces the debt-to-GDP ratio; conversely, given a growth
rate, a larger primary surplus (more belt-tightening) also reduces the
debt-to-GDP ratio. Consequently, there are different combinations of
growth and primary surpluses that ensure fiscal sustainability. There is
a trade-off between these sustainability-ensuring values of growth and
surplus in the sense that a higher growth rate requires a smaller primary
surplus and a lower growth rate requires a larger surplus.
This trade-off is illustrated in Figure 4.4. All points on the line SS repre-
sent growth rate/primary surplus (deficit) combinations that ensure
fiscal sustainability. All points above the line represent growth rate/
primary surplus (deficit) combinations that will reduce the debt-to-GDP
ratio over time. All points below the line represent growth rate/primary
surplus (deficit) combinations that will increase the debt-to-GDP ratio
over time.
A general rule of thumb for fiscal sustainability (derived in the
appendix to this chapter) is that a country must run a primary surplus
which, expressed as a proportion of its GDP, is equal to [the interest rate
S
Growth Rate
Growth Rate and Primary Surplus/deficit

combinations that result in fiscal sustainability
0
Primary Deficit/GDP Primary Surplus/GDP
Figure 4.4 The trade-off between growth rate and the primary surplus/deficit for
fiscal sustainability
Source: Author.
it pays on debt less the growth rate in its GDP] × its debt-to-GDP ratio.56
This can be expressed as:
p* = ( g − r ) × b (4.3)
In Equation (4.3): p* is the primary surplus (expressed as a proportion

of GDP) needed for fiscal sustainability, g is the growth rate, r is the
interest rate, and b is government debt (expressed as a proportion of
GDP). Figure 4.5 shows, along the line SS, the relationship between p*
and g for given values of i and b.
In 2009, Greece had general government debt (as a percentage of
income) of 127% (b2009 = 1.27), a primary deficit (as a percentage of
income) of 10.3% (p2009 = −0.103) and growth rate in real GDP of −2%
(g = −0.02).57 If the interest rate is taken as the yield on 10-year Greek bonds
in July 2009, which was 5%, then i = 0.05. In this scenario, the primary
surplus needed to stabilise debt at 127% of GDP is 9% (as a percentage of
GDP): in the above PGR *
= [0.05 − (0.02)] × 1.27 = 0.07 × 1.27 = 0.09 .
However, in the same year, Greece had a primary deficit of 10.3%
which meant that it had a primary gap of 0.09 − (−0.103) = 0.193 which is
19.3% of GDP. With this information, Equation (4.3) shows that Greek
general government debt would be 146% of its GDP in 2010, 167% in
2011, and 189% in 2012:
b2010 = 1.07 × 1.27 + 0.103 = 1.46

b2011 = 1.07 × 1.46 + 0.103 = 1.67
b2012 = 1.07 × 1.67 + 0.103 = 1.89
Figure 4.5 shows various configurations of the growth rate and primary
balance that can achieve the target debt-to-GDP ratio. When growth is
negative (−2% per annum), maintaining b2010 *
= 1.33 requires a primary
surplus which is 2.5% of GDP; zero growth requires a primary balance of
zero; positive growth (+2%), permits a primary deficit of 2.5% of GDP;
growth of 5% allows a primary deficit which is 6.4% of GDP. This is the
empirical counterpart of line SS shown in Figure 4.4 where the values in
Figure 4.5 were computed using Equation (4.3).
In 2011, Ireland had general government debt (as a percentage
of income) of 112% (b2011 = 1.12), growth rate in real GDP of 0.6%
(g = 0.006). If the interest rate is taken as the average yield on 10-year
Irish government bonds from 1991–2012, which was 5.77% (r = 0.058),
then, in this scenario, the primary surplus needed to stabilise debt at
5
4
2 2.5
2
0 0
0
Negative Growth Zero Growth Positive Growth High Growth
–2
–2 –2.5
–4
–6 –6.4
Growth rate Primary balance
–8
Figure 4.5 The trade-off between growth rates and the primary balances to
achieve desired debt-to-GDP ratio of 1.33 in Greece in 2010
Source: Author.
112% of GDP is, as a percentage of GDP, 5.8%.58 However, in the same

year, Ireland had a primary deficit of 6.8% which meant that it had a
primary gap (which is the difference between the primary stance needed
for fiscal sustainability and its actual primary stance) of 0.058 − (−0.068)
= 0.126, that is, 12.6% of GDP.
Similarly, in 2011, Portugal had general government debt (as a
percentage of income) of 101.7% (b2011 = 1.017), growth rate in real GDP
of −2.2% (g = −0.022). If the interest rate is taken as the average yield
on 10-year Portuguese government bonds from 1997–2012, which was
4.88% (r = 0.049) then, in this scenario, the primary surplus needed
to stabilise debt at 101.7% of GDP is, as a percentage of GDP, 7.1%.59
However, in the same year, Portugal had a primary deficit of 1.7% which
meant that it had a primary gap of 0.071− (−0.017) = 0.088, that is, 8.8%
of GDP.
Conclusion
Notwithstanding these bail outs, the markets’ assault on Ireland and

Portugal continued. There were further rating agency downgrades
of Ireland and Portugal centring on (a) whether subsequent bail outs
would be necessary for these two countries and, (b) if so, whether this
time private investors would, as they did in Greece, have to take a loss
on their loans to the Irish and Portuguese governments. On 5 July 2011,
Moody’s cut the status of long-term Portuguese bonds to Ba2 from Baa1
citing two reasons:60
1. The growing risk that Portugal would require a second round of offi-
cial financing before it could return to the private market and the
increasing possibility that private-sector creditor participation would
be required as a precondition for a second bailout.
2. Heightened concerns that Portugal would not be able to fully achieve
the deficit reduction and debt stabilisation targets set out in its loan
agreement with the European Union (EU) and International Monetary
Fund (IMF) due to the formidable challenges it faced in respect of
reducing spending, increasing tax compliance, achieving economic
growth and supporting the banking system.
On 14 July 2011, Moody’s cut the status of the government-guaranteed

debt of Ireland’s five banks from Baa3 to Ba1, its lowest investment grade
level, citing reasons similar to those for downgrading Portuguese debt:
“to reflect the growing possibility that, following the end of the current
EU/IMF support programme at year-end 2013, Ireland is likely to need
further rounds of official financing before it can return to the private
market, and the increasing possibility that private-sector creditor partic-
ipation will be required as a precondition for such additional support, in
line with recent EU government proposals.”61
Confounding these predictions, however, the Irish government
announced in November 2013 that Ireland would exit the EU–IMF bail
out programme by returning to normal market funding in 2014 without
needing a precautionary credit line from its international partners. This
fulfilled one of the most important goals of the Fine Gael/Labour coali-
tion since it came to power after the Irish general election of February
2011. Several factors have combined to produce this result. Setting
aside the political kudos associated with this exit, Ireland’s economy
looks healthier (unemployment fell for 15 consecutive months up to
November 2013 as 34,000 new jobs were created), its property market
has stabilised, and the UK, which is a big market for Irish exports, appears
to be in the first stages of an economic recovery.
On the assumption that the interest rate is exogenously given, either
or both of two things must occur to close the primary gap: the growth
rate in GDP must rise so that the primary surplus needed for fiscal sustain-
ability (p*t) falls and the primary deficit (–pt) must be reduced and, if
possible, converted into a surplus. Portugal has the advantage over
Ireland in having a lower primary deficit as a percentage of GDP (1.7%
in Portugal compared to 6.8% in Ireland), but Ireland has the advantage
over Portugal in having better growth prospects implying that it would
require a smaller primary surplus for fiscal sustainability. Lying at the
heart of these outcomes is, of course, the tension between policies that
promote growth and those that impose austerity: growth requires inter
alia demand for goods and services and this is precisely what austerity
seeks to take out of the economy.
But, regardless of how debt reduction is achieved, governments for
several reasons need to take action to control their primary deficits. First,
there is the issue of repayment credibility. If the rate of interest exceeds the
growth rate, the debt-to-income ratio will rise over time unless action is
taken to generate the primary surplus appropriate to fiscal sustainability.
If such action is not taken then investors in the country’s debt, upon
observing a sustained rise in this ratio will begin to entertain doubts about
its ability to repay. Interest rates will rise, the gap between the interest rate
and the growth rate will widen and the debt-to-GDP ratio will rise.
The second issue is one of crowding out. The rise in interest rates will
crowd out private-sector activity as demand by consumers and firms for
goods and services (consumer durables, houses, investment goods) are
stifled. This will reduce the rate of economic growth.
The third issue is the recessionary effect. As growth in the economy
slows, non-discretionary public expenditure will rise and tax revenues
will fall. The primary balance will deteriorate (smaller primary surplus
or larger primary deficit), the primary gap will widen and the debt-to-
income ratio will rise.
Fourthly, there is the interdependency effect. The interest rate that inves-
tors demand to hold a country’s debt is not independent of the coun-
try’s growth performance. When growth is strong, a country’s economic
fundamentals are viewed as sound. Investors have confidence in the
country’s ability to repay and the interest rate is also low. However, if
growth is weak – especially if it is viewed as being the result of structural
factors – investors’ lack of confidence in the country’s ability to repay
might result in a high interest rate causing the interest rate-growth rate
gap to widen and, therefore, the debt to income ratio to rise.
Fifthly, there is the political effect. A significant feature of the present
crisis is the power of “the market” to topple governments. In Ireland,
Brian Cowan’s Fianna Fáil government was voted out in the February
2011 general election following the Irish bailout. In Greece, the Socialist
Prime Minister George Papandreou resigned in November 2011, as a
result of his failed attempt to hold a referendum on the terms of the
bail out negotiated with the EU, and was replaced by Lucas Papademos,
a technocrat heading a grand coalition government. In Portugal, Prime
Minister Jose Socrates of the Socialist party lost the election of June 2011
and was replaced by the right-wing coalition of the Social Democrats and
the People’s Party headed by Pedro Passos Coelho. The political lesson
is that any government which – rightly or wrongly, for good reasons or
for bad – ignores the precepts of “good housekeeping”, by allowing its
finances to slide into deficit, risks death at the hands of the market. For
within the straitjacket of the EMU, this godlike creature – the Minotaur
of modern times – has become both the economic and the political
master of smaller countries and needs to be propitiated through regular
affirmations of fiscal austerity.
Appendix 4.1: Deconstructing competitiveness
The UK price level, expressed as a mark-up over unit costs is:
WUK × NUK W
PUK = (1 + λ UK ) = (1 + λ UK ) UK (4.4)
YUK ΩUK
where PUK is UK output price (expressed in £), WUK is the nominal wage
in the UK, YUK is UK output, and ΩUK = YUK / NUK . In an open economy,
UK output has to be sold abroad (say, to in the USA) and the relevant
$
price is the price of UK output expressed in dollars, PUK :
WUK
$
PUK = (1 + λ UK ) × ×E (4.5)
ΩUK
where E is the nominal exchange rate $/£ expressed the amount of

dollars a £ will buy. Analogous to Equation (4.4), the USA price level
(expressed in dollars) is:
WUS
PUS = (1 + λ US ) × (4.6)
ΩUS
From Equations (4.5) and (4.6), the change in UK competitiveness, rela-

tive to that in the USA is:
(
PUK − PUS = ⎣⎡ λ UK − λ US ⎦⎤ + ⎡ W ) (
⎤ E)
⎣ UK − US − ΩUK − ΩUK ⎦ + $£
W (4.7)
where the dot above a variable denotes a rate of change. From Equation
(4.7), the UK has four instruments for improving competitiveness, rela-
tive to the USA:
1. lower profit margins through increased competition

2. higher productivity growth through greater efficiency and innovation
3. lower wage growth through more responsible wage demands
4. exchange rate depreciation through a flexible exchange rate
Appendix 4.2: The relationship between government

deficits and government debt
Both the Maastricht Treaty and the SGP place emphasis on outcomes
regarding government deficits (a ceiling of 3% of GDP) and government
debt (a ceiling of 60% of GDP). Quite obviously, the two entities are not
independent of each other: common sense tells us that a succession of
deficits/surpluses would result in a build-up/run down of debt. However,
underlying the obvious link between deficits and debt, there is a more
complex relation between deficits and debt, which is explored in this
appendix.
If Dt is the deficit during period t, Bt is the stock of debt (in nominal
terms) at the end of period t, Yt is nominal GDP in period t, and gt the
growth rate of nominal GDP in period t (that is, Yt [1 + g t ]Yt −1), then:
Bt Bt −1 Dt
Bt − Bt −1 = Dt ⇒ − =
Yt Yt Yt
Bt Bt −1 Yt −1 bt −1 (4.8)
⇒ − = dt ⇒ bt − = dt
Yt Yt −1 Yt (1 + g t )
⇒ bt − bt −1 = (1 + g t )dt − g t bt
If the debt-to-GDP ratio is to remain constant over time (fiscal sustain-

ability) so that bt = bt–1 we have from Equation (4.8):
gt
dt = bt (4.9)
1 + gt
Dt B
where dt = is the deficit-to-GDP ratio and bt = t is the debt-to-GDP
Yt Yt
ratio.62
The implications of the above relationship are drawn out by Baldwin

and Wyplosz (2009). Under the Maastricht Treaty, dt = 3% and Bt = 60%
implying that the two conditions will be approximately satisfied if
nominal GDP grows at 5% annually or, equivalently, if real GDP grows
at 3% and the inflation rate is 2%. Nominal GDP growing at 7% (say,
5% real growth, 2% inflation) will allow a higher deficit-to-GDP ratio of
4%, while maintaining a debt-to-GDP ratio of 60%. Conversely, a 3%
deficit, combined with 7% nominal growth, would see the debt-to-GDP
ratio fall to 46%.
The government deficit, Dt, can be separated into a part which repre-
sents interest payments on past debt (itBt –1, for a nominal rate of interest rt)
and the primary surplus (Pt = Tt – Gt, where Tt is tax revenue and Gt is
public expenditure in year t) such that:
Dt = it Bt −1 − (Tt − Gt ) (4.10)
With this distinction between interest debt and primary debt, the rela-
tion between the debt-to-GDP ratios in two successive time periods for a
primary-balance-to-GDP ratio, pt, is (dropping subscripts for i and g, for
ease of presentation):
Bt
Bt = Bt −1 + iBt −1 − (Tt − Gt ) = (1 + i ) Bt −1 − Pt ⇒
Yt
(1 + i ) Bt −1 Pt (4.11)
= −
(1 + g ) Yt −1 Yt
1+ i
Since (1 + i − g ), we have:
1+ g
bt = (1 + i − g )bt −1 − pt ⇒ bt − bt −1 = (i − g )bt −1 − pt (4.12)
Fiscal sustainability requires bt – bt–1 = 0 so that, from Equation (4.12):
P T − Gt
p*t = t = t = (i − g )bt −1 (4.13)
Yt Yt
where p*t is the primary-balance-to-GDP ratio which is consistent with

fiscal sustainability. Equation (4.13) provides the general rule of thumb
that, for fiscal sustainability, a country must run a primary surplus which,
expressed as a proportion of its GDP, is equal to [its nominal interest rate
less its growth rate in nominal GDP] × its debt-to-GDP ratio. If π is the
inflation rate, then Equation (4.13) may be rewritten as:
p*t = (i − g + π − π )bt −1 = [(i − π ) − ( g − π )]bt −1 = ( r − s )bt −1 (4.14)
where: r is the real rate of interest and s is the rate of growth of real GDP.
Equation (4.14) provides an equivalent rule of thumb that, for fiscal
sustainability, a country must run a primary surplus which, expressed as
a proportion of its GDP, is equal to [its real interest rate less its growth
rate in real GDP] × its debt-to-GDP ratio.63
If the rate of interest equals the rate of growth (r = s), fiscal sustain-
ability requires that the budget be balanced (Gt = Tt, or p*t = 0). If the
rate of interest exceeds the rate of growth (r > s), fiscal sustainability
requires a primary surplus (Gt < Tt, or p*t > 0), the required surplus being
larger the greater the difference between the interest rate and the growth
rate; if the growth rate in GDP exceeds the rate of interest (r < s), fiscal
sustainability can be achieved with a primary deficit (Gt > Tt, or p*t < 0 ),
the deficit being larger the greater the difference between the growth rate
and the interest rate. The primary gap in a year is defined as the differ-
ence between p*t and pt (the actual primary balance to income ratio) that
is as (r – s)bt–1 – pt = bt – bt–1.
The equation for the primary gap, bt = (1 + r – s)bt–1 – pt, represents a first-order
difference equation whose solution, for a constant primary balance to income
ratio, is:64
⎡ 1 − (1 + r − s )T ⎤
bT = (1 + r − s )T b0 − P ⎢ ⎥ (4.15)
⎣ s−r ⎦
If, in Equation (4.10), the interest rate exceeds the GDP growth rate
(r > s) – as is most likely – then for a given initial debt-to-GDP ratio, b0, the
debt-to-GDP ratio will increase over time if the primary balance is in deficit
(p < 0) or even if it is in balance (p = 0).65 If the debt-to-GDP ratio is to stay
at its initial value, b0, then the country would need to generate adequate
primary surpluses every year, from year 0 to year T. The size of these surpluses
(expressed as ratio of GDP), required to keep the debt-to-GDP ratio at its
starting level, b0, would be: p* = ( r − s )b0.66 The intuition behind this is that
the initial debt-to-GDP ratio would grow every year at r % (the interest rate)
but fall by s% (the growth in GDP) for a net growth rate of (r − s)%: in order
to prevent this growth, the primary balance should, every year, offset this
potential growth in the debt-to-income ratio.
On the assumption that the interest rate is exogenously given, either

or both of two things must occur to dampen this rise in the public-
debt-to-GDP ratio: the growth rate in GDP must rise and the primary
deficit must be reduced and, if possible, converted into a surplus. To see the
nature of the trade-off between the growth rate and the primary balance,
suppose that the target debt-to-GDP ratio for 2010 is b*2010 < 1.46 (1.46 being
the debt-to-GDP ratio that would occur under existing policies). Suppose,
for the sake of simplicity, we assume that b*2010 = 1.05 × 1.27 = 1.33 that
is, the target debt-to-GDP ratio for 2010 is the 2009 ratio grossed up for
interest payments. Then from Equation (4.3):
b*2010 = (1 + 0.05 − g ) × 1.27 − p ⇒ b*2010 −(1.05 × 1.27) = −1.27 g − p

⇒ p = −1.27 g
under the simplifying assumption made about b*2010.
5
Reforms, Hardship, and Unrest
The painter Eugène Delacroix (1798–1863), leader of the French

Romantic school, famously remarked that “experience has two things to
teach: we must correct a great deal; we must not correct too much”. This
injunction has relevance to the present European situation because the
banking and the sovereign debt crises in some of the euro area countries
have unleashed a demand for “structural reform” (both at the national
and the supranational level) within the countries of the European
Monetary Union (EMU) and for changes in the relationship between the
central authority of the European Commission (EC) and the European
Union’s (EU) Member States. In seeking to correct the faults of the past
lies the danger of overcorrection. `It is in this light that one must judge
the pace and nature of reform that the economic and financial crisis in
Europe has engendered.
Reform in the EU and within its countries has proceeded at two
levels. The first is at the national-level: here the pace of reform has
been particularly marked among those countries that have received
bail outs (Greece, Ireland, and Portugal) because these bail outs were
given subject to the recipients undertaking certain tasks. In the case of
Ireland, the most important of these tasks was to ensure that its banks
were sufficiently capitalised to withstand future storms without external
assistance and, equally importantly, that Irish banks refrained from
the risk-taking behaviour that, in the past, had had disastrous conse-
quences. The Portuguese were tasked with reducing their budget deficit
and strengthening their banks. The Greeks were required to undertake
a much more comprehensive set of reforms than was required of either
the Irish or the Portuguese. Labour markets were to be reformed, pension
arrangements were to be made less generous, public-sector employment
was to be reduced, and the minimum wage was to be cut. In short, a
97
dysfunctional economy, with a bloated and wasteful public-sector and

restrictive labour practices, was to be transformed, within a short period
of time, into something resembling a modern, competitive economy.
Although the details of reform varied between the countries, the aim
of reform was to bring order and discipline to public finances through
austerity and to reduce the malign nexus between banks and govern-
ment, which, in part, was responsible for the chaos in the finances of
some countries.
At the supranational level there has been a concerted move to impose
greater fiscal stringency on Member States and to increase the level
of fiscal surveillance by the EC on the budgets of the Member States.
In pursuit of this, 25 European leaders signed the Treaty on Stability,
Coordination and Governance on 2 March 2012, which aimed at further
strengthening fiscal discipline within the euro area by introducing
the “balanced budget rule”. This requires the national budget to be in
balance or in surplus, a condition that would be satisfied if the annual
structural deficit – the deficit that would exist even after the economy
recovers its “normal” level of output – did not exceed 0.5% of gross
domestic product (GDP) at market prices. Putting aside the question of
how to measure this elusive concept,1 the emphasis on structural deficit
means that the focus of policy is to eliminate cyclical deficits rather than
to control annual deficits. Moreover, this balanced budget rule needs to
be incorporated into the legal systems of the Member States and, pref-
erably, enshrined in their constitutions. The European Court of Justice
will offer a binding decision as to whether a national government has
adhered to this rule, and breaches will be penalised by a fine of up to
0.1% of GDP.
The second component of reform at a supranational level has been to
erect a firewall between the Member States and predatory bond markets
when the latter refuse to supply the former with access to funds. Towards
this end, the European Financial Stability Facility (EFSF) was established
in 2010 and assigned responsibility to provide emergency financing to
Member States till 2013. In September 2012, a permanent firewall in
the form of the European Stability Mechanism (ESM) was set up. By
providing EMU member states with access to financial assistance up to
€500 billion, the ESM is intended to beat off any market challenges to a
country’s financial stability. The ESM will cover all new bail outs to any
EMU member states while the EFSF will continue handling the earlier
bail out loans to Greece, Ireland, and Portugal.
Underpinning these supranational reforms has been a change in atti-
tude within the EU. The mantra under the Maastricht Treaty and the
Reforms, Hardship, and Unrest 99
Stability and Growth Pact (SGP) was (Schuknecht et al., 2011): no bailout,
meaning that each Member State was solely and entirely responsible
for its debts and this liability would not and could not be shared with
other Member States; no financing of government debt by the European
Central Bank (ECB), meaning that, while the ECB could lend to banks,
it could not directly finance government borrowing; no privileged access
to financial institutions by a government, meaning that national banks
could not be coerced into buying the debt of their governments. All
these shibboleths have now been abandoned: countries are being bailed
out by the troika of the EC, the International Monetary Fund (IMF),
and the ECB; permanent arrangements are being put in place to deal
with future bailouts; and the ECB freely accepts government bonds as
collateral for making loans to banks – no matter how fragile the state of
a country’s public finances – thereby enabling the backdoor financing
of government deficits.
National-level reform measures
Reforms at the national-level have taken two forms: measures to

improve the prospects for growth by improving competitiveness (growth-
enhancing measures) and measures to improve the state of public finances
by reducing expenditure and increasing revenue (austerity-enhancing
measures). These reforms raise the question about the appropriate mix
of growth- and austerity-enhancing measures. Under certain conditions
(for example, if home demand for domestically produced goods and
services is an important component of GDP) there could be a signifi-
cant trade-off between austerity and growth with more of the former
implying less of the latter. As one commentator recently observed: “The
problem is not so much that Greece has been unwilling to make sacri-
fices. It has made many. But Greece’s budget numbers look bleak because
its growth forecasts look bleak.”2 The previous chapter showed that in
order to steady the debt-to-GDP ratio (that is, achieve fiscal sustaina-
bility in the shape of a stable debt-to-GDP ratio) a country needed to
improve its primary balance (through austerity-enhancing measures)
and/or raise its growth rate (through growth-enhancing measures). The
latter involves, inter alia, improving competitiveness, attracting foreign
investment, offering incentives and opportunities to domestic owned
businesses to flower, increasing human capital, fighting corruption,
raising the quality of corporate and public governance, and making it
easier to do business by reducing the amount of bureaucratic red tape in
starting and running businesses.
Kapoor and Bofinger (2012) have made the case for “growth-friendly”
policies. Their argument is that the axe of austerity falls first on public
investment because such cuts are not as politically costly as cuts in
current expenditure. However, reducing investment retards growth by
reducing the capacity to grow. In a similar vein, they argue that efforts to
reduce public indebtedness should focus on raising revenue – particularly
through the taxation of property, land, wealth, and carbon emissions –
rather than on cutting expenditure. Furthermore, this increased revenue
should be appropriately allocated between deficit reduction, investment,
and lowering income tax for the low paid.
Although the issue of raising revenue is often couched in terms of
tax evasion – with, as discussed in the previous chapter, Greece as the
favourite whipping post – the issue of tax avoidance (where the very rich,
by exploiting tax loopholes, pay minimal taxes) is acquiring a certain
urgency in Europe. After an analysis of the tax returns of millionaires,
George Osborne, the British Chancellor of the Exchequer, was “shocked”
to learn how little tax they paid as a consequence of exploiting tax
loopholes and excessive tax avoidance schemes: two-thirds of Britain’s
top-20 tax avoiders wrote off business losses against income tax; others
offset the cost of business mortgages borrowing on buy-to-let proper-
ties against their income tax; yet others took advantage of relief on
donations to charity. By so doing they reduced their total tax bill by
£145 million.3 Kapoor and Bofinger (2012) suggest sharing and imple-
menting the most effective anti-avoidance/anti-evasion strategies across
all EU countries in conjunction with an agreement to help Member
States enforce their domestic measures. Such EU-wide coordination,
which would be more effective than the current raft of bilateral deals
(UK-Liechtenstein, Germany-Switzerland), would then begin to match
the heft of the United States’ (USA) foreign account tax compliance
act which, inter alia, requires EU banks to share, with the US Internal
Revenue Service, data on accounts held by USA citizens.
The dynamics of change
Schmieding (2011) has evaluated the adjustments made in different

European countries, in response to the post-2008 recession, in respect
of three important areas – external adjustment, fiscal adjustment, and
changes in real unit labour costs (RULC) – and ranked these coun-
tries (from highest to lowest) in terms of an Adjustment Progress
Indicator (API) (see Table 5.1). Two important points emerge from this
analysis:
1. The bail out countries – Greece, Ireland, and Portugal – and a “near
bail out” country, Spain, place within the top seven in terms of the
computed API. Much maligned Greece is second (after Estonia) in
terms of overall adjustment (API), second in terms of external adjust-
ment, second in terms of fiscal adjustment, and second in terms of
reducing RULC.
2. Countries that have not suffered the opprobrium of having to be
bailed out but whose indebtedness, nevertheless, places them in a
position of danger – Belgium, Italy, and France – are doing very little
to make appropriate adjustments to their economies.4
The lesson to be drawn from the first point is that countries which
have appeared as liabilities to the EMU, threatening the viability of the
single currency, are mending their ways. Greece, as Schmieding (2011)
points out, is the worst performing (see Table 5.1), but also (after Estonia)
the fastest changing, economy in the EMU. As Table 5.1 shows, Greece
is second in the adjustment progress ranking but last in the ranking
by overall health. The dramatic improvement in Greece’s fiscal and
competitiveness position suggests that the common perception, partic-
ularly in northern Europe, that lending to Greece is akin to throwing
good money after bad is wrong.
Table 5.1 EMU – 17 countries ranked by adjustment progress and overall health
indicator
Country Rank by API Rank by overall health indicator
Austria 17 8
Belgium 14 9
Cyprus 13 16
Estonia 1 1
Finland 10 7
France 15 13
Germany 16 3
Greece 2 17
Ireland 3 10
Italy 12 14
Luxembourg 9 2
Malta 4 11
Netherlands 8 4
Portugal 7 15
Slovakia 6 6
Slovenia 11 5
Spain 5 12
Source: Adapted from Schmieding (2011).

The lesson to be drawn from the second point is that some core coun-
tries of the EMU – in particular, France – are infused with a sense of
complacency layered by a sense of entitlement stemming from being
among the founding members of the EU. Government debt in France
was 90% of GDP in 2012 and rising; public expenditure, at 56% of GDP,
as a proportion of national income was higher than that in “socialist”
Sweden, unemployment was 10%, growth was only 1.7% per annum,
and with unit labour costs rising steeply its prospects for growth were
poor. These are a combination of economic outcomes that, as Table 5.1
shows, place France near the bottom of the economic performance
ranking of European countries on the basis of Schmieding’s (2011)
Overall Health Indicator (OHI).
Yet the leading candidates in the French Presidential elections of 2012
promised to balance the budget within five years – even though the last
time France had a balanced budget was as long ago as 1972 – without
specifying the budgetary measures that would bring this about. Instead,
in complete contrast to Greece’s politicians, the President of France,
Francois Hollande, in his successful 2012 election campaign, proposed
to reduce the retirement age from 62 to 60 for some workers, to raise the
minimum wage, and to increase the number of teachers by 60,000. For
this reason, it is claimed that that the real risk for the euro area is not
Greece but France.5 Greece is trying to mend its ways; France is not.
More worryingly, perhaps it does not even recognise the need to do so.
Austerity and social unrest
The main plank for the economic restructuring of the indebted coun-
tries in Europe has been austerity where “austerity measures” have taken
the form of (Callan et al., 2011):6
1. reductions in cash benefits and pensions

2. increases in direct taxes and other contributions
3. increases in indirect taxes
4. reductions in public services
5. reductions in the expenditure on public goods
6. cuts in public-sector pay
7. cuts in public-sector employment
In the 12 months between May 2010 and the end of April 2011, Greece,
inter alia, reduced social welfare spending by 9.6% (€3.4 billion);
reduced health expenditure by 30%; raised excise taxes by 33% on
fuel, cigarettes, and alcohol; raised VAT by 20%; combated tax evasion
through swingeing fines and increasing the number of audits of self-
employed professionals; cut nominal public-sector wages by 15%; cut
nominal pensions in the private and public-sector by 10%; reduced
public-sector employment by 10% (82,400 persons); and closed 1,976
schools with the loss of 2,000 teaching jobs.7
Since 2008, Ireland has taken €28 billion out of the economy in
spending cuts and tax increases.8 Measures to effect these budgetary cuts
included public-sector workers being required to make an additional
“pay-related deduction” of 7–8% of salary in respect of their pension
(2009 budget); a reduction in public-sector salaries of 5% on the first
€30,000, 7.5% on the next €40,000, and 10% on the next €50,000
(2010 budget); cuts in social welfare payments affecting universal Child
Benefit,9 welfare payment, rates,10 Jobseekers Allowance,11 and the aboli-
tion of the Early Childcare Supplement of €1,100 per year (2008, 2009,
and 2011 budgets).
In its latest set of austerity measures contained in its budget of
November 2013, Portugal decreed that the 600,000 public-sector
employees (about 80% of all public-sector workers) earning more than
675 euros a month would have their salaries reduced by up to 12% and
their monthly pensions in excess of 600 euros reduced by 10%. In addi-
tion, public-sector working hours would be raised from 35 to 40 hours a
week while public-sector holiday entitlement would be brought on par
with the private sector’s entitlement of 22 days per year. These latest
measures came on top of a rise in VAT from 20% to 25% (January 2011),
an increase in income tax rates by 1% to 1.5%, a freezing – between
2009 and 2011 – of the nominal value of the social benefit index which
is the base for most social benefits, a reduction in the amount of family
benefit, and a tightening of the eligibility conditions for such a benefit.
Because of this raft of measures, a concomitant of austerity has
been hardship with pensions being reduced, salaries of public-sector
employees being cut, and unemployment – in particular, youth unem-
ployment – reaching stellar heights. Even the IMF recognises the scale of
austerity-induced hardship, particularly in Greece. As Poul Thomsen, the
Danish official in charge of the IMF programme in Greece and Portugal
acknowledged: “While Greece will have to continue to reduce its fiscal
deficits, we want to ensure – considering that social tolerance and political
support have their limitations – that we strike the right balance between
fiscal consolidation and reform [needed to modernise the economy]”.12
The most visibly disturbing effect of austerity measures has been the rise
of social unrest, principally, though not exclusively, in Greece.
In a latter day reprise of Agamemnon having to sacrifice his daughter

before the becalmed Achaean fleet could set sail from Aulis, the troika
requires the Greek government to extinguish the hopes of a generation
of its citizens before the wind can blow into its economy’s sails. The
latest casualty was on 5 April 2012, when a retired pharmacist, Dimitris
Christoulas, killed himself in Athens. It was an extreme response to the
disproportionate burden borne by middle- and lower-middle-class Greeks
of the stringent tax increases and the pay and pension cuts imposed upon
the population. This was the latest manifestation of violence, which
began on 5 May 2010, against the troika-imposed budgetary cuts. Three
people were killed in the initial protest, which ignited a series of further
protests (25 May and 29 June 2011), all of which fanned the flames of
anti-troika and anti-government sentiment among the populace.
The Indignants movement in Spain was a series of protests in which
an estimated 7 million Spaniards participated to protest against welfare
cuts and rising unemployment. Most recently, baton-wielding riot
police charged and arrested several demonstrators on 20 February 2012
at a student protest against spending cuts in Valencia. In Portugal, seven
persons were wounded on 24 November 2011, in a general strike in
Portugal which was only its second since it regained democracy in 1974.
Recently, the number of anti-austerity activists has been swelled by the
forconi (‘pitchfork’) movement in Italy, which led to protestors clashing
with police in Rome, Turin, and Venice in December 2013.
The social unrest engendered by austerity raises the very real ques-
tion about the legitimacy of government – if governments act according
to external instruction, in opposition to the wishes of their people, then
governmental legitimacy is severely undermined. No taxation without
representation is a fundamental principle of political life and its violation
often leads to the overthrow of offending governments. The hated salt tax
of 1930 imposed by the British government in India triggered a campaign
of national resistance and spawned a wider civil disobedience movement
which culminated in Indian independence. A similar situation looks likely
to arise in Greece when “political disobedience” by the Greek electorate
could see them elect a raft of anti-austerity parties thus making implemen-
tation of the troika’s austerity package all but impossible. When, and if,
that time arrives, the Greek government may reign over the country but
social unrest will ensure that it will not rule over its people.
The point is not that austerity, or a wider programme of economic
reform, in Greece (or in other countries) is undesirable. What is undesir-
able is that it is imposed with breathless haste, by a ham-fisted govern-
ment, and a tin-eared EC. In effect, the people of Greece (and the
other bail out countries) are being punished for the wrong doings of
others. West Germany’s attitude towards its eastern part after German
(re)unification in 1990 provides a contrast to German attitudes towards
Greece. At the time of unification, East Germany was a poor, unpro-
ductive country in which a malign state played a disproportionate part
in the economic, social, and, indeed, personal lives of its citizens. But
rather than suggesting that this was somehow the fault of the people,
West Germany, quite rightly, diagnosed East German frailty as being
the consequence of a failure of its political and economic system. The
solution, again quite rightly, was not to starve East Germany into good
health but rather to build its strength through massive investment
in that neglected part of the country. The funding of this investment
resulted in repeated breaches by Germany of the SGP fiscal guidelines
but nobody at the time thought of penalising Germany or accusing it of
fiscal profligacy.
In the midst of the social unrest that characterises countries affected
by austerity measures, Ireland remains a singular exception. Apart from
a few protests by pensioners and students, the Irish have been remark-
ably stoical in the face of salary cuts, pension levies, and higher taxes. Of
course, one reason for this is that Ireland is a richer country than either
Greece or Portugal and so although its GDP shrank by 3.5% in 2008,
and by a further 7.6% in 2009, the fall was from a comparatively high
level of income. This has spared Ireland the levels of absolute depriva-
tion currently being experienced in Greece after six consecutive years of
recession since 2008.13
However, another reason may lie in twin traits of the Irish personality:
an inordinate desire to be liked and to be thought of well by one’s peers
and a stoical passivity in the face of adversity. In response to Ireland being
described as the “role model” for other bail out countries, Fintan O’Toole,
writing in the Irish Times, said that the reality is that “they [Irish politicians]
are engaged in utter humiliation. They are reduced to operating Home
Rule with the added twist that it is under Frankfurt, not Westminster.”14
In much of the discussion about the countries that needed bailing out,
Ireland has sought to distance itself (the good European) from Greece
(the bad European): “Ireland is not Greece”, as Ireland’s Finance Minister,
Michael Noonan announced in October 2011.
The stoical personality was earlier evident during the child abuse
scandal which resulted in two damning reports, the second of which
(The Commission of Investigation (2009) report, popularly known as
the “Murphy report”) concluded that “the Dublin Archdiocese’s preoc-
cupations in dealing with cases of child sexual abuse, at least until the
mid 1990s, were the maintenance of secrecy, the avoidance of scandal,

the protection of the reputation of the Church, and the preservation
of its assets. All other considerations, including the welfare of chil-
dren and justice for victims, were subordinated to these priorities.”15
Notwithstanding the evidence contained in the Ryan and the Murphy
reports, there was very little public anger displayed in Ireland against
the Church and clergy.
However, the first sign that even Irish patience with the unending
demands for belt-tightening might be wearing thin is provided by signs
that a tax revolt might be brewing over the property tax of €100 that
each Irish homeowner has to pay before 31 March 2012. By the due date,
85% of homeowners had yet to pay the tax. The organisers of the tax
boycott – going under the collective title Campaign Against Household
and Water Taxes – claim the household tax was simply the last straw
coming, as it did, after a litany of high unemployment, negative equity,
rising debt, and higher charges for fewer public services. As with Greece,
what is ominous for the mainstream political parties is that the protest
is supported by the middle-classes and the middle-aged who, even a year
ago, would have voted for the established political order.16
Austerity, growth, and hardship
Chapter 4 established a relationship between the primary balance and

the growth rate needed to achieve a particular level of fiscal sustainability.
This was expressed diagrammatically in Figure 4.5. One can, without too
much distortion, identify the size of the primary surplus (P) with the
degree of austerity (α) so that larger the primary surplus, P, the greater
the degree of austerity, α. Furthermore, there is a well-established litera-
ture, harking back to Keynes’ General Theory of Employment Interest and
Money, and more recently reprised in the context of the present recession
by Blyth (2013) and Krugman (2012a), expressing the view that austerity
and growth are not independent. Rather, in an echo of Keynes’ famous
dictum of “saving being a private virtue but a public vice”, austerity,
by shrivelling employment, income and, thereby, demand, will damage
the prospects for growth. In other words, if α represents the degree of
austerity and g represents the growth rate, then g depends upon (or is a
function of) α so that as α (the degree of austerity) rises, g (the growth
rate falls). Or, in terms of algebra:
dg
g = f (α ), Where <0 (5.1)
dα
Chapter 4 provided a way of calculating the various austerity-growth

combinations that will yield a particular level of fiscal sustainability
(meaning that the debt-to-GDP ratio will be held constant at a particular
value). Suppose that fiscal sustainability requires the debt-to-GDP ratio
to be held constant at the value, θ . Then the various α-g combinations
that will yield θ can be expressed as:
dg
θ = h(α , g ) Where <0 (5.2)
dα
We define a hardship function, which says that the level of hardship,

H, rises with the degree of austerity and falls with the rate of growth.
The combinations of austerity and growth that yield a constant level of
−
hardship, H, are defined by the equation:
dg
H = k(α , g ) Where >0 (5.3)
dα
Figure 5.1 is a diagrammatic representation of these three relationships.

The line SS in Figure 5.1 represents the locus of α–g combinations – from
equation (5.2) – that will yield fiscal sustainability for a given debt-GDP
ratio, θ; the further SS is away from the origin, the lower the debt-GDP
Fiscal sustainability function

showing α –g combinations that will
result in stable debt-GDP ratio H
S
G Hardship function showing α –g
combinations that yield
A
constant amount of hardship
α : austerity
High Low
austerity/low austerity/high
growth growth
equilibrium B equilibrium
G
Growth as a function of austerity S

H
g: growth rate
Figure 5.1 Austerity, fiscal sustainability, and hardship

Note: The convex shape of GG implies that increasing austerity requires greater growth
sacrifices.
Source: Author.
ratio at which fiscal sustainability is achieved. The line HH represents

the locus of α–g combinations – from equation (5.3) – that will yield a
given level of hardship, H; HH slopes upwards representing the fact that
tightening austerity (higher α) increases hardship while higher growth
(higher g) reduces it. The further up is the HH line, the greater the level
of hardship. We may think of H as the ‘threshold’ level of hardship such
that hardship levels greater than H lead to social unrest. Lastly, the curve
GG represents the relation between austerity and growth – from equa-
tion (5.1) – such that the more severe is austerity, the lower will be the
growth rate. The curve is drawn as convex to the origin signifying that
as the degree of austerity is tightened, the additional sacrifice in terms
of foregone growth increases.
The α–g combination on SS that ensures fiscal sustainability has to be
chosen subject to the constraint that it is feasible in the sense of being
located on the GG curve. As Figure 5.1 shows, there are, therefore two
points of equilibrium: A, representing high austerity/low-growth equi-
librium and B, representing low austerity/high-growth equilibrium. The
point A, however, yields a level of hardship which exceeds the threshold
level, H, and, so, leads to social unrest: fiscal sustainability is bought at
the price of anti-austerity protest. The point B, however, yields a level of
hardship that falls short of the threshold level, H, and, so, fiscal sustain-
ability is achieved without social unrest.
H
Gʹ
S
Sʹ G
α : austerity
A Gʹ
S
H Sʹ
g: growth rate
Figure 5.2 Growth-enhancing reforms

Note: The convex shape of GG implies that increasing austerity requires greater growth
sacrifices.
Source: Author.
If fiscal sustainability is to be achieved without social unrest then

either there should be growth-enhancing reforms or the fiscal sustaina-
bility target should be less ambitious. Figure 5.2 illustrates this. Growth-
enhancing reforms shift the GG curve outwards to G'G': a given degree
of austerity will, because of these reforms, be consistent with a higher
growth rate. The point B represents a feasible α–g combination that
will yield the desired level of fiscal sustainability without social unrest.
Without growth-enhancing reforms, the fiscal sustainability target would
need to be scaled back if sustainability is to be achieved without social
unrest. The SS line shifts inwards till S'S' when it is tangential to the GG
curve on the HH line. The point A represents a feasible α–g combination
that yields a lower level of fiscal sustainability than originally planned,
and without social unrest.
The forgoing analysis begged the question of what was the nature of
the “hardship” engendered by austerity. The next two sections of this
chapter address this question.
Austerity and hardship: health
In discussing the effects of austerity on hardship it is difficult to distin-

guish between the hardship engendered by the recession, which trig-
gered the austerity measures, and that due to the austerity measures
themselves. Research on health places considerable emphasis on the
effects on health outcomes of social and economic inequalities. “Health
inequalities” arise because material and social deprivation result in
poor persons having higher mortality rates and worse morbidity rates
than those who are affluent. Indeed, as Marmot (2010) observes, “the
link between social conditions and health is not a footnote to the
‘real’ concerns with health – health care and unhealthy behaviours – it
should become the main focus.” So, an important route to ensuring
better health for the population is to give more people the life chances
currently enjoyed by the few. For example, as Marmot (2010) points
out, if everyone in England had the same death rates as the most advan-
taged, the total those dying prematurely because of health inequali-
ties would, instead, enjoy between 1.3 and 2.5 million extra years of
life and, in addition, have a further 2.8 million years free of long-term
illness and disability. Because of health inequalities, the UK govern-
ment loses £31–£33 billion in lost output and £20–£32 billion in lower
taxes and higher welfare payments, and the National Health Service has
to pay in excess of £5.5 billion to cope with the consequences of health
inequality.
If improved life chances lead to improved health outcomes, an

economic downturn, by throttling people’s life chances, adversely
affects the health of affected persons by its impact on the social deter-
minants of health – employment, income, and housing. In turn, these
effects can be alleviated by governments following expansionary poli-
cies to counter the economic downturn; or, as is happening in several
European countries today, they might be exacerbated by governments’
contracting the economy by cutting expenditure and raising taxes and,
thereby, attenuating the effects of the downturn. Many of the adverse
health outcomes seen in Europe today could be attributed in part to the
nature of austerity policies.17
The most extreme of these health outcomes is suicide. Several studies
have shown that there are more suicides when the economy is shrinking
than when it is expanding. Chang et al. (2009) showed that suicide
rates in a selection of South-East Asian countries rose by almost 45%
following the Asian financial crisis, while Luo et al. (2011) showed that
between 1928 and 2007 the suicide rate in the USA rose in recessions
and fell during periods of economic expansion. Stuckler et al. (2011)
in a study encompassing 26 EU countries showed that rapid and large
rises in unemployment were associated with a rise in suicides among
working age men and women but that this effect was ameliorated
when investments in active labour market programmes were high.18 In
a subsequent study, Stuckler et al. (2011) analysed mortality rate data
by age group and cause of death using the World Health Organization
(WHO) European Health for All database and matched this with adult
unemployment trends from Eurostat. Their analysis for 10 countries of
the EU – six countries from pre-2004, and four from post-2004 – showed
that the steady decline in suicide rates in both groups of countries till
2007 was reversed as soon as the recession hit in 2008 – the increase was
1% in the new (that is, post-2004) Member States but it was 8% in the
old (that is, pre-2004) Member States.19
In the wake of the present European recession – during which
economic prospects were turned on their head in the space of a few
weeks – the number of suicides in Greece and Ireland rose by, respec-
tively, 24% and 16% between 2007 and 2009. The National Suicide
Research Foundation in Ireland, which looked at 190 cases of suicide
in Cork City and County between September 2008 and March 2011,
found that these were predominantly men, almost 40% of whom
were unemployed and 32% of whom had worked in construction.20 A
suicide helpline in Greece, which used to receive 10 calls a day in 2007,
fielded over 100 daily calls in 2012 with three out of four callers citing
economic worries as the reason for their despair.21 Before the financial
crisis began to bite in 2008, Greece had the lowest suicide rate in Europe
at 2.8 per 100,000 inhabitants; in 2011 now it had almost doubled that
number despite the stigma attached to suicide in a country where the
Orthodox Church refuses funeral rights to those who take their lives.22
Among the countries studied by Stuckler et al. (2011), only Austria had
fewer suicides in 2009 compared to 2007. In each of the other coun-
tries, the increase was at least 5%. Moreover, countries that were the
worst affected by the recession had the largest increases in the number
of suicides: Greece, Ireland, and Latvia.
Underlying the issue of suicide is the broader question of mental health.
As Bloomer et al. (2012) point out, “economic crisis increases the risk
factors for poor mental health, such as low household income, debt and
financial difficulties, housing payment problems, poverty, unemployment
and job insecurity”. Davalso and French (2011), using data from the USA,
show that unemployment worsens a person’s Health-Related Quality of
Life (HRQL) and that mental health decreases more than physical health
during tough economic times. Bambra (2010) argues that there are at
least two crucial differences between unemployment in past recessions
and unemployment in the recent recession: the reduction of the amount
of unemployment benefit has made the safety net more fragile and recipi-
ents who receive such benefits are stigmatised as “work-shy scroungers”.
As a consequence, the well-established relationships between unemploy-
ment and the risk of poor mental health, and between unemployment
and health-risky behaviour (like smoking, drinking, and drugs), have
been attenuated in the present economic climate. Stuckler et al. (2011)
emphasised the speed at which unemployment rose in the current crisis:
a slow, steady rise in joblessness was not nearly as damaging as joblessness
that emerged, as it were, out of the blue.
A unique characteristic of the present recession in Ireland, the USA,
and the UK is that its origins lie in the collapse of the housing market.
During the housing boom, which preceded the collapse, it became easier
for households to borrow more, both as a proportion of the value of the
house and as a multiple of their own income. Consequently, when the
housing bubble burst, it caused many households difficulty keeping up
with mortgage repayments on houses, bought when prices were high, with
income that the recession had shrunk through unemployment and wage
reductions. Foote et al. (2008) identified two factors that affected mortgage
default: a fall in house prices and a rise in unemployment. The existence of
both in Ireland has meant that mortgage default and home repossessions
became the reality of life. In many cases these difficulties have culminated
in homes being repossessed. So, in the present economic crisis, to the risk
of losing one’s job must be added the risk of losing one’s home.
There is a well-established literature on the role of the urban environ-
ment, and in particular housing, in determining psychological health
and mental stress. Taylor et al. (2007) examined the psychological costs
of unsustainable housing commitments – payment problems and rent
and mortgage arrears – using data from the British Household Panel
Survey. Their conclusion was that for male heads of households, both
arrears and payment problems had significant psychological costs but
that the costs associated with arrears were considerably greater than
those associated with payment problems. Indeed, the psychological
costs associated with arrears were equivalent in terms of magnitude with
those associated with unemployment or marital break-up.
Indeed, problems associated with housing are not unrelated to marital
unhappiness. One effect of falling house prices is on marital separation:
the numbers of people in Ireland who were seeking a legal separation
through the courts in 2010 was 19% less than in 2008, and lower than
any year since 2002. On one interpretation, negative equity prevents
unhappy spouses from dissolving their marriage because they can’t
afford a second home. If one adds to this the legal fees of €40,000 for a
legal separation, then a number of spouses who, a few years ago, would
have terminated their marriages are today trapped in unhappy relation-
ships that they cannot afford to leave.23
Recessions are characterised by high unemployment and also by
growing job-insecurity among many who continue to be employed.
Meltzer et al. (2010) examined the psychological costs of job insecurity
on the basis of a sample of 2,500 British households. Each respondent
was asked to rate the extent to which they agreed or disagreed with
the statement “My job security is poor” on a four-point scale, and
depression was identified in terms of six categories of “common
mental disorders”: generalised anxiety, depression, obsessive-com-
pulsive disorder, phobia, panic, and mixed anxiety depression. The
conclusion was that, after controlling for personal characteristics (age
and sex), economic factors (personal debt), and work characteristics
(type of work and level of responsibility), there was a strong associa-
tion between feelings of job-insecurity and depression. It is entirely
appropriate that society should be concerned about the distress of
people who lose their jobs in a recession; but, in addition, society
should also pay heed to the distress of workers faced with the prospect
of uncertain employment.
Austerity and hardship: youth unemployment and

migration
Following the definition adopted by the Labour Force Survey, a person

is defined as being unemployed if he/she is: between 15 and 74 years of
age; without work during the reference week of the survey; available to
start work within the next two weeks; and actively sought employment
at some time during the previous four weeks. The unemployment rate is
the number of unemployed persons (based on the above definition) as
a proportion of the number of persons who are economically active.24
The youth unemployment rate is the number of persons aged from 15
to 24 years who are unemployed (based on the above definition) as a
proportion of the number of persons, between the ages of economically
active 15–24 year olds. Table 5.2 shows, for countries of the EU, the
youth unemployment rate, the overall unemployment rate, and, for
2012, the number of unemployed youths expressed as a proportion of
the total number of persons who are unemployed.
The youth unemployment rates in 2012 in the 27 EU (EU-27) coun-
tries and the 17 euro area countries (EMU-17) were, respectively, 22.8%
(up from 15.5% in 2007) and 23% (up from 15.1% in 2007) against their
overall unemployment rates of 10.5% (up from 7.2% in 2007) and 11.4%
(up from 7.6% in 2007). This implied that of the total number of unem-
ployed in the EU-27 and the EMU-17, approximately one in ten was
a “youth” (that is, between the ages of 15 and 24 years). In the EU-17
countries, the highest rates of youth unemployment were in Greece
(55.3% in 2012, up from 22.7% in 2007), Spain (53.2% in 2012, up
from 17.9% in 2007), Portugal (37.7% in 2012, up from 16.4% in 2007),
Ireland (30.4% in 2012, up from 8.9% in 2007), and Cyprus (27.8% in
2012, up from 9.7% in 2007) – that is, in the bail out countries and in a
“near bail out: country, Spain.25 Compared to the overall population, the
number of economically active young persons (that is, in employment
or, if jobless, available for, and actively seeking, employment) is likely
to be small because a significant number of young persons, by virtue of
being in education or training, are not economically active. From the
figures in Table 5.2, one can deduce that, for the EMU-17 countries in
2012, approximately one in 20 (5%) of those who were economically
active were between the ages of 15 and 24.26
An area of concern about rising youth unemployment is the amount
of time young persons have to wait before they find a job. Figures from
the International Labour Organization (ILO) show that in 2011 (the
most recent figures are available), the proportion of unemployed young
Table 5.2 Unemployment rates in the European Union: 2010, 2011, and 2012
Youth unemploy-
Youth unemployment rate: Overall unemployment rate: ment as share in total
15–24 years of age 15–74 years of age unemployment
2010 2011 2012 2010 2011 2012 2012
European Union (27 countries) 21.1 21.4 22.8 9.7 9.7 10.5 9.7
Euro area (17 countries) 20.9 20.8 23.0 10.1 10.2 11.4 9.6
Austria 8.8 8.3 8.7 4.4 4.2 4.3 5.2
Belgium 22.4 18.7 19.8 8.3 7.2 7.6 6.2
Bulgaria 21.8 25.0 28.1 10.3 11.3 12.3 8.5
Czech Republic 18.3 18.1 19.5 7.3 6.7 7.0 6.1
Cyprus 16.6 22.4 27.8 6.3 7.9 11.9 10.8
Denmark 14.0 14.2 14.1 7.5 7.6 7.5 9.1
Estonia 32.9 22.3 20.9 16.9 12.5 10.2 8.7
Finland 21.4 20.1 19.0 8.4 7.8 7.7 9.8
France 23.6 22.8 24.3 9.7 9.6 10.2 9.0
Germany 9.9 8.6 8.1 7.1 5.9 5.5 4.1
Greece 32.9 44.4 55.3 12.6 17.7 24.3 16.1
Hungary 26.6 26.1 28.1 11.2 10.9 10.9 7.3
Ireland 27.6 39.1 30.4 13.9 14.7 14.7 12.3
Italy 27.8 29.1 25.3 8.4 8.4 10.7 10.1
Latvia 37.2 31.0 28.4 19.8 16.2 14.9 11.4
Lithuania 35.3 32.2 26.4 18.0 15.3 13.3 7.7
Luxembourg 15.8 16.4 18.1 4.6 4.8 5.1 5.0
Malta 13.1 13.8 14.2 6.9 6.5 6.4 7.2
Netherlands 8.7 7.6 9.5 4.5 4.4 5.3 6.6
Poland 23.7 25.8 26.5 9.7 9.7 10.1 8.9
Portugal 27.7 30.1 37.7 12.0 12.9 15.9 14.3
Romania 22.1 23.7 22.7 7.3 7.4 7.0 7.0
Slovenia 14.7 15.7 20.6 7.3 8.2 8.9 7.1
Slovakia 33.9 33.5 34.0 14.5 13.6 14.0 10.4
Spain 41.6 46.4 53.2 20.1 21.7 25.0 20.6
Sweden 24.8 22.8 23.7 8.6 7.8 8.0 12.4
United Kingdom 19.6 21.1 21.0 7.8 8.0 7.9 12.4
Source: Eurostat (http://epp.eurostat.ec.europa.eu/statistics_Explained/index.php/Unemployment_statistics).

persons who had been jobless for at least six months was 63.8% in
Ireland, 60.6% in Greece, 46% in Portugal, and 53.2% in Spain.27 Being
jobless for protracted periods – long-term unemployment – has several
adverse consequences. First, there is the “discouraged worker effect”
whereby many young people give up searching for jobs altogether (Bell
and Blanchflower, 2011). Second, long periods of unemployment early
in one’s career are likely to “scar” future prospects by depressing earn-
ings prospects later in life (Kahn, 2010). Indeed, as Bell and Blanchflower
(2011) and Morsy (2012) show, unemployment in one’s early life can
reduce happiness, health, and job satisfaction in one’s later years.
Early unemployment can also depress future employment prospects by
increasing the risk of future unemployment or of unstable employment
(Arumlamplam et al., 2001).
The probability of employment is positively related to the level of
education – or, to put it differently, education offers protection against
the risk of unemployment. The level of education achieved by a person
usually plays an important role in protecting the individual against unem-
ployment: the higher the level of education attained, the lower the prob-
ability of being unemployed. However, as Eurofound (2011) shows, the
degree of protection offered by education has diminished in the present
recession. Comparing the likelihood of being unemployed in 2007 with
that in 2009 shows that the “insurance” effect of education has declined.
Indeed, in some countries, there is little difference in the likelihood of
unemployment between persons who have completed tertiary educa-
tion and those with no qualifications. This is so for some Mediterranean
(Greece, Italy, and Portugal) and East European (Estonia, Lithuania,
Romania, and Slovenia) countries, as well as for Denmark and Finland.
People of all educational levels have been hit by the effects of the recent
recession, and higher education does not necessarily provide a protective
shield (Eurofound, 2011). Indeed, in the United Kingdom (UK), 47% of
those who graduated from tertiary education in 2013, or in the five years
preceding it, were working in roles that did not require a degree.28
Notwithstanding the diminished part that education plays in deter-
mining employment chances, a particular anxiety centres on young
people who are not in employment, education, or training, referred to
by the acronym NEET.29 Consequently, a person is a NEET if he/she is
either unemployed (available for a job and actively searching for one)
or inactive (unavailable or not searching).30 As the ILO (2013) observes,
because NEETs were not gaining labour market experience through
employment, or improving their employment prospects through invest-
ment in education or training, they were at risk of being trapped in
long-term unemployment with the attendant scarring effects referred to

above. These risks are aggravated by the fact that NEETs are more likely
to be drawn from already vulnerable groups in terms of disability, low-
income households, parents who have experience of unemployment,
and broken homes. Table 5.3 shows the “NEET rate’” (defined as the
number of NEETs as a proportion of the population 15–24 years of age)
for countries of the EU-27. The alarming finding from Table 5.3 is that,
Table 5.3 NEET rates for selected countries of the European Union, age group
15–24
2007 2010 2011 2012
European Union (27 countries) 10.9 12.8 12.9 13.1

Euro area (17 countries) 10.8 12.7 12.6 13.0
Belgium 11.2 10.9 11.8 12.3
Bulgaria 19.1 21.8 21.8 21.5
Czech Republic 6.9 8.8 8.3 8.9
Denmark 4.3 6.0 6.3 6.6
Germany 8.9 8.3 7.5 7.1
Estonia 8.9 14.5 11.8 12.5
Ireland 10.7 19.2 18.8 18.7
Greece 11.5 14.9 17.4 20.3
Spain 12.2 18.0 18.5 18.8
France 10.3 12.4 12.0 12.2
Croatia 11.3 14.9 15.7 16.7
Italy 16.2 19.1 19.8 21.1
Cyprus 9.0 11.7 14.6 16.0
Latvia 11.8 17.8 16.0 14.9
Lithuania 7.0 13.2 11.8 11.2
Luxembourg 5.7 5.1 4.7 5.9
Hungary 11.3 12.4 13.3 14.7
Malta 11.7 9.5 10.6 11.1
Netherlands 3.5 4.3 3.8 4.3
Austria 7.0 7.1 6.9 6.5
Poland 10.6 10.8 11.5 11.8
Portugal 11.2 11.5 12.7 14.1
Romania 13.3 16.4 17.4 16.8
Slovenia 6.7 7.1 7.1 9.3
Slovakia 12.5 14.1 13.8 13.8
Finland 7.0 9.0 8.4 8.6
Sweden 7.5 7.7 7.5 7.8
United Kingdom 11.9 13.7 14.3 14.0
Note: The NEET rate is the number of NEETs as a proportion of the population 15–24 years
of age.
in the three-year period 2010–2012, the NEET rate has risen steadily in
several countries of the EU so that, in some countries (Bulgaria, Greece,
Ireland, Italy, and Spain), around one in five persons aged 15–24 in 2012
was a NEET.31
Aggravating the worry engendered by young people not being in
employment, or improving their employment prospects through educa-
tion and training, is the further anxiety that many youths in employ-
ment have jobs that are non-standard (for example, work in informal
enterprises, casual day labour, and household work) or are part-time or
temporary. Thus, even those young persons who are in employment hold
jobs of low quality or uncertain duration. As the ILO (2013) observes,
one in four youths in the European Member States that are members of
the Organisation for Economic Co-operation and Development (OECD)
who were in employment in 2011 was working in a part-time job and
40% of young persons were working in temporary jobs. It is common-
place that, in times of economic stringency, firms let go of the newest
hires first. So, a recession raises the unemployment rate of young people
disproportionately to that of older people.32
Coexisting with the fact that 75 million young persons in the world
are unemployed are two further issues. The first is that in nine coun-
tries studied by Mourshed et al. (2012) – Brazil, Germany, India, Mexico,
Morocco, Saudi Arabia, Turkey, the UK, and the USA – only half of the
youths surveyed felt that their post-secondary education improved their
employment prospects. The second is that, in the same countries, 39% of
employers regarded a lack of skills as the primary reason for entry-level
vacancies. If these results are applicable to other countries then they
point to a more general malaise – one reason for youth unemployment
is that the education system is not equipping them with the skills that
employers need; to put it differently, there is a mismatch between the
skills that young jobseekers supply and those that employers demand. By
corollary, a part solution to the problem of youth unemployment would
lie in making the educational system more responsive to the needs of
industry. As Mourshed et al. (2012) point out, although employers need
to work with education providers so that students learn the skills they
need to succeed at work, there is little clarity on which practices and
interventions work and which can be scaled up.33
Another source of mismatch is that, following the post-2007 global
crisis, the large number of job losses was concentrated in a few sectors
so that many young persons who lost their jobs were forced to seek
employment in sectors for which they were ill equipped by virtue of
training. In this scenario what is relevant is not only the dysfunction
between education and employment, but also that some important

skills are sector/occupation-specific and, therefore, not portable between
sectors/occupations. Other forms of mismatch result not in unemploy-
ment but, instead, in people being “underqualified” or “overqualified”
for the jobs that they do. In both cases, skills mismatch affects job satis-
faction, wages, and employee turnover (Quintini, 2011). Consequently,
there may be a variety of sources of skills mismatch, generically defined
as an imbalance between the skills offered and the skills needed in the
world of work. In the light of this diversity, ILO (2013) offers a useful
typology of skills mismatch:
1. Skill shortage (surplus) meaning that the demand for a particular type
of skill exceeds (falls short of) its supply.
2. Skill gap meaning that the type or level of skills is different from that
required to do the job.
3. Vertical mismatch meaning that the level of education or qualification
is less (or more) than required for the job.
4. Horizontal mismatch meaning that the level of education or qualifica-
tion is inappropriate for the job.
5. Over- (or under-)education meaning that workers have more (or less)
than the years of education required for the job.
6. Over- (or under-)qualification meaning that workers hold a higher (or
lower) qualification than required for the job.
Notwithstanding concern about the role of skills mismatch as a cause

of youth unemployment, there can be little doubt that the main factor
responsible for joblessness among the young (and old) is the low-growth
rates in the countries of Europe, which have caused the number of avail-
able jobs to shrivel. The vast majority of young people will have left
school with far better qualifications than their parents – many of them
don’t need help in developing skills to hold down jobs, they need jobs.34
In response to the poor employment prospects in their own countries,
young people from European countries where youth unemployment is
particularly high have migrated to seek employment in countries that,
by escaping the recession that has blighted Europe’s jobs market, offer
better employment prospects.
In the context of migration, Ireland’s story (well told by Rigney, 2012,
and Allen, 2013) is instructive. In the four years after 2004 – when citi-
zens of the new accession countries (Cyprus, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia) to the
EU could move freely to Ireland, the UK, and Sweden – Ireland received
100,000 immigrants from Poland, Latvia, and Lithuania. More recently,

however, Irish persons have been leaving the country, thus resuming
the pre-Celtic Tiger tradition of Irish emigration. In 2011, 16,310 UK
National Insurance numbers were issued to Irish nationals; in Australia,
the number of temporary Irish residents rose to 20,493 in the first six
months of 2011 – an increase of a third over the previous six months;
Canada issued 3,869 work permits to Irish citizens in the first half of
2011; the United States issued 17,755 non-immigrant visas to Irish citi-
zens in 2011; and, in the second half of 2011, Irish citizens were arriving
in New Zealand at the rate of 400 per month (Rigney, 2012).
In 2011, 2,500 Greeks moved to Australia, 10,000 Portuguese left for
Angola, Spain’s National Statistics Institute estimated that over 40,000
Spaniards emigrated between January and June 2012 (compared with
28,000 in 2011), and Ireland’s Central Statistical Office projected that
50,000 Irish passport holders would have left Ireland by the end of that
year.35,36 Two generations are expected to be lost as a consequence of
Greece’s economic crisis, aggravated by the harsh measures its govern-
ment has been forced to apply in exchange for troika assistance.37 The
impetus for these departures (with Australia a favourite destination) has
been the high unemployment rate in all these countries, which in 2012
were: 24% in Greece, with a 55% youth unemployment rate; 15% in
Ireland, with a 30% youth unemployment rate; 16% in Portugal, with a
38% youth unemployment rate; 25% in Spain, with a 53% youth unem-
ployment rate. As their countries’ shrinking economies shrivelled their
prospects, the young from the peripheral countries of Europe sought
hope for a better future in migration.
Conclusions
Speaking before a business audience in Berlin on 23 November 2013,

the Greek Prime Minister, Antonis Samaras, warned that the pace of
(troika-imposed) economic reforms in Greece meant that Greeks were in
danger of suffering from “reform fatigue”. He described reform as a “step
by step” process that had to proceed with popular support. “If society
fails to reform, it will not survive ... but if it pushes reforms too fast, it
will not be able to sustain them either.” While the troika presses Greece
for further reforms in 2014 – in spite of the Greek government having
converted a primary deficit on its budget account into a surplus – there
is anxiety in Athens that the social tensions engendered by six years
of recession can no longer be contained.38 The first source of anxiety
is political: the left-wing opposition Syrizia Party, which is against the
reforms and believes that Greece will not be asked to leave the euro if
proves recalcitrant in refusing further reform, consistently polls as the
most popular party in Greece; this, combined with the fact that the
junior partner in the coalition, Pasok, is the least popular of the major
parties, means that the tenure of the coalition government, with its
current parliamentary majority of just four seats, is very insecure. The
second is a general perception among Greek voters that, with a budg-
etary turnaround that is now yielding a primary surplus, Greece has no
need to go cap in hand to the bond market asking for funds. Indeed,
because nearly all of Greek debt is now owned by the troika, markets
have all but lost interest in Greece.39
In Portugal, there is a deep rift in the ruling coalition over how much
austerity the country can bear. This has plunged the country into a polit-
ical crisis. At the heart of the rift was disagreement between the coalition
partners (the centre-right Social Democrats and the conservative Popular
Party) over the political and social costs of austerity.40 As in Greece, the
centre-left opposition party is ahead in the polls with the popularity
of the conservative partner in the ruling coalition collapsing. Further
complicating Portugal’s ability to impose further austerity measures on
its population is the attitude of it judiciary. In April 2013, Portugal’s
highest constitutional court struck down four of nine measures that the
government had introduced in its 2013 budget. This rejection included
€1.4 billion of the proposed €5 billion austerity package. This raises the
question of how much further austerity Portugal is prepared to tolerate,
not just by its citizens but also by its courts.41
In contrast to Greece and Portugal, where there was no defining event
precipitating the crisis in their economies, Ireland’s woes originated from
a clearly identifiable event. This was the Fianna Fáil government’s deci-
sion, made on 30 September 2008, to guarantee the debts of Irish banks
which meant that every person in Ireland became instantly liable for
€14,000 each in order to bail out its banks. As Allen (2013) writes, “the
decision to guarantee private debts was the greatest calamity that ever
befell the Irish people” – at a stroke, it converted private debt, gener-
ated by the misjudgement of private investors, into debt that ordinary
citizens, through no fault of their own, were forced to repay through
increased taxes and reduced public services.
Such an egregious decision was not unavoidable. As the experience of
Iceland shows, it is perfectly possible for a small country to resist pressure
from larger countries and avoid taking on the debts of its own banking
sector. Iceland’s banks went on a disastrous lending spree, culminating
in the collapse of Landsbanki in October 2008, and from this wreckage
only three domestic banks have emerged. Meanwhile, on one hand,

international bondholders and deposit holders have been left without
compensation but, on the other hand, Iceland escaped the burden of
publicly owned debt that Ireland so readily assumed.
Indeed, Iceland has another lesson to teach Ireland: the present
Icelandic government, headed by Prime Minister Gunnlaugsson, is not
bound by decisions made by the previous government. Iceland’s previous
government had negotiated terms under which it would repay British
and Dutch savers who had lost their savings, but the new government
of Sigmundur Gunnlaugsson, elected in April 2013, rejected these deals
comparing them to the reparations sought from Germany in the Treaty
of Versailles.42 Yet, in the April 2011 general election, when Irish voters
decisively rejected the Fianna Fáil government that had brought their
troubles upon them, the incoming Fine Gael/Labour coalition reneged
on their electoral anti-banker rhetoric and decided, instead, to honour
the outgoing government’s commitments.
As a consequence of all these reforms, the troika (comprising the EC,
the ECB, and the IMF) has pushed the bailout countries – Greece, Ireland,
and Portugal – too far and too fast. In Greece, the worst affected country,
a new underclass has emerged, and the sight of people sleeping on pave-
ments, park benches, in metro stations and shopping arcades, doorways
and cars, has lost its novelty. Educated professionals shamefacedly stand
in line with immigrants from developing countries waiting for food
handouts from town halls.43 In Ireland, large numbers of households are
unable to pay for the roof over their heads: the Central Bank of Ireland’s
figures showed that, at the end of 2012, nearly a 100,000 households
had been in arrears for over 90 days with over half of Irish mortgages in
negative equity (Allen, 2013).
Along with “reform fatigue” there is also the prospect of “compas-
sion fatigue”. This term, which was first used to describe a decline in
compassionate feelings by “helping professionals” towards their patients
or clients, is, today, also used to describe a decline in public concern
towards social problems (Kinnick et al., 1996). With a few exceptions,
media reporting of the austerity-induced problems that people face in
the bail out countries has almost disappeared. There is general disap-
proval about dissent and protest and Ireland44 and the Guardian news-
paper is a rarity in its coverage of Greek hardship.45
This decline is associated with a failure to empathise with the prob-
lems of others. Baron-Cohen (2011) defines “empathy” as “our ability
to identify with what someone else is thinking or feeling, and to
respond to their thoughts and feelings with an appropriate emotion”.
Empathy, therefore, requires two things: recognition and response. A

lack of empathy, stemming from either a failure to recognise or a failure
to respond, is associated with autism and Asperger syndrome (Baron-
Cohen, 2011). In its failure to empathise with the scale of hardship
experienced by large swathes of the population in the bail out countries,
the troika displays all the symptoms of autism – so focused on the task at
hand, namely reducing public debt, that it is blind to all else. As Giorgos
Apostolopoulos, who heads Athens’ municipal homeless shelter, wrote
in a letter to the then Prime Minister, Lucas Papademos: “homelessness
and even hunger – phenomena seen during the Second World War –
have reached nightmare proportions. The medicine we are taking has
proved fatal for the nation.”46 To which the troika’s response might well
be: Rest in Peace.
6
Conclusion
On 15 April 1912, just over 100 years ago, high in the crow’s nest of the
SS Titanic, on a calm North Atlantic sea, two lookouts suddenly sighted
an iceberg. Within 37 seconds of that sighting the ship’s hull scraped
the ice with a “faint grinding jar” and the Titanic’s fate was sealed. It
sank two hours and 40 minutes later with the loss of 1,500 lives. A
nonchalant calm pervaded the ship in its final hours: there were no
bells or sirens, many passengers spurned the “dangerous” little lifeboats
(of which there was a great, and deliberate, scarcity) in favour of the
“safety” of the large (though holed) ship. The band, more aware of the
prospect of impending death, played Nearer My God to Thee as the ship
slowly, but surely, foundered.
Several themes have emerged from the sinking of the Titanic. First,
there was the issue of hubris as the captain of the Titanic, E.J. Smith
(allegedly acting under pressure from the ship’s owners), ordered a
cruising speed that, in the context of the ice warnings he had received,
was unsafe.1 Second, there was the issue of class and money: the rich
had easy access to the Titanic’s lifeboats while the poor struggled to find
their way to the upper decks where these lifeboats were located. Third,
there was the issue of neglect as the SS Californian, which was only
eight miles away, disregarded the Titanic’s frantic signals of distress – by
wireless, Morse lamp, and rockets. Fourth, there was the foolishness of
those passengers who clung to the stricken ship rather than taking to
sea in the lifeboats. Lastly, there was the suddenness of the disaster as
the iceberg brought an abrupt halt to the merriment and optimism on
board the Titanic.
The sinking of the Titanic could well serve as a metaphor for the
economic crisis that has gripped countries in the European Monetary
Union (EMU). The euro was the currency that was going to unite the
124
Conclusion 125
diverse countries of Europe and rival the dollar as a world currency but
in an abrupt reversal of fortune, disaster has befallen. Travelling too fast
through the ice field of political diversity, it struck the iceberg of sover-
eign debt and was grievously – if not fatally – holed. The well-off have
taken their money and decamped – witness the flight of capital from
Ireland and Greece – while those in steerage wait, with ever diminishing
hope, to be rescued. Meanwhile, the distress of citizens in Europe’s
peripheral countries is viewed with a cold eye, and appraised with a
stony heart, by its core countries: Germany loiters while Greece sinks. In
the face of this disaster, the reputation of the euro and of the euro area
has been severely compromised. And yet, as the euro sinks, countries
cling to its decks afraid to set sail in their own currencies.
This is partly related to the failure of the officers on the bridge to
communicate with the passengers. For economic policy to succeed it
must be understood and accepted by the general public. Communicating
with people, in a language that they understand, the reasons why things
are as bad as they are, and how they might be improved, is something
the troika, and its agents in the form of the national governments of
the EMU, have failed to do. On the contrary, the harsh language used
towards the population of the periphery has systematically failed to
distinguish between those culpable for the crisis and the general popula-
tion. Consequently, people in the EMU’s peripheral countries are pessi-
mistic about there being light at the end of the tunnel because they
cannot see how the austerity-induced hardship they suffer is an invest-
ment in their future instead of being ... well, just unending hardship.
Nor do they understand why hardship is being imposed at the behest
of persons whose names they do not know, whose faces they do not
recognise, and whom they did not elect to preside over their destiny.
As the Nobel-laureate economist Amartya Sen recently observed: “[for
those] living in a Southern country, in Greece, Portugal, and Spain, the
electorate’s views are much less important than the views of bankers, the
rating agencies, and financial institutions ... with the consequence that
the population of many of these countries has no voice.”2
The hubris embodied in the single currency is reflected in the haste
with which the single currency was implemented.3 In the rush to estab-
lish the euro, admission criteria were relaxed (Belgium and Italy were
admitted notwithstanding their large public debts) and, in the anxiety
to preserve membership, transgressions were overlooked (Germany and
France were unpunished notwithstanding their continued infractions
of the 3% deficit rule). The Titanic too was relaxed about the fact that
it was carrying less than the full complement of lifeboats. That it hit an
iceberg was misfortune (though even that might have been avoided at a
slower speed). That so many lives were lost was carelessness. So too with
the euro. The depredations of Irish bankers and Greek politicians might
have been bad luck; the ensuing devastation was the result of the inflex-
ible system enshrined in the euro.
Under the facade of a single currency, there are at least two euros
in circulation within the EMU: at the risk of caricature, there is the
“German” euro and the “Greek” euro and an indication of rates of
exchange between them is provided by the yields on their respective
country’s government bonds. The fact that Greek (and, indeed, Irish)
euros are fleeing abroad – along with Greeks and the Irish – suggests
that the ordinary public in Europe’s periphery have little faith in their
“country’s euro” vis-à-vis that of Germany’s. Anxiety about the euro has
reached levels where a prize of £250,000 was offered by the think tank,
Policy Exchange, for the best plan to break-up the euro. In practice, as
The Economist newspaper notes, the fate of the euro (like its origins)
will be determined more by politics than economics. Debtors will tire of
austerity; creditors will weary of bail outs; and the Member States may
find the gradual erosion of sovereignty sufficiently offensive to want to
leave.4
That leaves the question of “solutions” to the crisis. How does one
find one’s way through the festering jungle of bursting bubbles, soured
bank loans, overwhelming public debt, and nervous markets to the
sunny uplands of economic growth, rising living standards, and social
harmony. In a possibly apocryphal story, a stranger seeking directions
from an Irish farmer was advised: “If I were you, I wouldn’t start from
here.” In similar vein, if Europe is to find its way it cannot be through
its present location in terms of a single currency – the euro is part of
Europe’s problem, not its solution.
The failure of the single currency does not mean that the greater
“European idea” – which has seen the nation states of Europe coming
together, under the aegis of the European Union (EU), to work on
projects of common benefit – has not been a success. As Judt (2005:
732), in his magisterial history of post-war Europe observed:
And yet, taken all in all, the EU is a good thing. The economic benefits
of the single market have been real, as even the most ardent British
Eurosceptic had come to concede, particularly with the passing of the
passion for “harmonising” that marked the Commission Presidency
of Jacques Delors. The newfound freedom to travel, work, and study
anywhere in the Union was a boon to young people especially. And
Conclusion 127
there was something else ... from the late Eighties, the budgets of the
European Community had a distinctly redistributive quality, transfer-
ring resources from wealthy regions to poorer ones and contributing
to a steady reduction in the aggregate gap between rich and poor:
substituting, in effect, for the nationally based social-democratic
programmes of an earlier generation.
However, as Judt (2005) has argued, the success of the European idea
lay in its imprecision. When the idea of a “European union” was aired
by the French President, Georges Pompidou, in the 1970s, the French
Foreign Minister, Michel Jobert, asked his colleague Edouard Balladur
(the future French prime minister) what exactly it meant: “Nothing”,
replied Balladur, “but, then, that is the beauty of it”.5 Underpinned by a
vague desire for “peace” and “prosperity”, the European Union was too
benign to attract controversy. Yet, under the cover of formulaic vague-
ness, it ushered in a system of governance among the countries of the
European Union that was (and is) remarkable in two respects: first, laws
were made at supranational level but implemented by national govern-
ments; second, because ultimate sovereignty rested with nation states
everything was done by reaching agreement through compromise. Or,
as Judt (2005) described it succinctly, the European Union represents
“international governance undertaken by national governments”.
In pursuit of the European idea, the imposition of a single currency
was, however, a step too far.
1. It replaced the imprecision of the European Union with a precise set

of rules for implementing the common currency – and almost imme-
diately eroded respect for these rules by exempting Germany and
France, who consistently broke these rules between 2003 and 2005,
from the prescribed financial penalties.
2. By compelling a group of countries, who were at disparate levels of
development and at different points in the economic cycle, to accept
a “one size fits all” exchange rate and interest rate, the adoption of
the single currency placed the entire burden of national economic
policy on fiscal policy. Before the current recession, some coun-
tries like Ireland were booming and could have done with higher
interest rates to choke demand while other low-growth countries like
Portugal needed low interest rates to stimulate demand. Instead they
all got a single, European Central Bank (ECB)-determined interest
rate and a single exchange rate determined by the euro area’s (in its
entirety) foreign trade performance. Because one of these countries
was Germany, the euro rate was inevitably uncompetitive for less
successful countries.
3. Placing the burden of adjustment on fiscal policy meant that a country
could only improve its competitive position through “internal deval-
uation” – a process of economic contraction, implemented through
tax hikes and cuts in public expenditure, to raise unemployment and
lower wages and prices.
4. At the same time, by restricting the scale of national budgetary defi-
cits through the Growth and Stability Pact (GSP), the scope for expan-
sionary fiscal policy was severely restricted – countries that ought to
have been spending their way out of recession were obliged by the
terms of the GSP to restrict their public expenditure.
5. When countries were running large current account deficits the
single currency did not offer the early warnings that a system of sepa-
rate currencies would have automatically provided: declining foreign
reserves and a weakening currency. Instead, bilateral transactions
between deficit and surplus countries in the euro area were replaced
by a trilateral system in which the deficit and the surplus country
transacted separately with the ECB, running up debits and credits on
the ECB’s slate without any real economic consequences. As has been
argued in the previous chapters, the crisis – which had its origins
in private-sector overspending – was only identified when it mutated
into a sovereign debt crisis as governments (spectacularly) breached the
terms of the GSP through being forced – by the terms of the ECB rules
which demanded it lend to governments and not directly to private
agents – to underwrite private-sector (that is, banking) debts.
6. The web of interdependency created by the single currency meant
that the failure of a Member State to meet its debt obligations would
pose systemic risks by creating problems for the EMU in its entirety
and, therefore, that the market assumption was that no country would
be allowed to fail. Consequently, smaller countries within the EMU
enjoyed an ease of access to bond markets they could never have imag-
ined earlier with their national currencies and some of them, Greece
in particular, took advantage of this by irresponsibly expanding debt-
financed public expenditure.
7. In order to meet the increased demand for expenditure by the private-
sector, banks within the EMU vastly expanded their lending by issuing
short-term bonds to fund long-term loans. Investors were prepared to
buy these bonds because they assumed that the sovereign debt that
banks held as assets would, under ECB rules, give them easy access to
ECB funds in the event of mishap. Banks, too, believed they would
Conclusion 129
be bailed out by the ECB if their investments soured and this made
them careless about evaluating the quality of their investments. The
upshot of this was that the operation of the single currency created a
moral hazard regime in which lenders and borrowers had strong incen-
tives to act without taking “due care and diligence”.
All these points raise the question of whether establishing a single

currency for Europe was a good idea? The most obvious benefit of the
euro is that within the euro area businesses can trade in a single currency
and, thereby, eliminate exchange rate risks and currency conversion
costs. The European Commission (EC) estimates these conversion costs
at €20–€25 billion per year (or 0.4%–0.5% of gross domestic product
(GDP)).6 Because the size of these costs depends as much upon exces-
sive bank commissions as upon the existence of national currencies, an
effective way to reduce these costs would be to cap these commissions.
However, the idea that a single market needs a single currency is
specious: the North American Free Trade Agreement (NAFTA) area func-
tions perfectly well with three national currencies. But, the idea of
establishing a single currency without adequate preparation was a bad
idea. As Feldstein (2012) observed: “this failure [of the euro] was not an
accident, or the result of bureaucratic mismanagement, but rather the
inevitable consequence of imposing a single currency on a very heter-
ogeneous group of countries.” However, discussion of the euro area’s
economic problems proceeds as though the single currency is beyond
reproach. Everything and everyone is blamed, from the feckless Irish, to
the profligate Greeks, to the low-productivity Portuguese, to an insuffi-
cient degree of subordination to a higher “European authority” – every-
thing except the black rat that, in the shape of the euro, has inflicted
this plague upon the House of Europe.7 Every conceivable solution is
proposed – austerity, haircuts for bondholders, new treaties, novel forms
of lending, exhortation, entreaty – except the obvious one of recog-
nising that imposing monetary homogeneity on economic diversity is
not the cleverest of ideas.
And yet, there is nothing sacrosanct about a currency union. Tepper
(2012), in an entry for the think tank Policy Exchange’s £250,000 prize
for the best plan to manage a break-up of the euro, points out that in
the past century there have been 69 currency break-ups – inter alia, the
Austro-Hungarian Empire in 1919, India and Pakistan in 1947, Pakistan
and Bangladesh in 1971, Czechoslovakia in 1992–1993, and the USSR in
1992 – and that the move from an old currency to a new currency could
be accomplished quickly and efficiently.8 For countries like Greece,
Ireland, Italy, Portugal, and Spain, exit from the euro followed by
default and devaluation would address the fundamental problem that
the euro has created for their economies: an overvalued exchange rate
that makes it impossible to regain competitiveness without the most
punishing deflation; and a debt burden that is impossible to shake off
without prospects of growth.9 In contrast, after a short, sharp contrac-
tion following default and devaluation, the European periphery could
then grow quickly, much as many emerging regions and countries – Asia
in 1997, Russia in 1998, Argentina in 2002 – have done after defaulting
and devaluing.
If the euro is to be preserved then the way forward is obvious. European
debt should be federalised and its responsibility spread across the coun-
tries of the euro area through the issue of euro bonds. Paul Krugman
(2012c) asks why the United States (USA) does not exhibit the kind of
regional crises afflicting the European Union? The answer is that the
USA has a strong central government that provides automatic bail outs
to states that get into trouble – for example, to Florida after its housing
bubble burst. These bail outs do not evoke carping comment in the
media and do not arouse resentment in states that are not in trouble. If
that were only so in Europe! Germany presents an insuperable difficulty:
as long as Germany, which will be the main guarantor of euro debt, plays
the bridegroom who is willing to marry but not to share the marital bed,
such a solution is well-nigh impossible. At the latest European summit
held in Rome on 22 June 2012, the German Chancellor, Angela Merkel,
gave little indication of heeding calls from France, Italy, and Spain for
pooling the region’s debt or using European bail-out funds to prop up
the government bonds of Spain and Italy.
The federalisation of euro debt, if it could be achieved, should simul-
taneously be combined with a strategy for growth, which will include
structural reforms, investment in infrastructure, and measures to improve
competitiveness. Easier said than done? As Gideon Rachman (2012) has
pointed out, “the past 30 years have seen a huge splurge in infrastruc-
ture spending, often funded by the EU. The Athens metro is excellent.
The AVE fast trains in Spain are a marvel. But this kind of spending has
done very little to change the fundamental problems that plague Greece
and Spain – in particular high youth unemployment.”
At the same time, while the scope for structural reforms in several
European countries is enormous the barriers to implementing such
reforms are no less formidable. The Croke Park Agreement in 2010
between the Irish government and the country’s public-sector unions
was supposed to make the delivery of public services in Ireland more
Conclusion 131
efficient. In return for assurances provided by the government (inter

alia, no further reductions in pay rates other than those applied in
2009 and 2010 and no compulsory redundancies), public servants and
their managers undertook to bring about changes in work practices
so that both the cost and the number of people working in the public
service could fall significantly without diluting the quality of services
provided.10 However, two years after its inception, a confidential review
of the Agreement by the Department of Finance has cast great doubt
on its viability because managers are resisting reform for “fear of being
accused of bullying”. This prompted the Minister for Public Expenditure
and Reform, Brendan Howlin, to admit that “managers haven’t
embraced the reform as enthusiastically as I would have liked”,11 which
was followed by a warning from the Transport Minister, Leo Varadkar,
that any future renegotiation of the Agreement was likely to include
compulsory redundancies.12
So, even though Ireland, by wearing the austerity hair shirt without
complaint, is the poster child of the troika, its prospects for growth are
poor. As The Economist (2013b) put it:
What is painfully clear, for the all optimism and brave faces Ireland’s
political and economic elites have put on, the Celtic Tiger boom has
drawn to a close. Ireland’s banking crisis saw to that during the finan-
cial crisis, and its consequences continue to act as a drag. The Irish
government could introduce structural reforms to boost the country’s
growth, but its politicians have more often sought to block, rather
than support, such measures. In many ways, Ireland deserves much
better. But with very little in terms of political will to force through
such reforms on the horizon, it will be many years until Irish eyes
truly smile once again.
In recent years, two economists advising the Italian government on

labour market reforms have been assassinated. On 20 March 2002,
Marco Biagi, a professor of economics at the University of Modena who
had been helping the centre-right government draft changes to Italy’s
labour laws, was shot dead outside his home in Bologna. His murder was
preceded by that of Massino D’Antona in 1999, another government
aide who had been working on the reform of Italy’s restrictive labour
laws.13 The efforts of Mario Monti, Italy’s erstwhile technocrat prime
minister, to carry out a significant pension overhaul, increase property
and other taxes, and crackdown on tax evasion have been watered down
by Italy’s political parties afraid of alienating their constituents.14
Greece, as McKinsey & Company (2012: 7) report, is “one of the most

regulated economies in Europe creating ‘red tape’ that affects businesses
from the development of land to the competitive intensity of several
regulated markets and professions. A complex administrative and tax
system creates legal, bureaucratic and procedural disincentives to set up
and expand businesses and fails to collect an estimated €15–20 billion
in annual tax revenue which would almost be sufficient to close the
deficit.” It would be a formidable achievement if Greece was to reform
its business-unfriendly environment and its cumbersome legal system,
which comprises a number of laws, of some of them are ambiguous,
obsolete, or even contradictory.
So, if the conditions for preserving the euro are near impossible to
obtain, why was a single currency ever established? As Moravcsik (2012)
has observed, the Maastricht Treaty of 1992, which established the EMU,
was a gamble. The gamble was that the economies of the Member States
would converge and, in so doing, ensure the EMU’s success. However,
this convergence would not be one between equals: it was expected
that other countries would begin to resemble Germany – converging
on German levels of productivity and competitiveness – rather than the
other way round. If this gamble succeeded, Germany stood to gain a
great deal. First, based on the euro, it would obtain an exchange rate that
would be far more competitive than one based on the Deutschmark. This
would cement its position as an exporting power. Second, by demanding
and obtaining the ECB, which embodied the anti-inflationary principles
of the Bundesbank, it would imbue the entire monetary union with its
economic conservatism.
The other set of persons who supported the single currency were those
idealists for whom the “European project” should and would culminate
in a political union and, in so doing, present to the world a “European
identity” and a “European way of life” that would rival, and outshine,
that of the USA.15 If political union within Europe was the holy grail of
European politics then establishing a single currency was to be a signifi-
cant step towards that goal. In that context, it was irrelevant whether the
EMU countries would have been better off with their national curren-
cies. What was important is that joining the single currency would be an
irrevocable step and, for this step to be taken without stumbling, greater
political union was essential. So, if the euro provides the glue that binds
Europeans to each other – happily or unhappily, willingly or unwill-
ingly, in hardship or in prosperity – in an ever-tightening embrace,
then, for those who seek this holy grail, it has served its purpose. But, in
order to maintain essential financial services for citizens and businesses,
Conclusion 133
governments have had to inject public money into banks and issue guar-
antees on an unprecedented scale: between October 2008 and October
2011, the EC approved €4.5 trillion (equivalent to 37% of EU GDP) of
state aid measures to financial institutions.16 With such a price tag, this
must be the most expensive political glue ever invented! One has to ask:
is it worth it?
Notes
1 Introduction
1. http://www.historylearningsite.co.uk/FWWcasualties.htm
2. Ferguson (2010).
3. Lewis (2011).
4. Greece joined on 1 January 2001, Slovenia on 1 January 2007, Cyprus and
Malta on 1 January 2008, Slovakia on 1 January 2009, and Estonia on 1
January 2011. The 18th country, Latvia joined on 1 January 2014.
5. Bulgaria, Czech Republic, Denmark, Hungary, Latvia, Lithuania, Poland,
Romania, Sweden, the UK.
6. Although these rates were supposed to differ between countries, taking
account of their risks of default, this never happened.
7. The UK price level in $ is:
UK wage
× E$£
UK productivity
where E$£ is the exchange rate (the price of a $). So, the growth in the price of
UK-produced products in the USA is:
UK nominal wage growth − UK productivity + % exchange rate change.
8. James Boswell, Life of Johnson (entry for 19 September 1777).
9. On 25 March 2013, Cyprus was offered a €10 billion international bail out by
the troika of the EC, the ECB, and the IMF in return for Cyprus agreeing to
close the country’s second-largest bank (Laiki) and to impose a levy on all
bank deposits larger than €100,000. Cyprus had created a massive offshore
banking industry with €60 billion invested in bank deposits by Russians.
Against this, Cyprus’ GDP was just €19.5 billion.
10. In April 2010, EU officials judged that the Greek deficit was 13.6% of GDP
and not, as estimated by the Greek government in 2009, 6–8%. In conse-
quence, yields on 10-year Greek government bonds rose to 8.6% in May,
almost triple the rate on German federal government bonds (bunds).
11. Measures to reduce the government deficit were not confined to the three
EMU countries that were bailed out. Latvia has undergone the most savage
bout of deficit reduction: with austerity launched during the 2009 recession,
its economy has shrunk by a quarter with unemployment tripling to 21%
in 2010. Austerity has been, and is, the centrepiece of UK budgets since the
Conservative-Liberal coalition government was formed in May 2010. The
fact that Italian government 10-year bond yields crossed the 7% “alarm
threshold” towards the end of 2011 led the new prime minister, Mario Monti,
to announce a series of austerity measures in December 2011 representing
€20 billion of savings till 2014.
12. See Bagus (2011) for a detailed discussion of the two visions.
13. The Economist (2011).
134
Notes 135
14. See Feldstein (2012).

15. Feldstein (2012).
2 Housing
1. http://en.wikipedia.org/wiki/List_of_countries_by_home_ownership_rate
2. Other Scandinavian countries – Sweden, Norway, and Finland – also experi-
enced a boom and then a slump in house prices.
3. X over the period t = 1 ... T, is defined as:

1 T T
GX = ∑∑ | Pi − Pj |,
2T 2 μ i = 1 j = 1
where Pi and Pj are, respectively, prices in periods i and j. In other words,
the Gini coefficient is computed as half the mean of the difference in house
prices between pairs of observations, divided by the average price (μ). So,
G = 0.45 implies that the difference in prices between two years chosen at random
will be 90% of the average price.
4. Financial Times 2009. Figure 2.1 is derived from these data.
5. More sophisticated measures enquire about the % of median income required
to occupy the median housing unit, both sold and rented.
6. http://www.economicshelp.org/blog/5709/housing/housing-market-stats-
and-graphs/ (accessed 24 January 2014).
7. Figures relate to 2006 for Ireland, 1991 for Germany, and 1992 for the UK.
8. Conefrey and Fitzgerald (2010).
9. There is also a depreciation element, which, in the case of long-lived assets
like housing, is likely to be small.
10. Oireachtas Library and Research Service (2010). The total indebtedness of
Irish households was €147 billion, yielding a debt-to-disposable income ratio
of 176.
11. OECD, 2011: Annex table 58.
12. A high proportion of the new homes built in Spain was to satisfy foreign (and
domestic) demand for holiday homes: such homes are almost a third of the
total Spanish stock. In Ireland, however, holiday homes are around 15% of
total stock (Conefrey and Fitzgerald, 2010).
13. Eurostat (2011). For the UK, employment in construction increased from
1.39 million in 2001 to 1.43 million in 2008 while in Denmark the increase
was from 184,000 in 2001 to 207,000 in 2007
14. Eurostat (2011) and OECD (2011).
15. This is the value of outstanding owner-occupier residential mortgages on
banks’ balance sheets. If this figure is adjusted to include the value of secu-
ritised mortgages, it rises to €147.6 billion (Oireachtas Library and Research
Service, 2010)
16. Weston (2009).
17. Figures from Oireachtas Library and Research Service (2010: table 1).
18. See Shedlock 2010.
19. Henley (2010).
20. See Tett (2009) for an account of how a group of bankers associated with
J.P. Morgan developed “collateralised debt obligations” and “credit default
swaps”.
136 Notes
21. See Andrews (2009) for an illuminating account of the variety of marketing
ploys used in selling mortgages in the USA.
3 Banking
1. Cipolla (1982).
2. These are typically current accounts which do not pay interest. Deposit
accounts, which do pay interest, are excluded from this definition of money
(known as M2) but are included in a broader definition of money comprising
notes and coins plus all bank deposits (known as M3).
3. See item 1 under liabilities on the assets side in Table 3.2. In Europe, for
example, the reserve ratio is 2% on sight and overnight deposits, on term
deposits up to two years and on debt securities of up to two years maturity.
4. Currency = 0.2 × €1 million and bank reserves held with the central bank
= 0.1 × 0.8 × €1 million.
5. The formula for the haircut is
Market price − Purchase price
× 100
Market price
6. See the above section on how banks create money, and Appendix 3.2 on
summing an infinite series.
7. Another factor affecting the computation of leverage is the definition of the
equity base of which assets are a multiple. The three commonly used defi-
nitions are: common equity (ordinary shares with voting power); shareholder
equity (ordinary shares plus preference shares where the holders of the latter,
while not having voting rights, are senior to ordinary shareholders in the
event of the bank’s liquidation); and total equity (which is shareholder equity
plus “subordinated” debt, a class of debt senior to shareholders but junior to
depositors).
8. The term irrational exuberance was first used by Alan Greenspan, chairman of
the Federal Reserve Board in Washington, during a black-tie dinner speech
entitled “The Challenge of Central Banking in a Democratic Society” and
given before the American Enterprise Institute at the Washington Hilton
Hotel, on 5 December 1996. He asked: “But how do we know when irrational
exuberance has unduly escalated asset values, which then become subject to
unexpected and prolonged contractions as they have in Japan over the past
decade?” and went on to downplay the importance of asset price bubbles by
answering his own question: “We as central bankers need not be concerned
if a collapsing financial asset bubble does not threaten to impair the real
economy, its production, jobs and price stability.”
9. The Telegraph (2009).
10. See also Kane (1989) and Akerlof et al. (1993).
11. New York Times (2011) 5 November.
12. Kaminsky and Reinhart (1999) also compared the behaviour of 15 macroeco-
nomic variables in the 24 months preceding and following a banking crisis
with the corresponding values in normal times. In the months preceding a
crisis, monetary growth and interest rates (both lending and deposit rates)
were above normal, suggesting a high level of demand for money and credit.
Notes 137
Among external balance indicators, export growth appeared below trend

(with an appreciating real exchange rate) prior to a banking crisis. Lastly,
real output growth was below trend about eight months before the peak of
the banking crisis, suggesting that banking crises were preceded by a cyclical
downturn.
13. More formally, if P(B) is the unconditional probability of a banking crisis,
and P(B|L) is the conditional probability of a banking crisis, given that finan-
cial liberalisation has occurred, Kaminsky and Reinhart (1999) showed that
P(B|L) > P(B); specifically, according to their calculations, P(B|L) = 14%−16%
while P(B) = 8%.
14. IMF (2005).
15. Calvo (1998) offers a view of why inflows of capital come to a “sudden stop”
in the context of self-fulfilling prophecies: a slowdown in inflows leads to
bankruptcies, fall in output, and a constriction of credit lines; these events
then rebound on other firms and more bankruptcies result, bringing the
confidence of international investors to a juddering halt.
16. 18.4% versus 13.2% for 66-country sample, 1960–2007 (see Reinhart and
Rogoff, 2009: table 10.7, at page 158).
17. Rajan (2005), Demirgüç-Kunt and Huizinga (2009).
18. Building Societies Association (2011) (accessed December 2011).
19. See Bank for International Settlements (2011) for a detailed discussion of the
concept and measurement of “global liquidity”.
20. “The boom is getting boomier”, as Bertie Ahern, the Irish Taoiseach (Prime
Minister) declared at the height of the Irish boom in 2005.
21. The same Bertie Ahern said about the economist Morgan Kelly, a leading
critic of the Irish boom: “Sitting on the sidelines, cribbing and moaning is a
lost opportunity. I don’t know how people who engage in that don’t commit
suicide because frankly the only thing that motivates me is being able to
actively change something.”
22. http://www.bbc.co.uk/news/uk-politics-15810966 BBC (accessed 18 January
2012).
23. Statement by President Barroso and Commissioner Barnier following
the European Parliament’s vote on the creation of the Single Supervisory
Mechanism for the Eurozone: see European Commission MEMO/13/781
12/09/2013
24. Eurostat.
25. Estonia joined the European Monetary Union on 14 January 2011; Lithuania
and Latvia are expected to join in January 2014.
26. Cassels (2009).
27. Ward (2009).
28. The LIBOR is set by a consortium of banks and published by the British
Bankers Association each day between 11 and 11.45 a.m.
29. The Northern Counties Permanent Building Society (established in 1850) and
the Rock Building Society (established in 1865).
30. The Barclays bid was £10 billion less.
31. The British scheme differed from the USA’s Troubled Assets Relief Program
(TARP) in that the former sought to buy equity in banks while the latter
sought to buy banks’ troubled mortgage-backed securities. There was also to
be a £200 billion Special Liquidity Scheme, operated by the Bank of England,
138 Notes
to provide short-term loans to British banks as well as £250 for underwriting

any eligible lending between British banks.
32. The use of the Fund was spurned by HSBC, Standard Charted, and Barclays
who preferred to raise capital from the market. Barclays, controversially, had
raised £3.7 billion from the Qatar Investment Authority in July.
33. Nyberg (2011) pointed out that “Anglo and to a much lesser extent Irish
National Building Society (INBS) are important for the wider crisis because
they were both seen as highly profitable institutions to which other Irish
banks should aspire. As other banks tried to match the profitability of Anglo
in particular, their behaviour gradually, and even at times unintentionally,
became similar.”
34. The six banks were: Anglo Irish, Bank of Ireland, Allied Irish, Educational Building
Society, Irish Life and Permanent, and Irish Nationwide Building Society.
35. The ELG scheme “provides for an unconditional and irrevocable State guar-
antee for certain eligible liabilities (including deposits) of up to five tears in
maturity incurred by participating institutions”. The eligible liabilities were
senior unsecured certificates of deposit, senior unsecured commercial paper,
and other senior unsecured bonds and notes. The original Scheme, which
ran till 31 December 2011, was renewed on that date.
36. A haircut of 35% was applied to the Bank of Ireland’s transfer of 12 billion
euros of assets to NAMA while a more severe haircut of 43% was applied to
Allied Irish (Carey and Coffey, 2010)
37. See Fitzgerald and Kearney (2011). The Central Bank stress tests required an
additional €24 billion but, after taking account of private asset injections and
asset sales, the state was required to put in only €17 billion.
38. Indeed, there were no systemic financial crises in the United States over the
much longer “Quiet Period” of 1934–2007.
39. Paul Friedman and Sam Molinaro in independent testimonies before the
Financial Crisis Inquiry Commission, 5 May 2010 Financial Crisis Inquiry
Commission (2010a).
40. Richard Fuld in independent testimony before the Financial Crisis Inquiry
Commission, 1 September 2010 Financial Crisis Inquiry Commission (2010b).
41. See Board of Governors of the Federal Reserve System (2008).
42. Kahneman (2012) considers a driver who, having come off a motorway where
he was driving at 120 kilometres per hour, does not immediately reduce his
speed sufficiently to meet the requirements of non-motorway conditions.
43. In the well-known television show Who Wants to be a Millionaire? a contestant
is asked to choose, from a menu of four optional answers, the correct answer
to a specific question. A contestant who is unsure can “ask the audience”
to vote on the various options offered and then choose an answer on the
basis of the audience’s assessment. Invariably, the answer that commands the
largest audience support is also the right answer.
44. Osborne (2013).
4 Sovereign Debt
1. Krugman (2012b) New York Times, 1 January.
2. Eurostat (2011). The figures refer to gross general government debt (nominal
value).
Notes 139
3. Though general government expenditure as a percentage of GDP is also

higher in Greece compared to the UK and the USA (50.3%, 43.5.8%, and
40.2%, respectively, in 2012). IMF (2013: Statistical table 3).
4. Ferguson (2010).
5. European Commission (2011b).
6. European Banking Authority (2011).
7. Alloway (2010).
8. http://financeaddict.com/2011/10/which-banks-have-the-most-belgium-
debt-exposure/
9. http://ftalphaville.ft.com/blog/2011/07/18/625136/goldman-answers-10-
questions-on-italy/
10. www.trading economics.com
11. Let S be the CDS spread (premium), R the recovery rate, and p the probability
of default. The expected payoff of the buyer of the CDS is (1 − R)p. When two
parties enter into a CDS transaction, S is set so that the value of the transac-
tion is zero: S = (1 − R) p ⇒ S /(1 − R) = p . If R = 40% and S = 500bp, p = 8.3%.
12. Consequently Macdonald (2006) argues that political systems (democracies)
that are based on a voluntary take up of debt have a greater capacity to survive
compared to systems that extract money by compulsion (autocracy).
13. http://www.wsws.org/articles/2007/jun2007/summ-j22.shtml (accessed 5
March 2012).
14. http://www.spiegel.de/international/europe/0,1518,671322,00.html (accessed
5 March 2012).
15. Eurobarometer 78, Fall 2012.
16. Boros and Vasali (2013).
17. Speech to the Institute of Directors, St George’s Hall, Liverpool, 18
October 2011, http://www.bankofengland.co.uk/publications/Documents/
speeches/2011/speech523.pdf)
18. Wolf (2011).
19. Countries joining the EMU on 1 January 1999 were: Belgium, Germany,
Ireland, Spain, France, Italy, Luxembourg, Netherlands, Austria, Portugal,
and Finland. Greece joined on 1 January 2001, Slovenia on 1 January 2007,
Cyprus and Malta on 1 January 2008, Slovakia on 1 January 2009, and Estonia
on 1 January 2011.
20. Eurostat databank. The figures refer to gross general government debt.
21. Originally, exceptional circumstances referred to low growth, defined as a
GDP decline of more than 2% with an intermediate case where it declined
by less than 2% but by more than 0.75%. Now, exceptional circumstances
refer to an unusual event outside the control of the Member State concerned
which has a major impact on the financial position of the government or a
severe economic downturn.
22. EU countries that were not EMU members were required to submit
Convergence Programmes, the contents of which were similar to the
Stability Programmes, of EMU members, except that they were not subject to
penalties.
23. The outturns for Germany and France were deficits of, respectively, 3.8% and
3.6% for 2004 and 3.3% and 2.9% for 2005.
24. BBC News (2012b).
25. Allan Little (2012).
26. See Wolf (2012).
140 Notes
27. See European Commission (2013b).

28. For example, prior to the economic reforms in India in 1990, Indian foreign
exchange reserves had dwindled to a low of $2.2 billion with less than
15 days’ cover against annual imports.
29. A similar story can be told about Latvia and Lithuania.
30. Bartels (2012).
31. The European Central Bank plus the central banks of the 27 countries in the
EU countries. The latter include those not in EMU but they do not participate
in matters relating to monetary policy.
32. Wolf (2012b). The Gold Standard was a system in which each country fixed its
currency in terms of gold and stood ready to exchange gold for its currency
at the stated parity.
33. It is worth emphasising this point because it has been the subject of some
controversy. The Bundesbank, as the system’s largest creditor, has a TARGET
balance of €320 billion with the ECB while the Central Bank of Ireland and
the Bank of Greece, as the system’s largest debtors, have TARGET liabilities
with the ECB of, respectively, €146 billion and €87 billion. It would be wrong,
however to interpret these amounts as debts owed to the Bundesbank by the
two debtor national central banks.
34. The critical point is that banking difficulties open up the prospect that euros
in the deficit countries (say, Ireland) are worth less than euros in the surplus
countries (say, Germany).
35. OCED (2011).
36. Noonan (2011).
37. http://economicsintelligence.com/2011/06/06/the-stealth-bailout-that-does
n%E2%80%99t-exist-debunking-hans-werner-sinn, accessed 10 March 2012.
38. http://www.iiea.com/blogosphere/professor-sinn-misses-the-target, accessed
10 March 2012.
39. Portugal had a budgetary deficit of 3.1%.
40. All figures from European Commission (2011b).
41. The troika is sometimes also defined as the collective of the EU, the ECB,
and the IMF. Since the European Commission is the executive arm of the EU,
representing the EU in all talks involving the troika, the two definitions are
equivalent. This book uses the EC + ECB + IMF definition because they are all
institutions.
42. On the World Bank’s “Ease of Doing Business”, Greece ranked outside the top
100 countries (World Bank, 2010).
43. More anecdotally, the Greek Finance Ministry reported that in one of the
wealthiest Athens suburbs, 90 out of 150 doctors claimed net annual incomes
of less than €30,000.
44. Of Costas Karamanlis’ Nea Demokratia party.
45. Later revised to 13.6% of GDP on 22 April 2010. In the past, too, Greece had
massaged its deficit figures to meet the Maastricht criteria for EMU entry
(Featherstone, 2008).
46. http://en.citizendium.org/wiki/Eurozone_crisis/Timelines.
47. Featherstone (2011).
48. Financial Times (2010).
49. This was Greece’s third (and most comprehensive) austerity package, following
those of February and March 2010. Taken collectively, they involved a cut
Notes 141
in the bonuses and salaries of public-sector employees, a rise in taxes (VAT,

property tax), a rise in average retirement age of public-sector workers from
61 to 65.
50. The €110 billion was meant to cover €30 billion for the rest of 2010 and €40
billion each for 2011 and 2012.
51. This was undertaken under a collective action clause whereby the swap was
mandatory for all bondholders if a specified proportion agreed to it; in the
end, the acceptance rate was 85.8%.
52. The Irish government issued €31 billion worth of “promissory notes” as
collateral for loans taken by Anglo-Irish Bank from the ECB.
53. On 11 November 2010, the spread between the yield on a 10-year Irish
government bond and its German equivalent reached its highest point since
the euro was created: 6.65 percentage points.
54. Kowsmann (2011).
55. A primary deficit is the opposite of a primary surplus.
56. See the appendix to this chapter for details. The interest rate and the growth
rate could be cast in nominal terms or in “real terms” (that is, after subtracting
the inflation rate from both the nominal rates).
57. The figures are from European Commission (2011b).
58. p *IRL = [0.058 − (0.006)] × 1.12 = 0.058 .
59. p *PT = [0.048 − ( −0.022)] × 1.017 = 0.071 .
60. McDermott (2011).
61. McDermott (2011).
B B D B B Y bt − 1
62. Bt − Bt − 1 = Dt ⇒ t − t − 1 = t ⇒ t − t − 1 t − 1 = dt ⇒ bt − = dt ⇒ bt −
Yt Yt Yt Yt Yt − 1 Yt (1 + g t )
bt − 1 = (1 + g t )dt − g t bt . If the debt-to-GDP ratio is to remain constant,
gt
bt − bt − 1 = 0 ⇒ (1 + gt )dt = g t bt ⇒ dt = bt
(1 + g t ) .
Yt
63. If Q t is the price level, and Zt = is real GDP then : Yt = (1 + g )Yt −1 ⇒ Zt = (1 + g )
Q
Qt −1 1+ g
Zt − 1 = Zt − 1 = (1 + g − π )Zt − 1 = (1 + s )Zt − 1.
Qt 1+ π
64. See footnote 63. Constancy of p implies that, in each period, the primary
balance Pt grows at the same rate as Yt.
65. Formally, bT+j > bT, for j > 0.
⎡ 1 − (1 + r − s )T ⎤
66. If bT = b0 , then ⎡⎣1 − (1 + r − s)T ⎤⎦ b0 = − p ⎢ ⎥ ⇒ p = ( r − s )b0 .
⎣ s−r ⎦
5 Reforms, Hardship, and Unrest

1. See Wolf, 2012.
2. Zakaria (2011).
3. Winnett and Kirkup (2010).
4. Though, subsequent to this study, Italy, under Prime Minister Mario Monti,
has embraced both austerity and labour market reform.
5. “An Inconvenient Truth”, The Economist, 31 March 2012.
142 Notes
6. Callan et al. (2011) detail the specific outcome for these items for six coun-
tries – Estonia, Ireland, Greece, Spain, Portugal, and the UK.
7. Hellenic Republic Ministry of Finance (2011).
8. The Economist, 19 October, 2013.
9. Reduced from €166 to €140 per month.
10. Reduced by 3% in October 2008, 4% in 2010, and again by 4% in 2011.
11. Reduced by 25% for those unemployed aged 22–24 years and by 50% for
youngest unemployed.
12. Smith (2012) emphasis added.
13. For an argument that Greece today represents a humanitarian crisis see http://
auslandshilfe.diakonie.at/goto/en/aktuelles/news/griechenland_-haertefalle-
durch-sparmasznahmen
14. O’Toole (2012).
15. Commission to Inquire into Child Abuse (Ryan Report) and Sexual Abuse Scandal
in the Catholic Archdiocese of Dublin (Murphy Report).
16. http://www.nytimes.com/2012/03/20/world/europe/growing-antitax-move-
ment-shows-irish-stoicism-wearing-thin.html
17. For example, as Hopkins (2006) shows, the Asian economic crisis in 1997–
1998 seemed to have few health consequences in Malaysia – which rejected
the World Bank’s advice to reduce health expenditure as part of a general
programme of expenditure reduction – compared to Thailand and Indonesia,
both of which agreed to cut health expenditure.
18. >$190 per head.
19. Pre-2004: Austria, Finland, Greece, Ireland, the Netherlands, and the UK.
Post-2004: Czech Republic, Hungary, Lithuania, and Romania.
20. Povoledo and Carvajal (2012).
21. CNN (2012).
22. Smith (2011).
23. Closure Conflict Solutions for Ireland (2010). On another interpretation, this
fall in numbers seeking separation represented an adversity-induced return
to traditional values.
24. A person is economically active or, equivalently, in the labour force, if
he/she is either employed or, if jobless, available for and actively seeking
employment.
25. By October 2013, the youth unemployment rate in Ireland had fallen to 25%,
but in Cyprus, Greece, and Spain it had risen to, respectively, 43%, 58%, and
57%.
26. If UR represents the unemployment rate, U represents the numbers unem-
ployed, EA represents “economically active”, and the subscript Y denotes
“youth”, then using the 2012 numbers for EMU-17 from Table 5.3:
URY = U Y/ EAY and UR = U/ EA ⇒ EAY/ EA = (U Y/ URY ) × (UR / U ) = (U Y/U ) × (UR /URY )
= (0.096) × (11.4 / 23.0) = 0.048 .
27. ILO (2013).
28. For example, as sales assistants and care workers. Groom (2013).
29. A related concept is that of “not in the labour force, education, or training”
(NLFET) which differs from NEET in excluding the unemployed (ILO, 2013).
30. There is, however, no agreed measure of inactivity with respect to NEETs. In
the UK, NEETs includes “looking after children or family members, on unpaid
Notes 143
holiday or traveling, sick or disabled, doing voluntary work or engaged in

another unspecified activity”. In Japan, persons “looking after children or
family members” are excluded from the definition of NEETs, but the age
range for NEETs is 16–34.
31. Nor is the phenomenon of NEETs uniquely European. According to offi-
cial figures, in 2010 there were 700,000 young persons in Japan – known as
hikikomori – who had withdrawn from society rarely venturing from their
homes.
32. See “Youth Unemployment: Generation Jobless”, The Economist, 27 April
2013
33. For example, a third of educators could not say how many of their students had
got jobs and many that offer a figure got it wrong (Mourshed et. al., 2012).
34. See McNeil (2011).
35. Pidd (2011).
36. “Spain’s Emigration up Sharply in 2012”. http://www.huffingtonpost.
com/2012/07/17/spain-emigration-up-2012_n_1679355.html (accessed 5
December 2013).
37. Smith (2011b).
38. Vasagar and Hope (2013).
39. Spiegel (2013).
40. Wise (2013).
41. Minder (2013).
42. Bowers (2013). See Keynes (1920) for a discussion of the pernicious conse-
quences of the reparations imposed on Germany after the First World War.
43. Smith (2012b).
44. See Mercille (2013).
45. See Smith (2013).
46. Quoted in Smith (2012b).
6 Conclusion
1. The above account of the sinking of the Titanic is taken from Lord (2012).
2. http://economicsintelligence.com/2012/04/12/an-interview-with-amartya-
sen-there-is-a-democratic-failure-in-europe/
3. In 1957, the Treaty of Rome launched the European Common Market. The
Common Market expanded in 1967 to form the European Communities
and, in 1992, the Maastricht Treaty (or, to give it its proper name, Treaty on
European Union) gave birth to the European Union and set a timetable for
adopting a single currency and an integrated market for goods and services.
The single currency came into being on 1 January 1999 and, under the rubric
of the EMU, it had an initial membership of 11 countries. By 2012, this had
expanded to 17 countries.
4. The Economist (2012).
5. As recounted in Judt (2005: 733).
6. European Commission (Economic and Financial Affairs).
7. See Jenkins (2012).
8. According to Tepper (2012): “Typically, before old notes and coins can be
withdrawn, they are stamped in ink or a physical stamp is placed on them,
144 Notes
and old unstamped notes are no longer legal tender. In the meantime, new
notes are quickly printed. Capital controls are imposed at borders in order to
prevent unstamped notes from leaving the country. Despite capital controls,
old notes will inevitably escape the country and be deposited elsewhere as
citizens pursue an economic advantage. Once new notes are available, old
stamped notes are de-monetized and are no longer legal tender. This entire
process has typically been accomplished in a few months.”
9. There were a total of five short-listed entries.
10. Department of Public Expenditure and Reform (2010).
11. McConnell and Lyons (2012).
12. McConnell and Drennan (2012).
13. Hennberger (2012).
14. Povoleddo and Erlanger (2012).
15. See Judd (2005: Ch. 24) for a discussion of the “European way of life”.
16. New crisis management measures to avoid future bank bail-out, European
Commission, IP/12/570 06/06/2012.
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Independent, 20 November.
Whelan, K. (2011), Ireland’s Sovereign Debt Crisis, UCD Centre for Economic
Research Working Paper Series WP11/09, Dublin: University College Dublin.
Winnett, R. and Kirkup, J. (2010), “George Osborne: I am Going after the Wealthy
Tax Dodgers”, The Daily Telegraph, 10 April.
Wise, P. (2013), “Portugal’s Political Woes to Complicate Bailout Programme”,
Financial Times, 3 July.
Wolf, M. (2011), “Creditors Can Huff but They Need Debtors”, Financial Times,
1 November.
Wolf, M. (2012a), “The Pain in Spain Will Test the Euro”, Financial Times, 7
March.
Wolf, M. (2012b), “Intolerable Choices for the Eurozone”, Financial Times, 31
May.
World Bank (2010), Doing Business 2010: Reforming Through Difficult Times,
Washington DC: The World Bank.
Zakaria, F. (2011), “Europe’s Real Problem: A Lack of Growth”, Washington Post,
13 October.
Index
ABN Amro, RBS acquisition of, 49 balance of payments

Adjustment Progress Indicator (API), correction, 8
100–1 deficits, 8, 80, 82
Allied Irish, 50, 53, 79–80 balance sheets, 27
anchoring effects, 55 bank assets, 35
Anglo Irish Bank, 25, 86 and market liquidity, 42
failure to turn over foreign banking crisis, 1, 57
borrowing, 52 in Baltic countries, 47, 56
formation of, 50 definition of, 25–6
growth of, 50 episodic view of, 53, 57
lending to builders and foundations of, 38–9
developers, 56 global liquidity role in, 42
recapitalisation of, 53 history of, 25, 26
Apostolopoulos, Giorgos, 123 insolvency problem, 38
Asian economic crisis in 1997, inter-bank linkages, 39
142n17 irrational exuberance in economic
asset prices agents, 37–8
crash, 38, 41, 42 liquidity problem, 38
rise in, 42 and macroeconomic events,
austerity and hardship, 103 connection between, 41
health, 109–12 macroeconomic variables
youth unemployment and preceding and following,
migration, 113–20 136n12
austerity measures, 2 structuralist view of, 53–4
forms of, 102 systemic risk, 38–9
Greece, 85–6, 102–3 unconditional probability of,
growth and hardship, relation 137n13
between, 106–9 banking union, 45
Ireland, 103 Bank of Ireland, 50, 53, 79
Latvia, 134n11 Bank Recovery and Resolution
Portugal, 103, 121 Directive (BRRD), 45
social unrest engendered by, banks
103–6, 120–1 assets in cash reserves, 32
balance sheet, 27
bail out becoming insolvent, problem with
of Cyprus, 134n9 allowing, 38–9
definition of, 9 capacity to create “money,”
of Greece, 10, 84–5 27–8, 33–4
of Ireland, 10, 85–6 capital of, 35
of Portugal, 10, 86 cognitive habits of, 56
bail out countries, API ranking dependence on wholesale
of, 101 funds, 42–3
balanced budget rule, 73, 98 as financial intermediaries, 26, 27
155
156 Index
banks – continued budgetary cuts, 103–4

lending standards, see lending budget deficit, 69, 72, 74, 82–3, 97
standards building industry
leverage of, see leverage and house price volatility, 14–15
and maturity transformation, 26 Irish banks lending to, 56
moral hazard problems in, 9, 39–41 Bundesbank, 79, 140n33
private-sector monitoring of, 40
and public debt, dangerous nexus Cameron, David, 44
between, 8–9 Campaign Against Household and
regulation and supervision, 40 Water Taxes, 106
relationship with central bank, 32 capital inflows
sources of borrowing, 36 political approval of economic
systemic importance of, 40 expansion engendered by, 43–4
unconventional and unorthodox rise in asset prices by, 42
tactics, 56 sudden stop of, 137n15
use of non-deposit sources by, 43 capitalist economies, 53
Basel II, 49 capital of bank, 35
Basel III, 49 carry trade, 43
Bear Stearns, failure of, 55 CDS transaction, 139n11
Belgian government debt, 64 central bank money
Belgium demand for, 32–3
“60% debt-to-GDP rule” supply of, 29–30, 33
violation, 70 Central Bank of Ireland, 79–80,
government debt-to-GDP ratio, 85, 122
61, 62 central banks, 28, see also European
Biagi, Marco, 131 Central Bank (ECB)
BNP Paribas and Belgian government balance sheet, 32
debt, 64 bond purchase and money
bond supply, 34
algebra of, 58–9 interest rates, 17
buying and selling, 29 money supply and interest rate,
buying by central bank, 34 28–9
definition of, 30 open market operations, 29
financial assets as, 28 child abuse scandal, 105–6
money supply from purchasing citizen-creditor, 66
of, 34 collateralised debt obligations
rate of return on, 59 (CDO), 23
yield to maturity on, 30–1, 58–9 collateral security, 74, 85, 86, 99
bond markets bank assets, 54–5
EMU member’s access to, 9 for ECB repos loans, 52
rates offered by, 65 haircut, 36–7
borrowing, 8 commercial paper, 36–7, 54
British banking, financial crisis in commercial paper market, 55
liquidity crunch, 48 “compassion fatigue,” 122
Northern Rock bank failure, 48 competition and currencies, 7
Royal Bank of Scotland (RBS) competitiveness, 7, 99
collapse, 48–50 deconstructing, 92–3
British government, “help-to-buy” instruments for improving, 93
scheme of, 44, 57–8 measures to improve, 75
Index 157
Cowan, Brian, 86, 92 East Germany, 105

credit boom, 41, 47 ECOFIN, 71, 72, 84
credit default swaps, rise in prices economic catastrophes, causes of
of, 65 availability of easy credit, 3–5
credit downgrades, 84, 89–90 single currency, adoption of, 5–9
creditor anxiety, 26 economic contraction, 7, 128
creditor confidence, 26 economic crisis, metaphor for,
creditworthy home buyers, 22–3 124–5
Croke Park Agreement, 130–1 economic growth, 110
currency and austerity, link between, 106–7
appreciation or depreciation, policy engendered by capital inflows,
instrument of, 6 43–4
break-ups, 129 and interest rate, link between,
competition between, 7 91, 95
demand for, 32, 33 economic stagnation, 83
currency crises and banking crises, Educational Building Society, 50
connection between, 41 educational system, 118
currency depreciation Eligible Liabilities Guarantee (ELG)
and competitiveness, 75 Scheme, 52, 138n35
impact on economic costs, 7 “Emergency Liquidity Assistance”
current account balance, 74 (ELA), 85
current account deficits, 74 empathy, 122–3
EMU policymakers response employment and education, link
to, 78 between, 116
financed through bank borrowing, EMU countries, 132
78–9 current account deficits,
measures to reduce, 75 see current account deficits
private-sector overspending role 1999 deficit and debt ratios, 70
in, 76–7 2010 deficit and debt ratios, 71
current account imbalance, 8 fiscal policy role in, 76
Cyprus, bail out of, 134n9 interest rate across, 6
ranked by API and overall health
Danish economy and housing indicator, 101
bubble, 18, 19 unemployment rates in, 113–15
D’Antona, Massino, 131 equity base, definition of, 136n6
debt swap agreement, 85 Estonia
debt-to-GDP ratio banking crises in, 47, 56
euro area, 61–2, 81 credit boom in, 46–7
and fiscal sustainability, 86–9, 93–4 deflation in, 47
measures to reduce, 96 economic growth in, 46
post-war USA, 60 structural reforms in, 45–6
for primary-balance-to-GDP ratio, EU banks
relation between, 94–5 exposure to public debt, 64
deficit-to-GDP ratio, 93–4 euro, see also single currency,
deflation, 7, 47, 75, 78, 130 adoption of
demand for money (Md), 28, 32, 33 conditions for preserving,
deposit guarantee scheme, 40 130, 132
Deutschmark, 11 fate of, 126–7
dollar, 65–6 future of, 10–12
158 Index
euro area countries “European Project,” 11, 132

average annual growth rate of, 64 European sovereign debt, see also
foreign trade performance of, 6 Greek sovereign debt crisis; Irish
government debt-to-GDP ratios for, sovereign debt crisis; Portuguese
61–2, 81 sovereign debt crisis
peripheral countries, 62, 64, 80–2, balanced budget rule, 73
120, 125 blame sharing, 68
political and social elites support and dollar currency, 65–6
to, 67 in euro area, 61–2
share of rent expenditure in HICP federalisation of, 130
for, 13 foreign investors’ exposure to,
single interest and exchange rate 64–5, 66
for, 6 inter-country hostility, 66–7
European Bank of Reconstruction intra-Europe issue, 66
and Development (EBRD) Maastricht Treaty of 1992,
structural index reform, 45–6 68–9
European Central Bank (ECB), 75, 99 non-European exposure to, 66
bail out package for Greece, 85 and SGP, see Stability and Growth
funding of external deficits, 8 Pact (SGP) of 1997
governance structure of, 45 structural deficit, 73
legal capacity to supervise euro and USA post-war debt, difference
area’s banks, 45 between, 61, 64, 65
repurchase operations, 8–9 European Stability Mechanism (ESM),
TARGET system, 79–81 98
tough anti-inflationary stance, 8 European Union (EU), 6, 46, 127
European Commission (EC), 2, 71, bail out terms for Ireland, 86, 90
83, 99, 129 bail out terms for Portugal, 10
budgetary surveillance economic benefits of, 126–7
announcements, 73 NEET rates for, 117–18
mandatory recommendations, 72 negative attitudes towards, 67
state aid measures for financial reform in, 97–9
institutions, 45, 133 unemployment rates in, 113–15
European Common Market, 143n3 Europe’s “problem” countries
European Court of Justice, 98 2006–2011 fiscal balance of, 3–4
European Economic Community, 11 real GDP growth in
European Financial Stability Facility 2007–2012, 2–3
(EFSF), 98 excessive debt, 37
European Monetary Union (EMU), 3 Excessive Deficit Procedure (EDP), 71
conditions for membership of, 6, excessive deficits
69 avoidance measures for, 71
“60% debt-to-GDP rule” violation, corrective measures for, 71–2
70 definition, 70, 71
“3% deficit-GDP rule” violation, 70 penalties for, 72
formation of, 5 exchange rate depreciation, 7, 75
member countries, 5, 69–70, Exchange Rate Mechanism
139n19 (ERM), 69
on private borrowing, 73 exchange rate movements, 41
system for settling inter-country exports, measures to increase, 75
transactions within, 8 external borrowing, 77
Index 159
Federal Reserve, 55 and current account balance, 74

Fianna Fáil government, 86, 92, division between private and
121–2 government borrowing, 75
finance availability and home France
purchase, 17–18 economic performance
financial assets, 28 ranking of, 102
financial crises flouting SGP rules, 72, 127
British bank failures, 48–50 real GDP growth in 2007–2012, 3
causes of, 44–5, 54
central paradox of, 40–1 Geithner, Timothy, 40
and earlier crises, difference Germany, 67
between, 54–5 flouting SGP rules, 72, 127
Irish bank failures, 50–3 government debt-to-GDP ratio, 81
magisterial quantitative history of, persuaded to renounce
25, 26 Deutschmark, 11, 132
outcome bias, 57 real GDP growth in 2007–2012, 2–3
overarching feature of, 54 ghost estates, 21–2
political effect of, 91–2 global economic volatility and
Swedish banks and Baltic banking crises, 41
states, 45–7 global liquidity, see international
financial intermediaries, 27, 54–5, 66, liquidity
see also banks gold standard, 78, 140n33
financial liberalisation, 56 government balance as percentage of
Financial Service Authority (FSA) GDP, 63
on ABN Amro acquisition, 48 government bonds
recommendations for lending as collateral, 99
practices, 20–1 credit-rating downgrades, 84
on remortgagers in UK, 21 German, 65
Finland, government debt-to-GDP Greek, 65, 84–5, 134n10
ratio of, 81 Irish, 10, 52, 88
fiscal balance as percentage of GDP, Portuguese, 89
2006–2011, 3–4, 63–4 government borrowing
fiscal discipline, 12, 73, 76, 98 as percentage of GDP, 76–7
fiscal policy, 6, 76 vs. private borrowing, 74
burden of national economic government debt, see public debt
policy on, 127–8 government deficits and debt, 3
and SGP, 7 and fiscal balance, 3–4
fiscal sustainability, 86–9 measures to reduce, 134n11
austerity and hardship, relation relationship between, 93–6
between, 107–9 Grant, John Sir, 72
definition of, 86 Great Moderation, 53
factors determining, 86–7 Great Recession of 2008, 1, 81–2
growth rate/primary surplus Greece, 9
(deficit) combinations for, 87–8, adjustments in response to
91, 94–5, 106–7 post-2008 recession, 101
Fitch, 84 austerity measures, 85–6, 102–3
fixed exchange rate regime vs. single bail out of, 10, 84–5
currency, 7 benefit of exit from euro to, 130
foreign borrowing default chance, 65
160 Index
Greece – continued cheap home mortgages, 17–18

2006–2011 fiscal balance, 3–4 dynamic of, 16–17
government debt-to-GDP ratio, 61, failure in planning policy, 22
62, 81 house prices
government revenue, 3, 62–4 factors determining, 15–16
real GDP growth in 2007–2012, 2–3 Gini coefficients for, 14
structural reform of, 97–8 for period 1997–2009, 13–14
tax-avoidance behaviour in, 64 volatility in, 13–14
youth unemployment and house price-to-income ratio, 15, 16
migration, 120 house purchase, banks’ credit
Greek banks, 64 standards and loans for, 17–18
Greek sovereign debt crisis, 64, 88 housing affordability, 16
causes of, 83, 84 measure of, 15
downgrading of, 84 housing boom, 18–19, 21, 23, 111
rise in bond yields, 84 housing bubble, bursting of
Greenspan, Alan, 136n8 and Irish economy, see Irish
gross fixed residential capital economy, impact of housing
formation as % GDP, 19 slump on
Growth and Stability Pact (GSP), 128 rise in interest rates, 18
growth-enhancing reforms, 108–9 and Spanish economy, see Spanish
Gunnlaugsson, Sigmundur, 122 economy, impact of housing
slump on
haircut, 136n5 supply-side responses, 19
collateral security, 36–7 UK and Danish economies, 18, 19
definition of, 36 unemployment rate, 18
hardship housing demand
and austerity, see austerity and and headship rates, 15–16
hardship and population growth, 15
economic growth and austerity, housing, political slogans related to,
relation between, 106–9 44
failure to empathise with, 122–3 human behaviour, herd mentality
headship rates and housing associated with, 56
demand, 15–16
health inequalities Iceland’s banks, collapse of, 121–2
causes of, 109 imports, measures to reduce, 75
impact on UK government, 109 income and housing demand, link
health outcomes and austerity, 109 between, 15
home repossessions, 111–12 Indignants movement, 104
poor mental health, 111 infinite series, summing, 59
suicide, 110–11 inflation, 69
herd mentality, 56–7 ING, 64
high-powered money, see central insolvency problem, 38
bank money Inter-bank lending, 39
holiday homes, 135n12 inter-country payments
Hollande, Francois, 102 for EMU countries, 79–80
home ownership rate, 13 under TARGET system, 80–1
home repossessions, 111–12 interest rates, 127
house price bubble, 1, 13 and economic growth, link
asymmetric effect of, 18–19 between, 91, 95
Index 161
in euro area countries and EU structural reform of, 97

countries, 17 total cost of bailing out, 53
influence on investment decisions, Irish economy
28, 29 impact of housing boom on, 19
and money market equilibrium, recovery of, 90
29–30 Irish economy, impact of housing
and money supply, link between, slump on, 18, 19
28, 29, 33 banking crisis, 22, 82–3
short-term and long-term, 31 decline in new mortgages, 20
international capital mobility, 42 ghost estates, 21
international liquidity high unemployment rate, 20
role in banking crisis, 42 mortgage default, 20
wholesale funds, 42–3 sovereign debt crisis, 22
International Monetary Fund Irish emigration, 120
(IMF), 99 Irish government
bail out package for Greece, 85 bail out agreement, 86
bail out package for Ireland, 86 ELG Scheme, 52
investment expenditure and saving, guarantee on debts of Irish banks,
gap between, 74 52, 83, 85–6, 121
Ireland, 6, 66 setting up of NAMA, 52
austerity measures, 103 Irish households, mortgage
bail out of, 10, 85–6 debt of, 20
benefit of exit from euro to, 130 Irish Life and Permanent, 50
debt crisis, 82–3 Irish National Building Society
fiscal sustainability, 91 (INBS), 138n33
government debt-to-GDP ratio, 61, Irish Nationwide Building Society,
62, 81 50, 86
headship rates in, 16 Irish sovereign debt crisis, 64,
home ownership rate in, 13 66, 88
mortgage prisoners in, 21 bail out of banks, 53
outstanding mortgages in causes of, 82–3, 85–6
2010, 18 credit downgrade, 89–90
prospects for growth, 131 downgrading of, 84
protests against austerity, 105–6 rise in bond yields, 84, 86
real GDP growth in irrational exuberance, 37–8, 136n8
2007–2012, 2–3 Italian government, 131
Irish banking crisis, 50–3 Italian public debt, 64
Anglo Irish Bank failure, 52 Italy
causes of, 51–2 benefit of exit from euro to, 130
Irish government’s strategy “60% debt-to-GDP rule”
towards, 52–3 violation, 70
Irish banks default chance, 65
credit to private sector, 50 government debt-to-GDP ratio,
exposure to property market, 51, 61, 62
82–3 real GDP growth in
exposure to public debt, 64 2007–2012, 2–3
foreign borrowing by, 51, 82–3
loan-to-deposit ratio of, 51 job insecurity, psychological costs
recapitalisation of, 53, 86 of, 112
162 Index
Krugman, Paul monetary policy and interest rate, 6,

optimism about public debt, 60 28, 75
on USA, 130 money, 136n2
components of, 28
labour costs, 7 creation by banks, 33–4
Latvia, 134n11 definition of, 27
austerity measures, 134n11 overall supply in economy, 33
banking crises in, 47, 56 money market equilibrium and
credit boom in, 46–7 interest rate determination,
deflation in, 47 29–30
economic growth in, 46 money multiplier (mm), 33
structural reforms in, 45–6 money supply
“Lawson doctrine,” 74 from bond purchase by central
Lehman Brothers, failure of, 55 bank, 34
lending standards and interest rate, link between, 28,
ECB computation of, 18 29, 33
relaxation for house purchase, and monetary base, 33
17–18 Monti, Mario, 131
leverage, 56 Moody, 65, 90
and bank’s profits, 36 moral hazard problems
factor affecting computation of, in liberalised financial systems, 9,
136n6 39–41
importance of, 35 source of, 40
and repos, 36 mortgage debt, 20–1
Lewis, Michael, 5 mortgage default, factors
liquidity problems, 38, 52 affecting, 111
Lithuania mortgage prisoners, 21
banking crises in, 47, 56 mortgage securitisation, 23–4
credit boom in, 46–7 “mortgages in arrears,” 20
deflation in, 47 Murphy reports, 105–6
economic growth in, 46
structural reforms in, 45–6 National Assets Management Agency
loan-to-value (LTV) ratios, 51 (NAMA), 52
London Inter-Bank Offered Rate national central banks, 8,
(LIBOR), 48 see also European Central
Long-term interest rates, 31, 69 Bank (ECB)
National Suicide Research
Maastricht Treaty of 1992, 6, 12, 68, Foundation, 110
73, 94, 132 NEET rate
criteria for EMU membership, definition of, 117
69–70 for EU countries, 117–18
violation of, 70 NEETs, 116–17, 142n30, 143n31
macroeconomic turbulence and Netherlands, government debt-
banking crisis, connection to-GDP ratio of, 81
between, 41 non-retail funding in British
market economies, 53–4 banking, 48
maturity transformation and Nordic banking crisis, 41
banks, 26 North American Free Trade
monetary base, 32–3 Agreement (NAFTA), 128
Index 163
Northern Rock bank private borrowing

failure of, 48, 54–5 EMU on, 73
reliance on wholesale money, 43, vs. government borrowing, 74
48, 56 as percentage of GDP, 76–7
notes and coins, withdrawal of, role in crisis within EMU, 76–7
144–5n8 private-rental sectors, 13
private-sector overspending, 73, 128
open market operations, 29 Prodi, Romano, 72
outcome bias, 57 property development loans, 52
psychological costs, 112
Papademos, Lucas, 92, 123 public debt, 1, 69, see also European
Papandreou, George, 92 sovereign debt
Pasok, 121 and banks, dangerous nexus
peripheral countries, 82 between, 8–9
banks exposure to public citizen-creditor ownership of, 66
debt in, 64 Krugman’s optimism about, 60
public finances in, 81 purchaser countries, 5
Poland, 67
Policy Exchange, 126, 129 rating agencies, 65
political union, 132 downgrading of government debt,
Politicians 84, 89–90
anchoring effects, 55–6 real wages, 7, 75
on heightened economic activity, 55 recessionary effect, 91
on housing credit, 44 “reform fatigue,” 120–2
population growth and housing reform measures, national-level
demand, 15 anti-avoidance/anti-evasion
Portugal, 6 strategies, 100
austerity measures, 103, 121 austerity-enhancing, 99
bail out of, 10, 86 bail out countries, 97–8
bank exposure to public debt, 64 growth-enhancing, 99–100
benefit of exit from euro to, 130 raising revenue, 100
fiscal sustainability, 91 reform measures, supranational
government debt-to-GDP ratio, 61, level
62, 81 balanced budget rule, 98
real GDP growth in ECB, 99
2007–2012, 2–3 EFSF and ESM, 98
Portuguese sovereign debt fiscal stringency and
crisis, 64, 89 surveillance, 98
causes of, 83 regulatory failure issues, 22
credit downgrade, 84, 89–90 Reiter, Janusz, 67
rise in bond yields, 84, 86 remortgagers, 21
primary-balance-to-GDP ratio, 94–5 repayment credibility, 91
primary deficits, reasons to control, repo lenders, 54–5
91–2 repos market, 36–7
primary gap, 95 reserve ratio, 32
primary surplus/deficit and growth retail deposits, funding from, 42–3,
rate, 87–8, 91, 94–5, 106, 107 48, 56
“prime borrowers,” see creditworthy return on assets (ROA), 35
home buyers return on equity (ROE), 35
164 Index
Royal Bank of Scotland (RBS), 48 avoidance measures for excessive

collapse, 49, 56 deficits, 71
equity tier 1 ratio under corrective measures for excessive
Basel III, 49 deficits, 71–2
excessive deficits definition, 70, 71
Samaras, Antonis, 120 and fiscal policy, 7
Santyana, George, 57 Germany and France flouting, 72
short-term bonds, 9 penalties for excessive deficits, 72
short-term interest rates, 31 Stability Programme document, 71
short-term liabilities, vulnerability Standard & Poor, 84
of, 54 structural deficit, 73, 98
single currency, adoption of structural reforms, 130, see also
benefit of, 129 reform measures, national-level;
consequences of, 6–8, 126–9 reform measures, supranational
hubris embodied in, 125–6 level
idealists’ support for, 132 aim of, 98
incentives to overspend, 8–9 business-unfriendly
problems associated with, 10–11 environment, 132
web of interdependency created by, Croke Park Agreement, 130–1
9, 128 demand for, 97
single currency project, 11 implementation, 2
Single Resolution Mechanism labour market reforms, 131
(SRM), 45 as a “step by step,” 120
Single Supervisory Mechanism subprime mortgages, 23, 44
(SSM), 45 supplier countries, 5
skills mismatch, 118–19 Swedbank, 47
social conditions and health, link Swedish banks and Baltic states,
between, 109 46–7, 56
social problems, decline in public Syrizia Party, 120–1
concern towards, 122–3 systemically important financial
social unrest and austerity, 103–6, institutions (SIFIs), 39
120–1 systemic risk, 38–9, 128
Socrates, Jose, 10, 92
sovereign debt, see public debt target debt-to-GDP ratio, growth
sovereign default on external debt rate and primary balance
history of, 26 configurations for, 88, 96
Spain tax avoidance, 3, 62, 100
benefit of exit from euro to, 130 tax evasion, 64, 83, 100, 103, 131
government debt-to-GDP ratio, 81 tax increases, 103–4
headship rates in, 15–16 Thomsen, Poul, 103
home ownership rate in, 13 Titanic, sinking of, 124
real GDP growth in 2007–2012, 2–3 trade imbalance, 5
Spanish economy, impact of housing Trans-European Automated Real-Time
slump on, 18, 22 Gross Settlement Express Transfer
Special Liquidity Scheme, 137–8n31 (TARGET)
spending cuts, 86, 103–4 inter-country payments under,
Stability and Growth Pact (SGP) of 79–81
1997, 6 Treaty of Rome, 143n3
Index 165
Treaty on European Union, see and suicides, 110–11

Maastricht Treaty of 1992 unit costs of production, 7
Treaty on Stability, Coordination and United States (USA)
Governance, 73, 98 mortgage lending in, 23
troika, 140n41 post-war debt, 60–1, 64,
troika aid, 2, 82, 83, 86, 99, 104, 120, 65, 66
122–3 subprime mortgage crisis in, 48
Troubled Assets Relief Program unsustainable housing commitments,
(TARP), 137n31 psychological costs of, 112
USA price level, 92
UK output price, 92 user cost of housing, 16, 17
UK price level, 134n7
UK’s Independent Commission for wage restraint, 7
Banking (UKICB), 39 West Germany, 105
United Kingdom (UK) West’s “indebtedness problem,”
Bank Recapitalisation Fund, 49 source of, 5
economy and housing bubble, wholesale funds, 65
18, 19 carry trade, 43
home ownership rate in, 13 dependence of banks on, 42–3
mortgage prisoners in, 21 World War, First
real GDP growth in 2007–2012, 3 slaughter of, 1
unemployment
definition of, 113 yield curve, 31
and educational levels, link yield to maturity, 30–1
between, 116 youth unemployment, 113, 130,
in European Union, 113–15 142n26
and HRQL, link between, 111 adverse consequences of, 116
long-term, 116 and educational system, 118
and migration, 113–20 in European Union, 113–15
NEETs, 116–18 and migration, 119–20
rises in, 18, 20, 47, 75, 90, 102, NEETs, 116–18
104, 106 skills mismatch, 118–19

Europe in The Age of Austerity

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Europe in The Age of Austerity

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Europe in an Age of Austerity

List of Figures viii

5 Reforms, Hardship, and Unrest 97

2.1 House prices in selected countries: 1997–2009

1.1 Growth rates (%) in real GDP in selected countries,

Monetary Union’s (EMU) single currency regime had no automatic

1. The housing bubble in Spain and Ireland which, when it inevitably

4. The implementation of austerity and structural reform in the countries

2007 2008 2009 2010 2011 2012

Greece 3.5 −0.2 −3.1 −4.9 −7.1 −6.4

Source: Adapted from OECD Economic Outlook, 2013.

Although the discussion of government deficits and debt focuses on

2006 2007 2008 2009 2010 2011

The source of the West’s “indebtedness problem”, both private and

The credit wasn’t just money, it was temptation. It offered entire

As Lewis goes on to observe in his book, people in different countries

process of economic contraction, implemented through tax hikes and

all previous form, undertook the historic economic reforms of 1990,

made a tidy profit on the difference between the interest received on

A bail out is defined as an act of giving financial assistance to save a

The future of the euro

project, which was to fundamentally and irrevocably change the economic

The housing bubble in three European countries with a strong culture

Figure 2.1 House prices in selected countries: 1997–2009 (2002 = 100)

Germany Denmark Norway Sweden Greece Ireland Italy Portugal Spain UK

Source: Authors own calculations.

summarise house price volatility in different European countries, Gini

Housing fundamentals: income and demography

Against this background, an important question is why house prices

occupied dwellings per 1,000 of the adult population in Ireland, Portugal,

Default rates fall:

Figure 2.2 The dynamic of a house price bubble

to pull away from incomes. This is precisely the dynamic of a bubble as

Housing fundamentals: finance

The easy availability of finance on favourable terms makes home

Euro Area Latvia Hungary

Figure 2.3 Central bank interest rates: annual data

Bursting the housing bubble

Ireland Spain UK Denmark

Housing downturn in Ireland: consequences

decade after 2000, land developers in Spain built hundreds of thousands

Appendix on mortgage securitisation

Loans to home buyers had the potential to profitably absorb a large

records ensured prompt and regular repayments on their mortgages –

the context of a conventional lender-borrower relationship; however,

government of an important financial institution (due to its financial

Banks and maturity transformation

Table 3.1 A stylised bank balance sheet

Cash & central bank balances Loans from other banks

to create an asset edifice the value of which is a multiple of the bank’s

1. Liquidity management: to ensure they have sufficient reserves to cover

However, banks are more than financial intermediaries. Several financial

or assets – and, in the modern world, has two components: currency

The central bank and open market operations

Central banks are concerned with money supply because they, in

Interest Rate The supply of money

The demand for money

Figure 3.1 Money market equilibrium and interest rate determination

What are bonds?

A bond is essentially a promissory note that a borrower (which could be the

Bond Price Yield to Maturity

Short-term and long-term interest rates

Bonds differ by maturity: a one-year bond can be redeemed in 12 months